Improving your MF Performance

There are many reasons why despite making some good investments as per your own judgement, the mutual funds that you have invested in may not seem to be generating returns on expected lines. The article takes a deeper look at why a portfolio may turn into a fizzled out affair.

Ramesh Babu, a resident of Hyderabad, is an IT professional and enthusiast investor who keeps on investing in mutual fund schemes based on his own research. He has invested in various funds both as a lump sum as well as through SIP and has been investing for more than five years now. With the boom in the IT sector and better salary and bonuses, he has increased his investment amount since the markets are also generating better results. But he is worried about the performance of his portfolio. He has been watching funds generating returns in double digits but his portfolio has not been reflecting the same returns. It is especially a few funds that are spoiling the overall performance of his portfolio. The bad part is that these are the funds he was more confident about. As for example, Aditya Birla Sun Life MNC Fund is one of such funds that had an impeccable record of generating superior returns. Ramesh started investing in this fund from March 2017 looking at its strong returns of the previous five years. For the five years ending March 2017, the fund has generated XIRR of 21.17 per cent. So, every monthly investment of ₹5,000 started in the month of March 2012 in this fund would have become ₹5,05,845.75 by the end of March 2017. Now, the problem is that every ₹5,000 investment since the start of March 2017 till now has generated ₹3,53,281.20, giving XIRR of a mere 6.52 per cent.

One of his friends had also recommended him to diversify his investment beyond domestic boundaries and hence he invested in a fund called PGIM India Emerging Markets Equity Fund which invests in the units of PGIM Jennison Emerging Markets Equity Fund that invests primarily in equity and equity-related securities of companies located in or otherwise economically tied to emerging markets countries. He started a SIP of ₹10,000 in the fund in the month of January 2019. It is now more than three years and he has invested about ₹3.9 lakhs, which is currently only worth ₹3.6 lakhs, giving him a negative XIRR of 4.76 per cent.

Non-Performance of MFs
This is a predicament not limited only to Ramesh Babu. There are many investors like him who are wondering why their portfolio is not generating returns that business news channels and newspapers are talking about. Some of their investments are not even able to beat the inflation rate now. 

Judging on Past Performance
One of the prime reasons is that investments are often based on past performance. This is one of the biggest mistakes that lead to sub-optimal returns for investors in future. They pick up one of the best performing funds and start expecting that the same performance level would continue going ahead. No fund has performed well forever over long periods of time. Even the best of the funds go through zenith and nadir.The past performance of a mutual fund does give us a fair idea of how efficient the fund manager was in picking up the right stocks at the right time. But that was in the past. There is no guarantee that the fund will repeat its past performance in the future too. We already saw an example earlier how some of the funds with great history in terms of returns have let down its investors. The following example will strengthen the argument.

For example, if someone would have picked Nippon India ETF Hang Seng BeES fund at the start of 2018, looking at its last five-year performance, he or she would actually have lost the capital amount in the last four years ending 2021. Another way in which investors lose the opportunity to earn better returns is by overlooking funds that are not performing well currently. For example, DSP World Mining Fund Growth generated XIRR of negative 3.6 per cent for five years ending December 2016. In the following five years the same fund generated XIRR of around 20 per cent. Similarly, Quant Small Cap Fund Growth had given XIRR of a mere 9.57 per cent in the five years ending 2017. In the following five years it gave XIRR of 37.9 per cent.

Hence, investing mostly based on past performance is like driving your car by looking into the rear view mirror instead of the windshield. In such cases, the chance of meeting with an accident is higher.

Investing Without Proper Asset Allocation
In Ramesh Babu’s portfolio, not all the funds are duds. There are funds that are doing exceptionally well. However, the weightage of such funds is too low to impact returns of the overall portfolio in a meaningful way. Being an IT professional, he had an insider view on the IT sector and invested in ICICI Prudential Technology Fund.Nonetheless, he had invested less than 5 per cent of his portfolio into the fund and it was not enough to move the needle, though it has doubled from the time he invested in the fund. Besides, a bird’s eye view of his portfolio shows that his portfolio is concentrated and tilted towards equities. More than 90 per cent of his portfolio is invested into equities. Till October 2021, his portfolio was doing reasonably fine.

However, once volatility increased in the equity market, his investments return turned from bad to worse. Higher volatility was first due to higher inflation and a likely increase in interest rate and later on due to the war between Russia and Ukraine. Most of his investments are generating average returns even after having remained invested for years. Analysing the performance of equity mutual funds since the start of the year shows that out of 578 funds, only 36 funds have generated positive returns. Most of these funds are dedicated towards commodity or based on the PSU theme. For example, HSBC Brazil Fund has generated return of eye-popping 35.92 per cent in the last three months. Similarly, Bharat 22 ETF generated return to the tune of 8 per cent. On the other hand, funds dedicated to debt have shown resilience and not fallen, generating average return of 0.82 per cent.

