Three mistakes in mutual fund selection

“All I want to know is where I’m going to die so I’ll never go there.”

Charlie Munger often uses this anonymous quote to explain his mental model of inversions.

Inversion is the idea that to solve a problem sometimes you can find the solution easier if you think about how not to solve the problem. The key idea is that if you are stuck, you can flip the problem on its head and figure out what not to do.

With more than 2,500 mutual fund schemes available in India, suitable funds selection can be a tricky task. Right mutual fund selection is indeed very important for overall portfolio health. Applying the mental model of inversion, it can be much easier and quite rewarding to know what mistakes to avoid in fund selection.

Fund return vs Investor returns

A study carried out by Axis Mutual Fund spanning 16 years from 2003 to 2019 showed that investor returns and fund returns can be significantly different. According to the study, over this period:

• Equity funds delivered a CAGR of 18.8% but investor returns were just 12.5%

• Hybrid funds delivered returns of 13.2% compared to investor returns of just 9.3%

• With respect to debt funds, the gap was narrower at 7.8% for the funds and 7.4% for investors

A difference of more than 6% in returns is quite substantial. Over a period of 20 years, the portfolio becomes 2.8x times bigger with 6% higher returns.

What impacts investor returns?

Lower investor returns via-vis fund returns mean that investors stay invested in a particular scheme during its underperformance period but miss the high-performance period of the same scheme. How investors are able to accomplish such an unfortunate feat on a year-on-year basis?

The reason is “improper way of fund selection by investors”.

Let’s see the three most common mistakes committed by investors in fund selection.

1. Fund selection based on last one year/quarter performance

Instead of doing a comprehensive assessment of mutual funds, many investors simply choose funds that yielded the highest returns in the previous period. Investors use this as a “Common Senses” approach for good decision-making. As in most fields, typically a past performance is a handy indicator of expected future performance. Such as

• A student scoring good marks in 10th standard has high probability of scoring goods marks in 12th standard also.

• A batman scoring lot of runs in a series has high probability of repeating such performance in a subsequent series.

• Top salesman of last year has high probability of giving good performance next year again.

Investors use the same logic in fund selection. But due to the volatile and cyclic nature of markets, this is not a very effective strategy for investing.

Let’s consider the last 5 years’ performance of Large Cap funds to understand this.

It is quite evident from this data that the top-performing funds in a year are not repeating their performance in the next year. In fact, in many cases, funds in the top-5 in one year are in the bottom-5 next year. Any investor switching funds solely based on the past year’s returns will have very poor performance over this 5-year period.

In Equity markets, no strategy or investing style performs all the time. Hence, judging performance solely based on the past year’s data is bound to result in sub-optimal decisions.

The fund needs to be given adequate time to let the strategy play out and generate adequate returns.

2. Buying lower NAV funds

Investors who do not understand how NAV is calculated for mutual funds again use their “Common Sense” to arrive at the conclusion that a lower NAV means the fund is available at a cheap price. Instead of educating investors about this mistake, mutual fund distributors exploit this misunderstanding to push New Fund Offers (NFO). No wonder one of the main sales pitches for NFOs is “it is available only at Rs. 10“.

Actually, NAV is a totally irrelevant data point for assessing the valuation of any mutual fund. Let’s understand this with an example:

There are two funds, Fund A and Fund B.

	Fund A	Fund B
NAV (In Rs.)	10	100
Number of o/s units	10 Cr	2 Cr
Fund AUM	100 Cr	200 Cr

Let us consider a fresh investment of Rs 1 Cr in each of the funds.

	Fund A	Fund B
NAV value in Rs	10	100
Number of existing units o/s	10 Cr	2 Cr
Number of new units issued	10 Lakhs	1 Lakh
Total number of units – post 1 Cr fresh investment	10.1 Cr	2.01 Cr
Total AUM – post 1 Cr fresh investment	101 Cr	201 Cr

Both funds will use this incremental 1 Cr to buy more shares of the same five companies.

We can see that 1 Cr investment results in the same exposure in underlying company shares for both funds. Post these investments, the total portfolio of the funds will look like this:

There is a common misconception that increase of NAV from 10 to 11 is much easier compared to an increase from 100 to 110. The logic used for this is, in the first case NAV needs to increase only by Rs. 1 and in the second case, it needs to be increased by Rs. 10.

This understanding is not correct. Let’s see.

Continuing with our earlier example. For simplicity’s sake, let us assume each investee company’s share price increased by 10% in 12 months.

	Current Price	Price after 12 months
Company 1	100	110
Company 2	50	55
Company 3	200	220
Company 4	400	440
Company 5	1,000	1,100

This increase in investee companies’ share prices will result in an increase in NAV of both the funds. By how much, let’s calculate.

NAV value after 12 months:

	Fund A	Fund B
Total No of units (1)	10.1 Cr	2.01 Cr
Total AUM (2)	111.1 Cr	221.1 Cr
NAV in Rs. (2)/(1)	11	110
% in NAV in 12 months	10%	10%

We can see that a 10% increase in the underlying portfolio will result in a 10% increase in NAV of each of the funds. The absolute value of NAV whether it is 10 or 100 will have no bearing on this.

Since NAV of all the funds at the time of NFO is fixed at Rs. 10 in India. Lower NAV can mean two things (1) either the fund is very new (2) Or the fund is continuously underperforming for long periods of time.

Next time if your advisor talks about the low NAV as a good reason to buy funds. Either that is pure mis-selling or a lack of understanding on the advisor’s part. Both are good enough reasons to stay away from such an advisor and his recommendations.

Both are not good reasons for selecting the fund.

3. Frequent churning

We have already discussed, why it makes sense to avoid frequent churning of funds purely based on recent performance.

There is something else that makes the frequent churning of funds even more disastrous.

Tax implications.

For equity mutual funds, long-term capital gain i.e., for holding period more than 12 months is 10% (plus applicable surcharge and cess), and short-term capital gain i.e., for holding period less than 12 months is 15% (plus applicable surcharge and cess).

Let us consider two scenarios. In the first case, the investor switches to a new fund on a half-yearly basis. This will have STCG implications every time such switching is done. In the second case, the investor holds the same fund for 10 years and sells only at the end of 10 years, incurring LTCG at that time.

In 10 years, the portfolio values of these two scenarios will be as follows:

Over a period of 10 years, with the same level of returns by funds, starting investment of Rs. 1 Cr will have a difference of 54.8 lakhs in portfolio values in two different approaches. The difference is only on account of taxes.

Avoiding these three mistakes can result in vastly improved performance of mutual fund portfolios.