Quite a lot of times, we hear someone saying that mutual fund investment is useless and they have lost money in it before. You might also have an experience where your mutual fund investment has backfired big time. So, are mutual funds that bad? Should you avoid them totally? Such questions are common to most of us. I have tried to analyze reasons why few mutual funds fail to deliver.
Reason 1 – Investing based on past performance
This is the primary method for selecting a mutual fund. We look at the past performance of the fund and then choose to invest in it. Nothing wrong in it. But, how long is the past that you check? There are multiple funds which have performed for 3-6 months but failed later. Consistency is what matters here. You should ideally be checking the 3 year and 5 year performances of the fund rather than for 6 months. It would tell you if the fund was able to tide over various market cycles and interest rates. The top funds have been those which withstand the downside and then performed when the time arrived. Giving time for performance of the fund is very essential especially for equity funds which usually fail in short term but have potential to perform in the long term.
(Also see: Learn the art of picking mutual funds)
Reason 2 – High fees
Mutual fund charges fees in the form of expense ratio. It’s very important to know the expenses charged from you for managing the fund. The expense ratio is used for paying management fees, commissions, advertising expenses and other costs that the fund incurs in the process of investing. Expenses could be recurring in nature which means you will have to bear them every year till you redeem the units. The expense ratio varies from fund to fund. The usual range is 0.5-2.5%. For example, if you have invested Rs. 1,00,000 and after an year returns on the fund were 10%, your investment would grow to Rs. 1,10,000. 2% expense ratio on this would mean your investment will now become Rs. 1,07,800. If you are investing for the long term, it could be a significant factor for you since lesser amount will be invested for you. For funds which give you higher returns, it may not matter much. But, if this ratio is more for conservative funds such as debt funds which deliver returns in the range of 7-8% p.a, it should be a concern. It doesn’t mean that all funds which deliver lesser expense ratio deliver great returns and funds which charge lesser ratio have performed poorly.
Reason 3 – Markets
You may have chosen the right fund with a great track record. However, one thing which is always uncertain is the market. The market here includes stock market in case of equity funds as well as interest rate market for debt funds. If you have been into investing, you might understand this better. You must have seen recession, interest rate hikes, etc. All of these dent your mutual fund investment. Even the best of best funds have taken a hit in tough times. Some of them have recovered as there was value in those funds. One thing which you should always avoid is timing the markets. The more you try to time it, the more you lose. Of course, losing or winning in mutual funds depends on the fund managers timing the markets. It’s their job to do so. If you believe that you have got the fundamentals right in picking a fund, you should not worry about short term ups and downs of the market. Have patience.
Reason 4 – Choosing wrong type of fund
Choosing the right type of fund is as important as choosing the one with the best performance. Some define types of funds as active and passive. Some say there are equity and debt funds. These can be sub-categorized further too. Whatever be the categories and sub categories, you must be picking the fund which suits you. Just because you are conservative, there is no point investing in a short term debt fund which invests in securities of 30-90 days for your child’s education 18 years away. You should be looking at an equity fund such as large cap or small/mid cap. In the same way, you should not be investing a top mid cap fund for a goal such as buying a car after 6 months. I suppose you know this logic. But, what’s important is that you have to implement it. For this, you need to invest based on goals and not randomly.
Reason 5 – Fund Manager
This could be the significant reason behind failure of the fund. A fund manager is the backbone of a fund. He/she is responsible for the fund’s success or failure. Stock picking, timing the markets, predicting the interest rate movement, etc are usually handled by the fund manager. Usually, the best funds have been those where it had great fund managers who performed consistently for it. Prashant Jain is a great example for this. He has been with HDFC top 200 fund since 2002 and did an excellent job for the fund. Frequent change of fund managers may be a danger signal for you. Though it is difficult for a common man to monitor the fund manager’s performance, it could be worth having a glance at the past performance and credibility of the fund manager.
Reason 6 – Size of fund
Some call it AUM, some call it size. It is the amount that a fund manages. Does it matter to you how much corpus a fund manages? It may not affect you much. But, if you are looking to redeem a fund within few months of investing, a small sized fund may or may not allow you to do it. There have been cases where funds have had liquidity crunch and investors had to wait to redeem units. This may not happen in a large sized fund as lots of money flows into them.
Reason 7 – Taxability
The final reason would be taxation of your mutual fund. Let’s see how mutual funds are taxed at redemption. Equity funds held for less than 1 year before redemption are taxed at 15% but are tax free if held for more than 1 year. Debt funds held for less than 1 year are taxed as per tax slab but taxed at 10% flat or 20% with indexation if redeemed after 1 year. Also, DDT (dividend distribution tax) applies only for debt funds and not equity funds. It would affect the NAV of the fund indirectly. All these erode the returns you gain on the fund. The tax rules encourage you to invest longer in mutual funds and not trade frequently.
I have quoted some of the reasons why mutual funds usually fail to perform. There may be lot more reasons for bad performance of a mutual fund. Do think of these before investing in a mutual fund and even after investing in it. There have been multiple cases where investors did not consider these reasons and then go against mutual funds as a whole. Remember, mutual fund investments are subject to market risks.