It has been well-documented and researched that in the long run it is asset allocation that plays a vital role in determining the overall portfolio returns. Appropriate asset allocation based on one’s risk appetite prevents an investor from getting affected by the recency bias or short-term performance and at the same time investors can take wise decisions and reap benefits from opportunities provided by the market. This is specifically true for mutual funds that are goal-oriented instruments. Asset allocation is the practice of spreading one’s investment across multiple major asset classes. The objective of doing this is to have control over both expected returns as well as the expected risk to the portfolio. This can be achieved by mixing uncorrelated asset classes in various combinations. Uncorrelated assets imply having two assets that behave differently under the same market conditions. 

In the current situation, gold is performing better than many other asset classes. Thus, having gold and debt along with equities in a portfolio makes the investment curve smoother. One of the reasons of lower returns of Ramesh Babu’s portfolio is his concentrated portfolio. It’s not only asset classes but one may need to diversify within the asset classes also. Exposure to any single asset or even one theme exposes investors to greater risk and leaves the portfolio vulnerable to any untoward events. The point is that diversification should be applicable to all aspects of investing. Within domestic fund allocation also one must diversify as far as possible. Investors can look for style diversification and perhaps look for schemes with low overlap with peers to achieve their objectives

Untimely Exit or Stopping of SIPs
Another problem with Ramesh Babu is that he is impatient in terms of his investment made through SIP. At the first sign of volatility he starts exiting from his SIP investments. He wants to contain his losses. He needs to understand that SIPs are not pure equities where cutting your losses may be one of the best ideas. Experts say a SIP delivers its best results over a longer period of time. It is critical that investors do not get swayed by volatility in the interim. The power of compounding plays out more effectively when the SIP is retained over a reasonable period of time. SIPs help rationalise investing so that one doesn’t end up over-investing at peak prices and ensures that one invests more when the prices are subdued—also known as rupee cost averaging. 

The trend that we have observed historically is that inflows into equity mutual funds increase during the peak of the equity markets and fall when the markets fall. Historically we have seen that 70 per cent of inflows into equity mutual funds happen when the markets are over-valued, around 30 per cent when the markets are fairly valued, while negligible flows come in when the markets are undervalued. We saw this happening in FY21. The mutual fund SIP contribution had increased steadily over the years. From ₹43,921 crore collected in 2016-17, ₹67,190 crore in 2017-18, ₹92,693 crore in 2018-19, the SIP contribution hit the ₹1 lakh crore mark in 2019-20. Nonetheless, collection through SIP declined in FY21 and came below ₹1 lakh crore (₹96,080 crore) due to a crash in the market and other factors related to the pandemic

SIP inflows for the month of March 2020 were at ₹8,641 crore, which kept on declining as the month progressed and decreased for 11 consecutive months before it could breach the previous highs. Ramesh had started his investment in Quant Small Cap Fund in 2017. He started a monthly SIP of ₹5,000, which means he had invested ₹1.95 lakhs by March 2020. As he saw the market relentlessly falling in the last quarter of FY20, he redeemed his investments from the fund. The total value of his investment was at ₹1.23 lakhs, giving him a pathetic XIRR of negative 26.81 per cent. Now, consider a situation where he would have continued his investment till date. The return scenario would have been diametrically opposite. His investment till date in the fund would have been ₹3.15 lakhs, which is worth ₹7.5 lakhs, now giving XIRR of 33.77 per cent. SIP returns improve significantly with rise in the market and increased investment duration.

The reason for such difference in returns is because he would have got more units at a lower price as the market was fallingand as the market rose these units would have generated superior returns, thus lifting the overall performance of the fund and portfolio. Staying invested through SIPs will bear fruit over the long term. Perhaps, it is best to ignore short-term results, given the unprecedented volatility currently. Investing without a goal is like a car without a steering wheel and unfortunately most people invest without proper planning. A goal-based investment plan helps investors to decide on the right asset allocation required for the portfolio.

Choosing Dividend Option of MF for Regular Cash Flows
Another problem with Ramesh is that he selected the ‘dividend’ option of funds, especially for his equity-linked saving schemes (ELSS) funds. He did this to get a regular cash flow as they have a lock-in period of three years and he wanted liquidity in between. This also reduces the overall performance of the fund. Dividend in mutual fund is not the same as dividend from stock or equity. Dividend from mutual fund is a misnomer. Dividends in case of mutual funds are paid by redeeming equivalent units of the scheme and not necessary out of capital gains. 

