This is a question that comes up whenever there's some turmoil in the markets and mutual fund NAVs drop sharply. When fund investors evaluate funds and choose some, should they be studying their underlying portfolios? Over the last few weeks, I've seen the sharpest rise in investors agonising over this issue. The reason, of course, is that there's an unusual twin turmoil right now. While equities have nose-dived, that's a more or less routine event, one that equity investors should be used to. However, ILFS affair has meant that there's an unusual degree of fear, uncertainty and doubt that's raging in fixed income securities too.
I remember, the last time we were in such a period, I got a number of angry emails from investors who basically felt that mutual funds should not be investing in stocks that were going to drop so much. There was one particular investor - who was quite persistent in his idea that mutual funds investing in a particular IPO was bound to lead to losses, writing that "basically it is waste of hard earned money of small investors like me. Who is responsible for this loss? Can we initiate some action against these AMC that on what basis did they subscribe to such IPO?"
The obvious problem here is that no investment advisor, manager, or mutual fund (or indeed, any investor) can guarantee that every single investment in their portfolio will turn a profit. As it turned out, that particular IPO was indeed a dud, but the funds that invested in it got out quickly enough--and here's the key--made good money for investors in the following years. So the angry investor was right in that case, and yet fundamentally mistaken.
This approach assumes that mutual fund investors should evaluate the portfolios of the funds they invest in, and 'initiate action' if any one of the stocks in that portfolio makes a loss over any period selected by the investor. It's clear that this is a bizarre notion. The investor should evaluate the performance of the mutual fund as a whole, whether on returns or on volatility.
Underlying this approach of over-analysing funds' portfolios is the idea that investors should choose funds on the basis of their portfolios. Unfortunately, there's no shortage of people who try and do this. Unfortunately, this style of analysing mutual funds is prevalent not just among investors but even among some analysts and in parts of the financial media. Generally, the approach taken by this style of analyses is to find out a fund's latest investment portfolio and then try to read up on the individual stocks and see if they fit their current definition of stocks that are likely to go up in the near future.
There are two problems with this approach. One, it places upon the investor the onus of being a better judge of stocks than the fund manager. The starting premise itself is that the investor (or the salesman) know which stocks are going to move and they should judge the fund's last declared portfolio on that basis and then decide whether the fund is any good or not. Generally, this approach is taken by investors who have primarily been investing in stocks and have decided to dabble a little bit in funds. Based on the research reports I get from brokerages, my belief is that the prime drivers of this approach are stock broking outfits which have also added on the business of selling mutual funds. A typical piece of logic in such reports goes something like, "the top two holdings of this fund were ICICI Bank and Infosys; neither are on our buy list right now, so this fund is not recommended". Stock research is what these people do, so that's what they do in mutual funds also. When all you have is a hammer, then everything looks like a nail.
The other problem with this approach is one that is seen more often in the financial media. In keeping with the outrage-centric style of news in our country, they will pick out a few stocks in a fund's portfolio that has declined recently and rage against it, regardless of what the actual returns to investors have been.
A mutual fund's portfolio (as should be any portfolio) is a portfolio which is more than the sum of its parts. A stock may be held or sold for reasons that have nothing to with itself. Perhaps another stock in that industry has become more attractive and there's an internal limit on an industry. Perhaps there's an internal limit on total exposure to a certain size of company.
The most important input in analysing a fund is the returns that it has generated for investors, in comparison to the benchmarks and its peers. The only role that its holdings play is to analyse the past and potential quality of the returns, and that too more at an aggregate level. These are the kind of questions that analyst could expect to answer by looking at a fund's portfolio: How concentrated is a fund across industries or capitalisation bands? Are the top few holdings a lot larger than the smaller ones? Does the fund change its portfolio a lot in response to market conditions or only a little? Using it as a basis for selection is counterproductive.
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