Why many mutual funds fail to perform?

Mutual fund is a wonderful financial instrument for people who have neither time nor the inclination to test their understanding of the stock market. It helps people with a very small amount of money to diversify their portfolio to minimize the risk. But even then quite often amateurs easily outperform many mutual funds. In fact in long run most of the mutual funds underperform in comparison to their respective benchmark index.

As Peter Lynch says, this is not because of the inability of the fund managers, but it is the inherent fear of losing. Success is one thing, but it is more important not to look bad if you fail. Managers are quite aware that if they lose even 20-30% of investors’ money on company like Reliance, people will question Reliance for its failure than the manager to predict such movement. But a 10% loss on IFCI could call for reasoning behind such investment. It is better to fail on conventional stocks to keep the job safe than to try unconventional stocks and brings the job in jeopardy. That is the reason why most of the fund managers keep looking for reasons not to buy exciting stocks.

The other issue with mutual fund is the fee that management charges to their investor for managing their fund. An entry load of 2.25% brings down the returns by a significant level and again the exit load (In case of most of the mutual funds) of 2.25% further takes away return from the investors. According to Buffet, in Wall-Street, such management fund causes mutual funds giving less than 80% of return in comparison to the index funds.

Another hurdle with mutual fund is the regulation imposed by monitoring authority like Security and Exchange Board of India (SEBI). The upper cap of stake on a particular stock forces fund managers to look for some less attractive stocks than to increase stake on stocks which are bound to give better returns. Specially, in case of Small-Cap, size prevents manager to buy in such companies, because it is not possible to buy enough shares to have noticeable improvement in fund’s performance.

In such a situation, one of the alternative investors could think of is putting money in index funds, which do not need any management and hence can save the entry and exit load. Index funds are kind of exchange traded fund, where individuals’ money is put in different constituents on the index in proportion to their weight in the index. For example the index fund of NIFTY consists of 50 stocks which are constituent of S&P CNX NIFTY, and the money invested in this index-fund is proportionally distributed among these 50 stocks. One can also look for funds which have outperformed the index consistently in past 3 to 5 years. There are a few good mutual-funds which have beaten the index by a significant difference and hence preferred even after the management fee. More importantly, an individual needs to look at the fund-managers’ performance rather than the funds’ performance. As change of management could lead to change in ideology and can have impact on returns as well.