Mutual Funds – Mutual Mistakes

Money is a very strange thing–human beings make rational decisions while dealing with most aspects of life but make serious errors of judgment when it comes to dealing with money – while dealing with different aspects of money and finance including earning, protecting, budgeting, saving, spending, leveraging, investing and insuring.

Completely rational investors take totally irrational decisions when part of crowd – their own individual rational minds come down many levels to the irrational level of the crowd. Many a times, individual rational intelligent persons commit simple mistakes while making investment decisions in common stocks. And those mistakes get compounded while investing in mutual funds. Fund managers, marketers as well as the markets themselves have its own ways of finding and exploiting human weaknesses. I try to explain and explore the 10 most common mistakes which investors almost mutually commit while investing in Mutual Funds (MF).     

Mistake 1: Imagining that Low NAV is Cheap

This is one of the most silliest of mistakes which an investor commits while investing in Mutual Funds. The investor feels that a fund with a lower Net Asset Value (NAV) is cheap compared to a fund with a higher NAV. There is nothing further from truth. This mistake stems from the simple fact of a person who does not know the meaning of mutual fund. This blunder is because the investor neither understands nor appreciates the difference between price and value. A MF unit in itself has no value – it is “not” an asset like a house property, bond, equity stock, gold etc. Yes, the MF unit in itself simply has no value on its own – it derives the value from the underlying asset which it owns. The NAV is nothing but the value of the total underlying assets of the fund divided by the number of units. For example, if a fund has equity shares in different companies who current value sums upto Rs.1000 crores and has 50 crore units then its NAV is Rs.20 per unit while another fund whose current total value of equity shares is again Rs.1000 crores but has 100 crore units then its NAV amounts to Rs.10 per unit. Does it mean that the second fund with a NAV of Rs.10 per unit is cheaper than the one with Rs.20 per unit. Certainly not. This is because the total value of the assets of each fund is the same Rs.1000 crores – in the first case it is distributed among 50 crore unit holders while in the second case it is 100 crore unit holders.  

Mistake 2: Too costly or very cheap

This is a continuation of the first mistake. A MF unit can’t be costly or cheap – it is not an asset in itself which can be costly or cheap – it derives its value from the underlying investment. If the value of the underlying investment goes up then the NAV will go up and vice versa. For example, there are two funds – A and B. Now, the NAV of Fund A is Rs.10 per unit while the NAV of Fund B is Rs.50 per unit. Does this mean that Fund A is cheaper than Fund B. Not at all. The NAV simply means that Fund A is holding such assets in totality which when divided by the total number of units results in a NAV of Rs.10 and ditto computation for Fund B which results in NAV of Rs.50. Further assume, that the portfolio of both these Funds is exactly the similar. In that case, a 20% rise in the value of the portfolio will result in a commensurate 20% increase in the value of the NAV of the Funds – Rs.2 in the case of Fund A while Rs.10 in the case of Fund B. Hence, while investing in MFs don’t look at the price of the NAV but rather the underlying value which is derived from the portfolio of the Fund.

Mistake 3: Buying MF NFO at “par”

This is another derivative of the first two mistakes – an investor can’t become more foolish when he / she invests in a MF NFO simply because it is available at “par value”. As explained above, the MF NAV is meaningless in itself as it is merely the value of the underlying asset. Therefore, buying a MF unit because it is available at par value would be one of the most silliest mistake which an investor can commit with its money. Remember that MF unit is not a scarce resource – a MF can create as many units as the inflows into the fund – it has to just print the units and send it to the investor – similar to how the Government can infinitely print currency notes. The same is not true for an equity share because a company can’t just print its shares without diluting the holding of its assets.    

Mistake 4: Fancy Funds, fads and fantasies

Many new funds and schemes prop up during times of exuberance. Banking Funds will be launched when banking stocks have performed well, infrastructure funds when the infrastructure stocks are rising or IT funds when the technology boom is underway, so on and so forth. These sector funds are simply smart tactics to collect money from the gullible investors. No sector or theme continuously performs well over a longer term. Even worse than it, a sector fund is generally launched after the sector has already performed well because the fund has to show good past performance to attract fresh investor money. And by applying the “law of averages”, it becomes more likely that the sectors which have already performed well in the past will actually not perform so well in the future. Hence, never fall prey to fund gimmicks and invest in sector or theme based funds.

