Does Equity-Dedicated Mutual Fund Investment Beat Inflation In The Long Run?

Does Equity-Dedicated Mutual Fund Investment Beat Inflation In The Long Run? 

Equity dedicated mutual funds find popular favour among investors while building and managing their investment portfolios. Particularly investors lacking knowledge and understanding of directly picking stocks, they prefer to invest through mutual funds to add an equities component in their portfolios. An AMFI BCG report suggests that the mutual fund industry could attain an AUM of Rs.100 lakh crore and 10 crore customers by the year 2025. As of September 2019, assets managed by the Indian mutual fund industry stood at Rs.25.60 lakh crore as against Rs. 24.31 lakh crore a year back, which is a growth of 5.31 per cent over the previous year. Although these figures look sizable, we need to view them relatively, to get a better perspective. India ranks 7th in the world on GDP, but the country's mutual fund AUMs rank at 17. So, in a country with a population of ~130 crore people, only about 2 per cent invest in mutual funds. This does not match with other developed nations, where a larger proportion of their populations are invested in mutual funds. In India, equity-oriented mutual funds (which includes equity and equity-oriented hybrid funds) account for 42.1 per cent of the overall industry assets (which comes to around Rs. 10.78 lakh crore) as on September 2019. Said that, it is interesting to know that 68 per cent of the individual investor assets are in equityoriented mutual funds. 

Many investment facilitators and intermediaries including stock brokers, insurance agents and mutual fund distributors driven by the intent to earn higher commissions, often create a rosy picture about investment products, which may not exactly be true. Commonly, when suggesting avenues to meet your long-term financial objectives, investment advisors fail to factor in inflation while determining estimated returns from investments. Financial planning is about how much money you would need to attain your goals at a future date with due consideration to the inflation factor and make investment decisions accordingly. 

Why to account for inflation? 

Inflation reduces your purchasing power. You would be able to consume less with the same amount of money at a future date than in the present due to increase in prices. Simply put, inflation is nothing but increase in prices of things over time across the broader economy. If a movie ticket cost Rs.100 earlier but Rs.300 now, then it reflects a 200 per cent rise in its price in absolute terms. Further, if the income stays constant, then you would be able to save less given the increase in prices, despite there being no increase in your consumption. So, inflation directly affects your purchasing power and cuts down your savings and investment allocations if there isn't a commensurate increase in your income. 

What is personal inflation? 

As previously mentioned, people usually don’t adequately factor in the “correct” inflation while financial planning. What's “correct” inflation? Its answer lies in the concept of Personal inflation. People usually consider general inflation while planning their finances. But it is pertinent that you account for subjective cases like extension of the family and other aspects that are subjective to you. Let’s understand this with the help of an example. Say, presently you are single. So, your expenses on food, home, medical, etc. would be commensurate to you being single. However, your expenses will increase when you get married and have kids in the future. So, while planning your finances to attain future goals, factoring in general inflation in your estimated portfolio size calculations will not meet the purpose. Incorporating personal inflation into the calculations would be necessary to plan your finances more accurately. 

Beating inflation by investing in equity mutual funds 

Equity as an asset class can potentially beat inflation. Let us look at the performance of equities over a longer period. 

So, as we can see, the performance of equities gauging by Sensex returns, has been convincingly beating the general inflation over the longer term. We have assumed general inflation to be 7 per cent. However, personal inflation matters more than general inflation. So, now let’s see whether Sensex is able to beat personal inflation of 9 per cent and 12 per cent over a 15-year time period. 

As we can see, the broader market (Sensex) is able to beat even personal inflation of 9 per cent and 12 per cent over a 15-year period. However, as an investor, you typically wouldn't confine your equity investments to an index (Sensex) fund, but would also explore large cap, mid cap, small cap and multi cap funds and also thematic funds probably, depending on your profile. So, it is quite possible that your equity MF portfolio would outperform personal inflation by an even higher magnitude than that depicted by the Sensex. 

Large Cap Funds 

The above graphs suggest that the best performing fund is easily able to beat the general inflation of 7 per cent as well as personal inflation at 9 per cent and 12 per cent. On the other hand, the worst performing fund fails to counter inflation. Also, investments in large cap oriented MFs should preferably be held for a longer term from the viewpoint of negating the impact of inflation. 

Mid Cap Funds

In case of mid cap funds, we can see that not just the best performing but even the worst performing fund is able to beat general inflation, and personal inflation at 9 per cent as well as 12 per cent over the longer term. However, the interesting thing to notice here is that the best as well as worst performing funds took around 6 years to beat inflation by a considerable margin. We can also see that in the shorter term the objective to beat inflation couldn't be fulfilled. So, as in the case of large cap funds, investments in mid cap funds too need to be held for a longer period to meet the objective of negating the impact of inflation. 

Small Cap Funds

Like mid cap funds, even the small cap funds, the best as well as the worst performing ones, are able to beat general as well as personal inflation of 9 per cent and 12 per cent. Also, investments in small cap funds take 6 to 7 years to beat inflation. 

Conclusion 

Our study clearly indicates that returns provided by the equity mutual funds on an average are able to beat general inflation at 7 per cent and personal inflation at 9 per cent as well as 12 per cent. However, if invested in the worst performing large cap fund, you wouldn't be able to beat inflation even in the long term while this doesn't hold true for investments in mid cap and small cap funds. So, when having a large cap bias, it is better to invest part of the allocation in large cap funds and the remaining in index funds or ETFs (Exchange Traded Funds) dedicated to large cap stocks. This will better meet the purpose. Finally, the right approach would be to build a portfolio that best suits your risk and return profile as well as your investment time horizon.