One of Our Youtube Videos titled ‘The Truth about the Mutual Fund Industry’ released more than an year back on October 2017, garnered a lot of views and a lot of staunch criticism. Our Point of View that in the Long run (over 15-20 years), Actively Managed Mutual funds by taking 1-2% cannot (and have NOT) beat the market and that the less than 2% Mutual fund schemes which DO BEAT the market over 20 year periods are impossible to know before hand. Given such terrible odds, a know-nothing investor is better off investing in Index Funds.
In one of the Youtube Comments, a Gentlemen had raised a question “about alpha returns generated by the fund managers especially Prashant jain, Nilesh shah and Anup Maheshwari even after taking into account the expense ratio for doing their homework….& have beaten your benchmark Sensex by a wide margin of at least 5 percent CAGR over 20 years . Expecting your reply on this”
The above argument is valid in that it is TRUE that a very select group of managers have outperformed the market over 20 year periods BUT we cannot conclude from the above premise that, because a few managers have beaten the index, a Common Investor will profit by Investing in Mutual Funds as a whole.
The above conclusion is akin to saying, “3 people made a Billion dollars by betting in Las Vegas, therefore, Everybody should go to Las Vegas and spend their hard earned money on Gambling”
Regardless, our intention behind the video was to give a clear message to our viewers – MUTUAL FUNDS AS A WHOLE CANNOT BEAT THE MARKET AVERAGE OVER THE LONG TERM.
The reasoning as to WHY we believe so has been covered in our latest 6 video series – Mutual Funds Vs Index Funds also along with the Explanations given below.
Mr. Varun Malhotra’s answer to the above query went as follows :
“Sir, I would suggest you to read about efficient Market hypothesis. What it basically says is if you are on a very crowded street and you see a lot of 2000 rupee notes, don’t waste your time to pick them, because in all likelihood people would have picked them up and have left them only because the remaining ones are fake. In a efficient market the moment people see a 2000 rupee note they would just grab it up in seconds. that is the reason you don’t find 500 and 2000 rupee notes on the streets.
Similarly investing in market can also be thought to be an efficient market (though Warren Buffett followers don’t believe that it is completely true, but advice Retail investors to invest assuming markets are efficient- will answer at the end why) so in markets there are number of players (all MF managers , foreign Institutional investors, big retail investors, etc) looking for, say hidden gems that will deliver higher returns than the index.
Now when so many people who are skilled enough to find such stocks (Think : notes on floor) are constantly trying to find such stocks (notes), efficient market says that it would be irrational to assume that only YOUR mutual fund manager out of other 1000’s will be able to find them. Say, I tell people that there are 4 diamonds worth a crore each in our Delhi Seminar auditorium, and there are thousands of people in the auditorium, who do you think will find the diamonds?
Somebody will for sure, but it would not be decided based on their skill but their luck because thousands of people have the skill. So the efficient market hypothesis says that though somebody will definitely find hidden gems that will beat the index, but this will not be because of their skill, but rather because of sheer good luck. This has been proved by a number of experiments.
In the year 1973 Princeton University professor, Burton Malkiel claimed in his bestselling book, A Random Walk Down Wall Street, that “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” (Read experts = Investment Professionals/Fund Managers).
In 1975 Index funds were launched by John C Bogle, the father of index investing. Index funds did not gain lot of popularity initially even in the USA and the index was often ridiculed because everybody believed that smart, well paid and highly educated investment professionals SHOULD beat the market. Many years later, Warren Buffett came into the debate and his quote ” a know nothing Investor by periodically investing in the index fund, will be able to beat most of the investment professionals” is reflective of his point of view about active Mutual funds.
Warren Buffet went even further and to prove his point, he made a million dollar bet with high fees charging hedge funds, betting that they would not be able to beat the unmanaged and boring index.
The bet started in 2008 , and Buffett has won the bet very convincingly. S&P was up by 85.4% and hedge fund average was 22% till 2016 (cumulative Return).
