The mutual fund was designed as the perfect vehicle for the small investor to participate in financial markets. It is certainly the best instrument available and indeed, in markets such as treasuries and corporate debt, it is often the only instrument available. It can offer very broad exposure to equity investors. After struggling for over a decade, Sebi has finally managed to evolve regulatory policy that works reasonably well.
So the industry is flourishing. But no, the mutual fund isn't perfect and it never will be. There are reasons why the mindset of an active fund manager will never quite match that of the "ideal" fund investor. And that mismatch can result in (slightly) disappointing results.
What is the profile of an ideal mutual investor? It is somebody who is prepared to invest systematically and hold over the long-term. That in turn, implies it is somebody who wants value and steady long-term appreciation rather than momentum stocks.
What are the compulsions of the average fund manager? He has to survive quarterly reviews and match the returns of the benchmark. He also has to make enough “noise” to attract new corpus inflows - this means trying to beat the benchmark by a large margin, which may involve taking risks. Three-month returns fit the profile of a momentum player rather than that of a value investor. Mismatch number one.
In addition, the fund manager is reluctant to waste time on relatively small companies. It takes just as much time to research a Rs 50 crore business as it does to research a Rs 5,000-crore business. However a small company can absorb a very small percentage of a fund's corpus. So why bother? Most fund managers don't bother - their small cap allocations tend to be just about 10-15 per cent of total AUM.
Most of the fund allocation is into the top 200 stocks by market capitalisation. Yet the top 200 are all companies where stock-picking by a professional can only add marginal value to a portfolio. Corporate governance and transparency tends to be good in large caps and information is very quickly disseminated through normal channels.
It doesn't take special knowledge to make a selection of these companies. A novice could pick a portfolio of Top 200 companies either at random or through a Google search followed by a few financial filters. Hold any diversified portfolio of top 200 stocks for long enough and it is likely to offer a return that matches that of most funds.
Stock picking can really add value when it's a small unknown company with serious growth prospects. Those are potential multi-baggers and the fund managers' greater access to information and better stock-picking skills should create the best payoffs.
Indeed studies suggest that small cap appreciation is higher over the long-term though small businesses are also subject to greater volatility. However the small cap component in any normal fund is hardly large enough to bring this into play. Mismatch no. 2.
Hence, an investor is often paying managers to operate in a manner that is different from the ideal. Can an investor creatively use his knowledge of the fund industry, factor out its biases and compulsions and generate better returns on their own?
Here's a thought experiment.
Suppose you decided to focus on the top 10 holdings of DE funds in October 2006, bought one share in each company and held for a year? These are all large caps naturally and you get a return of 46 per cent by end-October 2007- the (weighted) Sensex returned 53 per cent during that period. Not so good.
Suppose you did the same thing with the top 10 small cap holdings of October 2006? That portfolio would return 53 per cent. That is better though it's still lower than one would hope for, given that the (weighted) BSE Small Caps also returned 53 per cent in the same period.
Of course, this is just one year and to draw any conclusions from such a back-of-the envelope calculation is silly. One would have to back-test this "method" of passive investing over long periods to see if it generated meaningful returns in excess of the DE category average.
But the fact is that mismatches in mentality exist between the active fund manager and the long-term fund investor. Also the majority of funds don't beat their benchmarks consistently. This does make the argument in favour of passive investing