Mistake 5: Ignoring Index Funds

This is another very common mistake which MF investors commit – ignoring a simple low cost index fund in favour of the high cost actively managed fund. You will get these kind of advice most of the time from majority of the people that equity investments are for the experts and if you don’t know how to pick your stocks then you should entrust your money to the expert fund manger etc. However, I dare to say that these are probably one of the most useless advice which you can ever receive. Hold on, I am not saying that you don’t entrust your money to the experts and start picking your own stocks – no their may not be a bigger financial suicide than this. I just humbly submit that it’s very difficult, if not impossible, to beat the stock market indices consistently over a longer period of time. If that were not the case, then why over a periods of a decade or more, approximately 75% of all “actively” managed stock funds underperform the passively constructed stock indices. The fact of the matter is that most people have no reason whatsoever to believe that they can pick winning stocks or time the markets and their success at it would be the same as it would be like throwing darts at the financial pages. I would like to quote Dr. William Bernstein who told that “there are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know where the market is headed. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know where the market is headed”. Nothing more succinctly explains the real world of professional investing and stock picking. Mr. Merton Miller, Nobel laureate and professor of Economics of Chicago commented that “if there are 10000 people looking at the stocks and trying to pick winners, one in 10000 is going to score, by chance alone, a great coup, and that’s all that’s going on. It’s a game, it’s a chance operation, and people think they are doing something purposeful, but they’re really not”. Then I would quote Mr. Rex Sinquefield, co-author of Stocks, bonds, ills and inflation that “we all know that active management fees are high. Poor performance does not come cheap. You have to pay dearly for it”. Thus, active fund management is nothing but paying heavy fees for underperforming the passive indices! Then for the investors who are always on the look out for the next hot fund, the next great sector fund or so, Bethany McLean, columnist for Fortune magazine wrote “skepticism about past returns is crucial, the truth is, much as you may wish you could know which funds will be hot, you cant and neither can the legions of advisors and publications that claim they can. That’s why building a portfolio around index funds isn’t really settling for the average. It’s just refusing to believe in magic”. And let me further quote Mr. Jon Bogle, founder and retired CEO of the Vanguard group “Index funds eliminate the risks of individual stocks, market sectors, and manger selection. Only stock market risks remain”. In other words, when you invest in a passively managed index fund than all the risk relating to the fund manager, his / her stock selection and market timing, individual sectors etc all go and the only risk which remains is the risk of the whole stock market and that is precisely the risk which would like to expose yourself to when you invest in equities. Mr. Nicholas Taleb has written an excellent book titled “Fooled by randomness” wherein he explains the role of chance in life and in the markets and I will recommend that book to anyone who believes that he / she can consistently pick winning stocks and / or time the markets to perfection. Last but not the least I would like to jot the words of the great legendary investor Mr. Warren Buffet who once said that “most investors, both institutional and individual, will find the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to bear the net results (after fees and expenses) delivered by the great majority of investment professionals”.

The conclusion therefore is that there is no reason for you or anybody else to believe that they can pick winning stocks or time the markets. Hence, the best solution for any equity investor is to stock into low cost passively managed index funds because year after year they would beat atleast 75% of the actively managed funds and over the longer term in most probabilities beat almost all the funds.

Mistake 6: Selling Winning Funds while sticking on to the loosing ones

This is a grave mistake which people commit with MFs, equity stocks, other kind of investments as well as in many real life situations – sticking on to the loosing ones while selling the winning ones. It’s important to be realistic about investments that are performing badly including MFs. Recognizing the losers is hard because it’s also an acknowledgement of your own mistake. But, it’s important to accept and book a loss or else future loss would be even higher.   

