When Retail Investors Sour On Mutual Funds, Where Do They Go?

If a vast number of investors do lose faith in mutual funds as a tool of wealth creation, where would they invest their money?

Train tracks are seen on Amtrak’s northeast corridor line. (Photographer: Andrew Harrer/Bloomberg)
Train tracks are seen on Amtrak’s northeast corridor line. (Photographer: Andrew Harrer/Bloomberg)

We often see the law of unintended consequences at play in the fields of public policy and regulation. Simply put, it is a series of unseen and unexpected events that occur as a result of addressing an issue that is seen and apparent. Sometimes these consequences could be unfortunate with far-reaching negative effects.

I am reminded of this because I hear a growing buzz against mutual funds as an investment vehicle. Some of this is stemming from frustrated investors who were expecting double-digit annualized returns. The bigger worry is that part of this refrain comes from voices that reflect a general loss of trust.

That prompts one to ask... if a vast number of investors do end up losing faith in mutual funds as a tool of wealth creation, where would they invest their money? When high net-worth individuals are vulnerable to every trick in town, what are smaller investors expected to do?

Here are two questions every investor should ask themselves:

  1. Are your expectations from equities in the right place? How can you find out if that is so or not, and why?
  2. Has anyone been filling your head with fairy tales, pushing you to get greedy – away from what the truth about a fair return is?

The evil in the world almost always comes of ignorance, and good intentions may do as much harm as malevolence if they lack understanding.

– Albert Camus

When we expect more than the risk-free rate available, we have implicitly agreed to take on risk. The go-to product for a no-risk investor (or saver) is fixed deposits. We took an average of the post-tax SBI fixed deposit rates over the last 10 years. The number is 5.3%, assuming the highest tax bracket.

Would it be fair to say that equities should earn 2% more than this on a compounded basis? Okay, let’s say 3% more on a compounded basis. 4% would be a stretch unless you are in riskier funds and can live through multiple years of possible disappointment in this long journey. Even that would give us a 9% compound annual growth rate or CAGR.

If your money grows at 9% post-tax, in 10 years, it would grow (1+9%)^10 = 2.367 times approximately.

Here is what you should expect for high single-digit CAGRs.

Do you say you could have done better? Well, compounding happens when you are able to reinvest the returns you make at a steady percentage. That is why your EPF compounds – it earns interest on interest. You could make some superlative gains in your investments in a given year but can you be sure of reinvesting the money at that same rate? Do those calls go right every time?

I have done this calculation for many clients. Portfolios as a whole, do not grow at even a 5% compounded rate. This is because we do not always reinvest in a timely way; sometimes portions of our capital are lost due to bad investments, sometimes trading yields poor results.

If your whole portfolio compounded at even a high single-digit number you would be much richer than you imagined.

This brings us to three recent beliefs about mutual funds, that need to be cleared up.

1. ‘SIPping Is Useless’

A systematic investment plan is just a method of investing periodically like a recurring deposit is. It was made to make your investing routine easier. You could go on and invest unsystematically if you think you are smarter than the best ‘default’ ever created.

It is likely that the issue is not with the method, it is with the underlying instrument.

2. ‘All Mutual Funds Are Bad’

Given recent events, investors can’t be blamed for feeling this way. And there will be more accidents. Try indexing if you do not like active fund managers. At the very least, make your core portfolio with index funds.

Index funds that track the Nifty, have returned a CAGR of a high single-digits. Here is some data on SIPs on a 10-year monthly rolling basis.

If you remain disappointed with these numbers, you need to see if you have been subjected to lies and misreporting at some point in time. Did someone tell you you to expect 20% annual returns from your investments?

3. ‘Let’s Pick Stocks Instead’

Most rookie investors who naively set out to jump right into the deep end tend to eat humble pie soon enough. I don’t doubt anyone’s stock-picking skills, but the ability to compound continuously. Interest on interest, don’t forget, is not child’s play.

What could be the unintended consequences?

If you book losses at some time that look significantly large in the absolute sense – let us say you lost 20% (Rs 2 lakh of your Rs 10 lakh corpus), you will want to take on higher risks to make up for the loss. This may expose you to a spiral of taking greater and greater risks. Many of us know at least one person who has lost their fortune trying to deal in derivatives or penny stocks. Stories of suicides are not uncommon as well – unintended consequences can be fatal.

Anyone who has a well-managed portfolio and has held it for a few years already knows the value of compounding. They would not claim that compounding at 9% is a bad deal. It is only those who have neither invested nor managed a portfolio, who tend to make such remarks. Advice is free, the unintended outcome is costly.

Lest my friends in the mutual fund industry think that I see no flaw in them, let me clarify that we are approaching a moment of reckoning for mutual fund managers. We need you to perform. If you do not—and even index funds are ignored because they are not being recommended enough—an entire generation of young investors will try to trade on their own. The success stories will be discussed. The failure stories will be buried. That can’t end well.

The next article will analyse the landscape for high net-worth individual investors.

Abaneeta Chakraborty has close to two decades of experience in managing money for ultra-HNI families, and founded Abanwill Consultants LLP in 2017 to provide independent views on investing. She is also Visiting Faculty at Praxis Business School.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.