You could not have missed the large ads in the last two weeks, advertising 100% returns over the last year. Are they lying? Is this another scam? It is too good to be true. None of the above.
The advertised funds have indeed doubled your money over a year. And so have at least 100 other funds. No magic, it’s just that the market indices, the Sensex and the Nifty, have doubled over the last year as the Indian economy rebounds after reacting to the global slowdown. A fund would have had to do some really stupid things to give returns less than 100%—as around half the funds have actually done. You’d have been better off buying a passive fund than investing in these managed funds.
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A quick recap: A managed fund is one that actively takes market calls on stocks in an effort to outperform the index. A passive fund simply buys all the stocks in an index it chases in the same proportion as held by the index. Both index funds and exchange-traded funds (ETFs) are passive funds. So, unless the index fund manager is really challenged, as four are—they managed to underperform the index by around one percentage point—it works for investors with little time or inclination to actively manage their fund portfolio. Those looking for at least 5-10 percentage points return more than the index use managed funds with a view to earning higher return. It is to compensate the fund house for the extra work in active fund management, which means research teams and an ear to the ground.
Passive funds spend less and hence charge less. Good passive funds in India cost 50 basis points (a basis point is one-hundredth of a percentage point) in annual fees as against 1.75-2.5% in active funds. Though this difference looks small when written in percentage points, for the same return, it translates into a large difference to your portfolio. If both active and passive funds were to give a 15% annual return over 10 years and you were investing Rs5 lakh each year, the cost difference in the two (assuming 50 basis points in an ETF and 2% in an active fund) would get you Rs7 lakh less in the active fund due to higher costs, while the ETF returns just over Rs99 lakh. Which is why active funds must over-perform the benchmark index to compensate for the higher cost.
While most mature markets are moving to a pure ETF or index investing style, there is still some steam left in managed funds in India. Using a mix of an ETF plus managed funds approach is one that I use for my investments.
So while the 100% return is a good attention hook for you to look at funds in general, there are two other numbers you are looking for. One, what does the fund return over a three-, five- and 10-year period. We may not find too many schemes (though there are over 40 equity schemes that have at least 10 years of performance to show) out of the around 1,000 equity schemes in India with a 10-year history, but there are enough with a five-year pedigree. Look at the return over each time period.
The next number you are looking for is the benchmark return. Over each time period, compare what the index the fund is benchmarked against, does. If the fund has managed to keep its head over the index by at least 4-5 percentage points, it makes the cut to be shortlisted for investment. Of course, just past performance is not any guarantee that the fund will do well, but look at it more as a report card of a child seeking admission into a new school. While the past grades are no guarantee of what the child will do in the future, it is a track record of what the child has done in the past.
Retail investors like us typically come into the market at the peak of the bull run and exit at the bottom of the market. I remember urging investors through my columns and a weekly TV show to go on investing all through the second half of 2008 when markets were collapsing, to continue with their systematic investment plans in mutual funds. Nobody can catch the bottom of the market, but the crash and rebound has shown a tiny group of investors that the boring old rule actually works. A small network of friends and family are using financial planners to invest and they have a single comment today: Mutual funds work, we just have to find the right fund and go on investing.
The right fund would have given at least 100% return over the last year, as the ads say. They will also have the same track record over the past years, low expense ratios and a steady fund management team. If this looks like too much work and yet, you want the growth kicker of managed funds, use Mint’s curated portfolio of Morningstar rated 50 schemes to choose from. You can see it at livemint.com/mint50
Monika Halan works in the area of financial literacy and financial intermediation policy. She is consulting editor with Mint and can be reached at firstname.lastname@example.org.