Mistake 7: Fund Churning

This is a common advice which might be showered on you by your MF Distributor. Instead of churning your fund just churn the MF distributor who gave you that advice. Distributors love the churning game – simply because it gives them extra commissions and fees while it gives you extra income tax, expenses and most probably a sub optimal fund.

Mistake 8: Paying credence to recent past performance

A common mistake which a fund investor does is by looking at recent past performance. Past performance is certainly important but if you give too much importance to “continuous performance by looking at daily NAV” then you are inviting unnecessary worries for you in the form of selling a good fund and moving to a not so good fund, the MF churning advisors, income tax, higher commissions and other costs etc.          

Mistake 9: The Dividend Temptation

You may be advised by the MF Distributors and marketers that a fund has declared dividend and it is trading cum-dividend and therefore take the advantage of earning free dividends. But, there is no free lunch in this world – particularly not in the world of investments and mutual funds. The dividend which a fund pays to an investor is immediately reduced from the NAV of the fund. So what is the sense of the dividend when on one hand you receive the cash and on other hand your NAV falls by that much amount? On the contrary, I would say that don’t invest in a fund which has declared lofty dividends because that is against your purpose of investments –you are entrusting your money to the Fund Manager to manage it on your behalf and not to return back to you! (unless ofcouse you require regular income in the form of dividends).

Mistake 10: Not Understanding the Type of Funds

The primary purpose of MFs is to make your life simpler by investing your money on your behalf. However, actually they have made your life difficult by making available a plethora of different categories and schemes. Hence, before biting the bullet get acquainted with which category of Fund you are investing in – Equity, Fixed Income, Balanced, Commodity and within them the various sub-sets like sector, theme, gilt, income, short-term, liquid etc in which you are investing. The risk, expected return, income tax, expenses, required time horizon are immensely different in each of those categories. So don’t commit the unpardonable mistake of investing your money in a fund without actually knowing where and in which asset class it is going to deploy your money.

Market is a place which will test your patience and character. Many times you might have bought the right stock or Mutual Fund for all the right reasons at the right price but it simply refuses to go up for a long period of time – just hang on to it because the day you get frustrated and sell it off, there are chances it will then start rising. Hence, patience and character are key virtues which will be repeatedly tested by the market.

To conclude, there are many simple and avoidable mistakes which investors mutually commit while investing in mutual funds and I have tried to explain some of the most common ones of them. Kindly note, that simple logical things work far better in the market place rather than complex algorithms, theorems, valuations principles, DCF etc. And there is no other place to test your virtues than the market – be it common sense, logical thinking, patience, perseverance, mental balance, emotional intelligence, performing under stress etc. All the qualities which make a successful human being will be tested by the market –it has its own method of finding and exploiting human weaknesses. Investing is not about beating the market or anybody else, its simply beating your own self, your own negative traits and once you are able to master your own self and become a complete human being, then only you would also become a successful investor. Articulate your investment goals, know your time horizon, recognize your risk appetite, understand your need for income and growth, invest regularly although it may be in small lots, do your thinking and research and after doing it don’t panic just because the market went against you, accept your mistakes and flaws and avoid the common mutual mistakes which investors mutually commit while investing in Mutual Funds so as to embark on becoming a successful Mutual Fund investor and a complete human being.

Currency Induced Interest Cut

There is lot of expectation from the RBI about a possible cut in key interest rates in its upcoming policy. While the expectations of rate cut might be warranted keeping in mind the slowing economy and falling commodity prices, primarily oil, but we have to remember that there is another variable besides interest rate which is affecting the monetary conditions. And that is the Exchange Rate. This article does not try to predict the timing and extent of the interest rate cut; it only tries to explain the “other’ variable which affects monetary policy and the interlinkage and dependence between both of them.  

The economy is in equilibrium where the IS-LM curve meet – the relationship between interest rates and real output in the goods and services market and the money market. The intersection of the IS and LM curves is the "general equilibrium" where there is simultaneous equilibrium in both markets. Now, let us shift focus to the money markets and transmission of monetary policy on the aggregate demand (or prices or credit). We have to see which are the factors that affect the “aggregate demand” or “prices” in the economy.

