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Home > Money > Budget 2007 > Personal Finance

3 things NOT to expect from a mutual fund

Amit Trivedi, | March 09, 2007 09:15 IST

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The role of a financial or investment advisor is to manage expectations of the client more than to manage the money. Time and again, clients get dissatisfied with their advisors because they started with wrong expectations. The expectations are either set very high or they are not clearly defined at all.

Never try to predict the future performance based on its past

Extrapolation of past performance is an objective process of setting expectations, but could be a landmine if not understood properly. This is one of the most popular methods of setting expectations in many client-advisor dialogues. Often, they will look at past performance of a fund or an asset category (an investment option, in short) - either only the returns or a combination of returns and risk - to put an estimate to the future performance of the scheme.

It is fair if one concludes that there is a possibility to beat inflation through investment in equity, looking at long-term performance of equity as an asset class. But if someone concludes that since equity has delivered 15 per cent p.a. for the past 20 years, it will continue to do so every single year, one is only daydreaming. Similar things can be said about individual schemes. It actually becomes more difficult to arrive at a conclusion regarding individual schemes than an asset category.

A lot of the investment advisors and investors, in 1999-2000, thought it was prudent to assume the growth rate of infotech companies in the range of around 50 per cent to 75 per cent p.a. for the foreseeable future, since the past growth of these set of companies was in excess of 100 per cent p.a. The stocks got priced with the assumption of such high growth rates. They were in for a rude shock.

If you assume the company to grow its profits at a high rate for the next 5 years, with the present EPS being Rs 50, the present value of the future profits at a discounting rate of 8 per cent would be Rs 2138 for 100 per cent p.a. growth, Rs 1276 for 75 per cent p.a. growth, Rs 920 for 70 per cent p.a. growth and Rs 735 for 50 per cent p.a. growth.

Look at the crash in valuations for a small drop in growth rate from 75 per cent p.a. to 70 per cent p.a. The prices also trace this path generally. Between 2000 and now, many infotech companies have experienced handsome growth rates, but the share prices have seen a fall.

This can only be explained if we look at the expectations at the beginning of the period under consideration. The growth in the profits, although being spectacular by any standards and much more than most sectors in the economy, has been lower than the expectations of the investors.

It might be a better idea to understand the basic characteristics of the asset class to set the expectations rather than the price movements in the recent past. Just looking at the price movements, one is likely to set wrong expectations and erect the building of long term relationship on a weak foundation.

In lighter vein, if extrapolation was the way to predict future, an 80 year old would live for another 80 years, whereas a 20 year old has another 20 years to live. Truth is far from this.

Even fund managers cannot predict market direction

A classic example of wrong expectations is what one expects from a mutual fund manager. The debate resurfaces every time the market experiences one of its regular crashes. Many investors expect the equity fund manager to exit the stock market just before the downturn starts.

Now, if one looks at the objective of an equity fund, it is supposed to be invested in stocks at all times. It is this objective, for which the investor should have invested the money with the respective fund.

The very objective of having a fund's objective is to help the investor arrive at an informed decision regarding what the fund manager intends doing. If the fund manager exits stocks, even while taking a call on the market direction, it is a deviation from the fund's objective. Taking a call on the direction of the market, on the other hand, is extremely difficult - well, almost impossible.

To quote John Bogle, the founder of Vanguard, "I don't know anyone who's ever got market timing right. In fact, I don't know anyone who knows anyone who's ever got it right."

Or as mentioned by the legendary investor Benjamin Graham, "There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he himself is a part."

What should an investor, then, expect from a mutual fund manager?

Well, the fund manager is required to invest the investors' money in line with the fund's objective. The selection of stocks is crucial. If the fund manager has done his / her job well, every single time when the market recovers from a crash, the fund's portfolio should start to recover faster than an average individual investor.

A crash in the prices of stocks is often a function of the shift in preference away from stock market or the drying up of liquidity from the markets. In such a scenario, the exiting investor does not look at the quality of the stocks, which causes even the best of the stocks also to lose.

However, it is the good quality stocks that recover the first. In the current meltdown also, the investor needs to check if the fund's portfolio consists of good quality stocks and leave the rest to the market.

Do not start your investment journey without setting any goal

If the above discussion was regarding setting up wrong expectations, there are certain investors and advisors, who started without setting any goals at all.

"Would you tell me, please, which way I ought to go from here?"
"That depends a good deal on where you want to get to," said the Cat."
- Lewis Carroll, Alice's Adventures in Wonderland

There was an investor, whose portfolio was appreciating every day, used to tell his friends: "I just don't want to go through the details of various investment options - it's too much for me. I just ask my investment advisor where to sign - no questions asked. I will check only after two-three years what happened to my investments. I am interested only in the bottom-line - the returns - not the mundane details. And I have done very well so far."

These discussions happened in early April-2006, with the Sensex soaring sky-high. So, the investor was right to be happy about the performance of his investments. But what can one understand from the said investor's approach to his investments. How can someone be so grossly lackadaisical about one's investments, which is such a serious business?

Let us visualise what would happen when the same investor were to travel to some place around 12 hours from here. Will he go to the railway station and ask the ticket clerk to give him whichever was the best train according to the ticket clerk and only check where he has reached after 12 hours - the stipulated time of travel? Will he get on board the train just because someone recommended or check where the train was going?

He has to be simply lucky in order to reach his destination. The investor in the above example also was simply lucky till the time of those discussions, but such a hands-off approach is hazardous to anyone's financial health.

The author works with a leading mutual fund company. The views expressed are personal

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