Suppose you invest ₹10 in an equity fund. The NAV of the fund increases to ₹15 and the fund manager declares a dividend of ₹2. After the payment of dividend, the NAV of the fund falls to ₹13. The problem is that you might not even get a total of ₹2 in your bank account. Depending upon the type of fund (equity or debt) you need to pay tax on ₹2 that you received as dividend. Besides, you cannot expect a regular dividend from such funds as there is no compulsion to announce such dividends. So, to make investors aware of such a difference, the regulator has changed the terminology of such schemes from ‘dividend plans’ to ‘income distribution cum capital withdrawal’ plans or IDCW

The Securities and Exchange Board of India (SEBI) with an aim to improve the way dividend in mutual funds is perceived by investors went ahead announced such a change. Now, there is no such thing as dividend in mutual funds. What used to be called dividend is now simply called distribution. As the new name rightly suggests, IDCW plans just take some of your capital that was already yours and distribute it to you. Therefore, while the underlying portfolio of both the dividend plan and growth plan is exactly the same, the difference is in how the returns earned by the scheme are used in both these plans. In the growth plan of a mutual fund scheme, you let returns made by the scheme get reinvested while in the case of IDCW you do not opt to receive them at regular intervals.

Since returns are reinvested, you may earn returns on return and thereby benefit from compounding. The following example of every ₹10,000 invested in Franklin India Bluechip Fund will help you to understand the difference. If you had invested ₹10,000 in the fund at the start of 2010, the total cash flows would have been greater in case of ‘growth’ without even considering the tax aspect. The difference in cash flow is to the tune of ₹13,354 crore, which is almost twice the initial investment.

Though the XIRR looks similar in the above two cases, there is a catch. All the cash flows in case of the dividend option are subject to taxation, which might reduce cash flows in your hand. In the above calculation we have ignored taxation. Tax gets deducted by the mutual funds at source every time a dividend is paid out, or reinvested. In effect, in the reinvestment option, your money keeps getting reduced. Even though the percentage of tax on capital gains is the same as dividend, your eventual returns will be severely impacted because the dividend tax constantly reduces the amount available for further growth.

Getting More out of MF Investments
Many investors have seen a persistent gap between a fund’s reported total returns and what investors experience. This phenomenon is prevalent globally. A study by Morningstar titled ‘Mind The Gap’ shows that after adjusting for the impact of cash inflows and outflows, investors earned about 7.7 per cent per year on the average dollar they invested in mutual funds and exchange-traded funds over the trailing 10 years ending December 31, 2020 as compared with reported total returns of 9.4 per cent per year. 

This shortfall or ‘gap’ stems from inopportunely timed purchases and sales of fund shares, which cost investors nearly onesixth the return they would have earned if they had simply bought and held. The return gap does not look alarming in the shorter investment horizon. However, if you are investing for your retirement, it can significantly reduce your monthly withdrawals. Hence, there is enough that is left on the table and you can squeeze more out of it if you follow these simple strategies:

1) Portfolio: Keep it Simple - There are almost 40 categories of funds offered by mutual funds in India after SEBI implemented categorisation of funds in 2017. Now there are more than 40 fund houses offering funds in these categories with different options such as ‘direct’, ‘regular’, ‘growth’ and ‘IDCW’, among others. So, an investor is spoiled by choice and is confused about what to choose. History has shown that investors have fared far better by keeping things simple and sticking with plain-vanilla, broadly diversified funds. These funds have fared significantly better than narrower offerings like sector funds and alternatives. If you want exposure to more asset classes, you can choose categories that offer built-in asset class diversification i.e. funds that invest in different asset classes such as ‘multi-asset allocation’ funds. 

2) Keep a Check on Sector or Thematic Funds - Most investors suffer from recency bias and invest in themes and sectors that are doing well currently. They are prone to performance-chasing, with investors often piling on to popular sectors after a strong showing and then bailing out when they fall out of favour. The infrastructure sector-dedicated funds attracted large inflows in 2007 and 2008. Similarly, healthcare funds experienced significant asset growth from 2010 through 2015, but funds from this sector have lagged since 2016. Only in 2020 could they recoup the losses. Hence, do not allocate much of your assets towards sector funds and exit sooner than later after the trend in the sector ebbs out. 

3) Invest in Growth and Direct Plan - If you are a DIY investor, it is always preferable to invest in a direct plan of a fund instead of a regular plan of the fund. This is because a regular plan has higher expense ratio which eats your returns. In the long term it can significantly reduce your returns. Besides, there is no reason you should go for the dividend option. If you need regular cash flows, opt for systematic withdrawal plans (SWPs) by which you can specify a certain amount that is withdrawn automatically every month and credited to your bank account.

Conclusion

To become a contented investor, Ramesh Babu needs to be consistent with his behaviour pattern. He should not become overoptimistic when the funds are doing great or become extra pessimistic when they are not performing to the mark. The only way to manage your investments over long periods of time is to keep it simple, maintain appropriate asset allocation, keep rebalancing between different asset classes and keep your expectations of returns reasonable