Please read the link below. https://www.investopedia.com/articles/investing/030916/buffetts-bet-hedge-funds-year-eight-brka-brkb.asp to read about Warren Buffett’s bet with Protege Partners.
To explain it further, if the economy is growing by about 15% p.a (8% real growth + 6% inflation + 1-2% Dividend), is it possible that the aggregate return of Mutual funds can be more than that? If that is possible it would mean that Prime Minister should just allocate money to some MF rather than building ports, highways etc.
We must Remember that it is the industry which generates returns, Mutual funds just act a medium to transfer that return to retail investors. But if these funds/managers are between you and the industry and charge say 2% for transferring those returns, let us understand the effect on your portfolio.
Somebody investing 500 INR for 40 yrs every month compounded at 16% pa. would have an accumulated amount of 2.15 cr. and if the return goes lower by 2% because of the Mutual fund in between the same 500 for 40 yrs every month compounded at 14% pa, the accumulated amount would be 1.11 cr only!!!!
So warren Buffett says billions of dollars are being wasted because people invest through managers. And if you believe in efficient market hypothesis , probability that you, me, your fund manager or a monkey would beat the markets is the same, so why not save that 2% by just investing in a low cost index fund , where the charges (expense ratios) are as low as 0.1%?
Now the question is when most of the mutual funds in india are able to beat the index why invest in index funds.
1) Mutual funds quiet surprisingly compare their performance to Nifty returns and not nifty total return index. Total return index includes the dividends declared by the companies, whereas Nifty that you see on TV channels is without dividend. From Feb 2018 , SEBI has asked everybody to show their performance in comparison to Total return index (TRI). Dividend income of 1.5% or more which would vary from index to index will actually give a better picture.
2) Survivorship Bias: Say there are 500 people in a room and I ask them to toss a coin and get heads. 250 people Should be able to get Heads. Do you think these 250 people are skilful or lucky? Similarly if one MF beats the index by increasing allocation to certain stocks, there have to be losers. If total return is say 14- 16% of Nifty but if telecom industry grows by 20% and Bharti Airtel grows by 25%, there has to be player in the industry which grows slower than the avg. and in the process of trying to find the winners you might not only end up paying more fees but also land up in a MF that underperforms the index, and since you now understand that cost of losing 2%, you can understand the effect it has on your Portfolio.
Now if I ask the losers in the coin flipping contest to leave the room and ask the winners (250 people) to get a tail next time, Again 125 should be able to do that and if I keep on pushing out the people who lose I would be left with only winners – this is known as survivorship bias. The funds that are able to beat the index, survive, but which don’t do well they are either merged closed, so their under performance cannot be measured.
3) Adding Midcap stocks to the fund and still keeping benchmark as Nifty. Junior nifty has been able to beat nifty, that does NOT mean junior is better. So sometimes wrong benchmarks also create confusion. Finally you can check on websites like value research – Nifty bees, a fund that replicates Nifty.
Nifty Bees rank in the funds which fall under this category in 1 year 56/182 ( if you wanted to beat 120 + MF managers in the category out 180 all you had to do was buy Nifty, that’s why warren Buffett says when the dumb money, accepts it is dumb, it ceases to be dumb. Think of a class of top MF managers and if by buying nifty your rank is 56, thats great by any standard, that too without knowing anything about investing and if you try to find the better 55 funds, you might end up holding the worst fund.
3 yr – 92/162
5 yr – 95/151
10 yr – 27/52
Did you notice the funds for comparison in 10 yrs are only 52, whereas in last 1 year it is 182. That is survivorship bias. also funds which were once the best don’t remain the best since the ranks keep on changing. So warren Buffett suggests, if you get average return (Nifty) for a long period of time the result is above average. Also check return of junior Nifty and its rank in its category. You would be surprised to see the results.”
Thanks for reading
Varun Malhotra & EIFS Team