The most noticeable feature of the aggregate demand curve is that it is downward sloping. There are a number of reasons for this relationship. Remember the downward sloping aggregate demand curve means that as the price level drops, the quantity of output demanded increases. Similarly, as the price level drops, the national income increases. There are three basic reasons for the downward sloping aggregate demand curve. These are Pigou's wealth effect, Keynes' interest-rate effect, and Mundell-Fleming's exchange-rate effect. These three reasons for the downward sloping aggregate demand curve are distinct, yet they work together.

The first reason for the downward slope of the aggregate demand curve is Pigou's wealth effect. Don’t forget that the nominal value of money is fixed, but the real value is dependent upon the price level. This is because for a given amount of money, a lower price level provides more purchasing power per unit of currency. When the price level falls, consumers are wealthier, a condition which induces more consumer spending. Thus, a drop in the price level induces consumers to spend more, thereby increasing the aggregate demand.

The second reason for the downward slope of the aggregate demand curve is Keynes's interest-rate effect. Recall that the quantity of money demanded is dependent upon the price level. That is, a high price level means that it takes a relatively large amount of currency to make purchases. Thus, consumers demand large quantities of currency when the price level is high. When the price level is low, consumers demand a relatively small amount of currency because it takes a relatively small amount of currency to make purchases. Thus, consumers keep larger amounts of currency in the bank. As the amount of currency in banks increases, the supply of loans increases. As the supply of loans increases, the cost of loans i.e. the interest rate decreases. Thus, a low price level induces consumers to save, which in turn drives down the interest rate. A low interest rate increases the demand for investment as the cost of investment falls with the interest rate. Thus, a drop in the price level decreases the interest rate, which increases the demand for investment and thereby increases aggregate demand.

The third reason for the downward slope of the aggregate demand curve is Mundell-Fleming's exchange-rate effect. Recall that as the price level falls the interest rate also tends to fall. When the domestic interest rate is low relative to interest rates available in foreign countries, domestic investors tend to invest in foreign countries where return on investments is higher. As domestic currency flows to foreign countries, the real exchange rate decreases because the international supply of dollars increases. A decrease in the real exchange rate has the effect of increasing net exports because domestic goods and services are relatively cheaper. Finally, an increase in net exports increases aggregate demand, as net exports is a component of aggregate demand. Thus, as the price level drops, interest rates fall, domestic investment in foreign countries increases, the real exchange rate depreciates, net exports increases, and aggregate demand increases.

There are two monetary variables which affect aggregate demand (or somebody can assume credit growth also):

a)       Domestic Interest Rates

b)       Exchange Rate

We all know that interest rates affect the aggregate demand and result in a northward or southward shift of the “demand curve” depending on whether interest rates are increased or decreased. Exchange rate also affects the “aggregate demand” at the macro level through its effect on the exports, imports and trade balance. Hence, to find the combined effect of both, interest rates and exchange rates on aggregate demand, an index needs to be created whose formula will be somewhat like this:

   Wi (Ri – Ro) + We (Et – Eo)

Wherein

t = 0 is the base period and Wi and We are the weights derived from the estimated coefficients of real interest rate and real exchange rate from the generalized aggregate demand equation. It is from this equation that it is derived that in India 58% of aggregate demand change is explained by interest rates and the remaining 42% from exchange rates. Hence, interest rates play a bigger role that exchange rates in explaining aggregate demand. And actually also that should be the case because exchange rates are also affected by domestic interest rates. It is also pertinent whether we consider the Real Effective Exchange Rate or the Nominal Effective Exchange Rate. From the application of this formula it is derived that a the 10% nominal effective exchange rate depreciation of the Indian Rupee is equivalent to 100 bps of rate cuts in terms of impacting monetary conditions.

To conclude, I am not here to speculate whether the RBI will cut rates or no and when and by what quantum. I just want to state one thing that while we may expect the RBI to cut rates but we should alongside keep in mind that a deprecating rupee has in effect resulted in what I call as the “currency induced interest cut” of a significant magnitude over the past few months.