Why do people invest in Mutual Funds vs say Directly investing in the stock market?
One reason is that Mutual fund offers a diversification that may not be easy to achieve by a lay investor with limited funds.
A bigger reason, reason number two is that there is hope that the fund manager knows better about companies and their future prospects and will not make ill advised investments that go bust when the sentiment changes.
A question that was bothering me recently was the role played by mutual funds in bubbles. A bubble literally sucks everyone and its only later one realizes the absurd valuations that one was paying for those whereas the same is seen as rational during the course of such a bubble.
In the 2000, as Infotech stocks zoomed breaking barriers upon barriers, I remember quite a few funds getting launched (Sector funds) with focus on investing in the hot info-tech companies. How many were launched and how many are still present till date?
In 2007 we saw a lot of funds launching Infra focused funds since this time Real Estate and Infra were the hot sectors everyone was looking up at. Every time a real estate company acquired land, it notched up gains as it was seen as a major moat (land bank). Once again, how many funds remain active today (a observation made by some one a long time back was how many a Infra had big investments in sectors such as Banking making its comparison with the Infra index totally unreliable).
In recent time, this role has been played by Mid and Small caps as they notched up enormous gains and while the large cap Nifty 50 topped out in quarter ending March 2015, the Mid Cap Index closed at its highest level in December 2015 (lag of 9 months).
A rise in itself doesn’t mean anything since undervalued stocks can rise greatly to catch up with what the market believes as its fair value. So, let me once more present to you the Mid Cap Index Price Earnings ratio which I had posted in my previous post
At the end of 2015, valuations were the highest we have ever seen and came very close to touching the 3rd Standard Deviation. Mid and Small caps are more easily prone to move from under-valued to over-valued due to lack of liquidity and the frenzy making it seem like many of these will transform themselves to become large cap over time.
But liquidity is a two bladed sword. When the swords turns around, it literally can slice through portfolio’s like a hot knife through butter.
The above chart is a Quarterly chart of Nifty Midcap 100 Index. As can be seen, after the rise in 2009 / 10, the Index had more or less flattened out till the next leg started from the quarter starting 1st October 2013. From its close in September 2013 to end of December 2015, the Index rose a incredible 91.50%.
So, how did the Assets under Management of funds change in the period. Here is a pic depicting the same
Above is data compiled using data from AMFI India and selecting funds which had MidCap in their names. AUM above is in Lakhs of Rupees.
From End of September 2013 to End December, Assets under Management increased by 316% while number of funds increased by nearly 50%.
The question now is, how much of this flow of money pushed the valuations of Mid Cap stocks to levels it had never seen earlier. And the bigger question now is, how much of this will stay as historical evidence points out that future returns from times of high valuations are really poor (in a post earlier, I have posted data of future returns you can expect if you invest at different Price Earning ranges (for Nifty)).
Mid and Small Cap funds have given excellent returns over the last year and a half, but the question you need to ask is
Does it make sense to continue to be invested in such funds given the evidence above.
Do note that I may be totally wrong and the Small and Mid Cap rally can continue unabated, all I am offering you (with apologies to Morpheus) is data, nothing more.