Khota Paisa

The Risk With Mutual Funds

Posted in General by khotapaisa on November 9, 2009

Unlike common perception, mutual funds are not the silver-bullet of personal finance. They carry some inherent risks which are not apparent. I would try to list out some risks that mutual funds carry. It would help to keep it in mind during fund selection.

1. Herd Effect – Fund managers are like cattle herd. If one starts running in a direction, all will eventually follow. This is not unique to Indian fund managers. It happens everywhere. So, why are we charged annual fee (known as expense ratio) for managing our money? It makes sense to pay someone managing your money actively, in other words acting in your interest. But why should I pay someone to follow the herd? The herd metality of the fund manager also makes the fund less efficient and flexible making it more prone to market volatilities.

2. Size Matters – We tend to invest in funds which are large, assuming that large fund tend to be more stable. In contrast, large funds don’t always operate in the interest of retail investors as most of the investment of large funds comes from corporates (that too in large chunks). Let us say a big company invests a large amount of money in fund X. After sometime, they want to withdraw it. Since the amount is significant, the fund manager may have to sell investments which have long term horizon. This has adverse effect on the return for the remaining fund investors.
Another problem with size is that the large investors (corportaes) tend to influence the buying decisions of the fund manager. So, if Company X decides to put 500Cr in fund M, they fund manager will be expected to enforce his/her exposure to the shares of Company X. In simple words, I put money in your fund, you buy my shares.
Studies in U.S.A have shown that in mature markets, small to mid-sized fund outperform large fund on regular basis.

3. Fund Performance – The goal of a fund manager whould be to add value to the investor’s money. It means that the fund manager should allocate assets and manage them with long term horizon. Short-term volatilities should not influence his/her portfolio. But that is exactly what doesn’t happen. Most of the equity funds overhaul their portfolio more than once (many times) a year. The managers also take the short term fund performance as the one and only performance indicator. This is adverse effect for long term investors (real investors).

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