Equity mutual funds are not equity and fixed income funds are not fixed-income. Many mutual fund investors don’t understand this and end up using funds in a way that is harmful to their investments. There’s a lot of difference between the ingredients of a dish and the prepared dish itself.
This fact came home to me during a conversation with Nilesh Shah, who is the chief investment officer of ICICI-Prudential Mutual Fund. Shah said one of the problems with the way many investors approach funds is that they keep moving in and out of equity funds but they stay invested in the same type of fixed-income fund for a long period of time. This is the opposite of what should be done.
A vast majority of equity fund investors try to time their entry and exit into funds the way a trader does with individual stocks. Most of the time, this is counter-productive. A vast majority of this vast majority only succeeds in lowering their returns. Over the last two years, there's no dearth of people who pulled out of their fund investments only after they had fallen steeply in 2008. Then, they stayed out till the market had run up substantially during April and May.
Interestingly, after years of interacting with fixed-income investors, Nilesh Shah’s observation is that fixed-income fund investors also suffer from a version of the same problems. Fixed-income investors should be moving between different types of fixed-income funds as the economy goes through interest rate cycles. This makes sense only for professional investors, like treasury managers of corporations who need to park funds without risk for specific periods.
However, many individual investors think of fixed-income funds as equivalent to (or better substitutes for) fixed-income investments. They invest in these funds for longer periods of time and leave them there, as they would with a bank deposit or their PPF account. This isn’t a good thing to do. As I said earlier, fixed-income funds are best-suited for professional investors looking for short-term parking slots for their funds. They are far from being suitable as long-term fixed income investments for conservative individual investors.
In periods longer then a few months, fixed-income funds rarely give returns that are superior to what an individual would get from more suitable asset types. At present, the average three-year returns for most types of fixed-income funds range from 6 per cent to 8.5 per cent per annum. There’s no way that this is a better alternative to bank fixed deposits or even better, a sovereign-guaranteed asset like a post office deposit.
In fact, I’ve always thought that the Indian post office savings system is a hidden gem that is severely under-utilised by the typical urban investor. Government-guaranteed safety with no TDS deduction makes it far superior to many other ways of earning a decent and safe fixed-income return.
As for moving in and out of equity funds to chase market cycles, that seems to be genetically controlled. Some investors quickly learn that this isn’t a smart thing to do. Others don’t and spend a lifetime burning up returns in every market cycle both on the way up and the way down.