Fooling some of the people, all of the time

The single biggest reason you are given as to why you should invest in stock markets using a Mutual Fund and not via a Exchange Traded Fund or a Index Fund is proved by showcasing long term returns of few select funds that have over the last decade beaten the Index returns handily.

In past posts I have reflected on why this is not really the ideal comparison given the Survivor bias such lists tend to have yet the fact remains that few funds have really performed well over the long term. No two ways about it.

Here is a table detailing the percentage of funds that have beaten Goldman Sachs Nifty ETS Fund returns.

On the face of it, it seems that on the short term, funds really do deliver the results with more than 90% handily beating the benchmark ETF we have chosen for this exercise.

But this seems to keep dripping down as more time passes by though theoretically given the Survivor bias as well as the understanding that Alpha is generated by focusing on the long term growth, we should have actually seen that rising.

So, what is happening out here?

On the short term, there is a very high possibility of luck being mistaken for skill. Extreme short term returns aren’t hence the best viable way to evaluate a investment, especially one during a bull market where you can get away with higher risk (and hence the higher return) without anyone being wiser.

For instance, while on a 1 year basis, Goldman Sachs Nifty ETS Fund has given a return of 6.82%, over the same period, a Index fund tracking the Sensex had a range which went from a low of 2.85% by LIC MF Index-Sensex Plan to a high of 7.34% by HDFC Index Fund – Sensex Plus Plan. With both Indices seen as benchmark, and both Sensex plans theoretically following the same allocation pattern, one wonder what gives for such a large difference in returns. While the range wasn’t as big in Nifty Index funds, it still stretched from 5.19% (IDBI Index Nifty Fund) to a high of 7.96% (Edelweiss Exchange Traded Scheme-Nifty 50).

In his book, The Success Equation, Michael Mauboussin writing has showcased the importance of Luck and how tough it is to differentiate that from skill in the short term though on the long term, skill clearly distances itself from results which are owed primary to the significance of luck.

There are two ways of investing in funds. One is by way of lumpsum and another is by way of Dollar cost Averaging (commonly known as SIP). Both have their own advantages / disadvantages depending mostly on when the investment was done and the length of time it was held.

A few years ago, Vanguard had done a extensive test on whether a investor should go with a DCA approach or a Lumpsum. You can download the study from this link. In recent times, a investor in mutual funds has been bombarded with information on why SIP is the way to save.

But, how do you choose among the hundreds of funds that are on offer? When Index funds themselves have such a wide range of returns, the range expands more as you start comparing actively traded funds. And here comes the financial advisor who says that since you really cannot expend the kind of energy needed and understand the intricacies of those funds, we will (for a fee that is duly debited from you) help you pick the right fund.

Today, I noticed that Quantum Long Term Equity fund has reached the summit in terms of 10 year returns beating every other fund. But when it comes to AUM, its way lower since they were the first and till date the only fund that doesn’t utilize the services of a distributor. But I am digressing.

To help you pick the right fund, most distributors have what they would say as funds they believe is right for you. Yesterday, I was going through the Select funds of a major online distributor and was surprised at the number of funds that were added and removed in the short time frame I looked at.

When it comes to Systematic Investment Plans, the question is how long you should keep investing. Most application forms these days have the option of investing for eternity (theoretically) since the belief is that if you keep investing over a long period of time, the return you get is substantially on a higher level.

But while investing regularly for long is a correct thought process, the returns are dependent on the choice of  instrument.

In the table, you can see that funds are constantly getting churned all the time. While the advisor does point out that removal doesn’t warrant a exit, it still is suggesting that maybe further investing in such funds are sub optimal in nature.

When people flash about how 10 year SIP would have given so high a XIRR return (a number that most people confuse for CAGR but isn’t – read by previous post), how do you do that if large well known distributors keep shuffling funds based on short term returns (based on my understanding of what they looked at before removing).

If you started out in a SIP today in a fund that is part of the list but subsequently gets dropped, do you continue to invest in a scheme that may be sub-optimal. What if 10 / 15 years hence it showed that if you had just continued to invest, you would have beaten 80% of other funds and what if 10 / 15 years later you learnt that because you kept investing in bad fund, the returns are sub optimal?

In other words, Question leads to more Questions and further more Questions without there being a clear cut answer. If you are saving for your daughter’s education which maybe 20 / 25 years, do you really know which fund you should seek out to help you in mobilizing the said amount?

I don’t exactly remember when, but on the short term, Quantum fund was under performing due to its high cash holding. It was also the time when it got kicked out of Mint 50 (a set of best funds that you can select from). But given the funds recent performance as well as long term, how much of a cost would that have meant for a investor who was blindly following what was advised?

The biggest reason I like ETF’s is that after accounting for Expense Ratio and Tracking error, I know for sure how much I can get depending on the choice of instrument / index I have chosen. That is way tougher with active funds (Quantum included) since it requires a reading of the mind of the fund manager and what he believes is the way forward.

These days, I find a lot of funds coming out with what they say are their core philosophies. If you were to understand and accept that, it makes a lot more sense to just stay with them (and hope that they stick to their words) then keep switching in and out in an attempt to find the best funds.

But if you were to look at persistence of returns, as time passes by, I feel that you will find a way smaller list of funds that can persistently deliver. The pool of actual alpha generators is anyway way smaller than what we assume it to be based on short term out performances in a bull market.