Dear investor, you don’t have to run a mutual fund on mutual funds

My favourite Watterson quip is: “There’s never enough time to do all the nothing you want." Today is one such day. It’s raining. Gently, like it used to in Pune when I studied there. The road outside where I live is nice and quiet. The neighbour is not shouting at her kids. Bruce Springsteen, the Boss, is singingTenth Avenue Freeze-Out. I am sipping a cup of black coffee and just doing nothing. A state I want to continue existing in (I was until I had to start writing this).

As the American poet Robert Frost wrote: “The woods are lovely, dark and deep. But I have promises to keep." And deadlines to meet. And rent to pay. And money to make. These are the days when I hate my ancestors. Why couldn’t I have won the ovarian lottery?

Sometime back, a friend sent me his investment portfolio of mutual funds (MFs) to look at. The first thing I noticed was that his investment adviser had made him invest in 30 different equity MF schemes. His wife’s portfolio had 17 different equity MF schemes. I didn’t go any further. The couple was running a mutual fund on mutual funds. This happened because their adviser had sold them many new fund offers (NFOs)—or new equity schemes.

Essentially, there are two problems in investing in many equity MFs: practical ones and logical ones. Let’s say you have invested in many MFs and, god forbid, something happens to you. Imagine the problem your nominee is likely to face when they need to sort out everything.

There is another practical problem, albeit something that someone who has invested in one too many equity MF schemes isn’t really going to bother about. How do you keep track of the performance of so many schemes? If you bought these schemes through an app or an online platform, you would get the details at the end of every day. Even individual MF agents now send regular statements showing the value of the MF investments made.

But that’s just the performance of the overall investment. What about looking at the performance of individual schemes? How are they doing vis-a-vis other schemes in that category? Or how are they doing vis-a-vis the overall stock market? Anyone who tries and answers these questions would never invest in as many schemes as my friend has.

Now, let’s talk about the logical problem. Why does someone invest in stocks indirectly through an equity MF? Probably because they don’t have the time to sit and analyse stocks and feel that it’s easier to invest through MFs. But investing in many MFs doesn’t make life easier.

More than that, people invest in MFs to diversify their risk, and not put all their eggs in one basket. An equity MF can invest a maximum of 10% of its overall portfolio in one listed stock. By this definition, any equity MF is bound to have an investment in a minimum of 10 stocks, though equity MFs typically invest in more than 10 stocks at any point in time.

Now, let’s say you invest directly in stocks, but only in a few. If the price of one of these stocks crashes, the overall value of your portfolio is likely to drop dramatically. But when you invest in an equity MF, there is bound to be some diversification. Or as the Association of Mutual Funds in India (AMFI) points out: “In other words, you don’t lose out on the entire value of your investment if a particular component of your portfolio goes through a turbulent period."

That’s one part of the story. When you invest in equity MFs you diversify the risk of investing. But this doesn’t mean you should invest in many equity MFs to diversify risk more. That’s not how it works.

When someone invests in an equity MF, that fund then invests that money in stocks. But there are only so many stocks that MFs invest in. So just because you are buying more MFs doesn’t mean you are indirectly buying more stocks. It doesn’t work like that.

In fact, as Vashistha Iyer, the chief operating officer of Capitalmind, had tweeted in October: “Across 427 active funds, 95% of their (assets under management) is invested in 382 stocks. 80% in just 178 stocks." There is no reason to believe that the situation would have changed much since then.

There is a lot to unpack in what Iyer said. In an active equity MF, the fund manager decides which stocks to invest in, depending on the overall mandate of the fund. If the fund's mandate is to invest in large-cap stocks, then the fund manager will make active calls to invest in large-cap stocks. Large-caps are stocks ranked in the top 100 as measured by market capitalisation.

So, the question is why the bulk of the money of active equity MFs is invested in fewer than 400 stocks. Let’s look at some data before answering that question. As of 28 March, the National Stock Exchange had a total of 2,379 stocks listed on it. Of these, 124 stocks were not available for trading. That leaves 2,255 stocks.

Now, a bulk of the money collected by equity MFs is invested in fewer than 400 stocks even when more than 2,000 stocks are available. Why is that? There can be multiple reasons.

First, fund managers may not be confident about the business models of a large number of companies, and hence, stay away from them.

Second, many stocks do not have enough liquidity or trading volumes. Investing in such stocks or selling them becomes difficult without impacting their price, meaning that a large buy order can drive up the stock’s price and a large sell order can push it down.

This is the major reason why the investment universe of fund managers running equity MFs is limited to fewer than 400 stocks. More than 400 active equity MFs largely have an investment universe of fewer than 400 stocks, implying that there are more equity MFs than stocks.

Indian equity MFs are facing what Iyer called “the depth problem". There aren’t enough good stocks for fund managers to consider investing in.

This brings us to the basic point behind this piece—just because you invest in many equity MFs doesn’t mean your investments are more diversified. Beyond a point, fund managers will largely end up investing in similar stocks.

Given this, there is no point in going beyond five or six MFs in a portfolio. That should have you totally covered. In fact, the passive index fund space in India is still evolving. A passive index MF is one that takes money from investors and invests in stocks that make up a particular index.

Let’s take the case of a passive MF scheme on the Nifty 500 index. The money this scheme collects will be invested in the 500 stocks that make up the Nifty 500 in the same proportion as their weight in the index. Passive index funds that can be bought and sold on stock exchanges are referred to as exchange-traded funds (ETFs). This investment space is still evolving.

There should come a time when good index funds and ETFs are available on the Nifty 500 or the BSE 500 index. You can then possibly just buy such funds and be done with, instead of having to figure out the best equity MFs from among the more than 400 schemes available.

Of course, what’s good for a retail investor is not always good for those in the business of managing other people’s money (OPM), like asset management companies running MFs. Asset management companies make more money from managing active MFs than passive ones.

Further, passive MFs do not really require fund managers. MF agents, wealth managers, chartered accountants, and anyone else in the business of advising retail investors on which equity MFs to invest in will become redundant if good index funds and ETFs with enough volumes are available on indices like the BSE 500 and the NSE 500. Investors can then just buy those funds.

Data clearly show that the most actively managed equity MFs are rarely able to beat their benchmark indices. Why is this important? When retail investors invest in an actively managed equity MF, they are paying for a professional, the fund manager, to manage their money.

Hence, the fund manager should consistently generate returns higher than what can be generated by simply buying stocks that make up a stock market index. Active management should do better than passive management because that’s what the investors are actually paying for.

In fact, as the S&P Indices Versus Active Funds (SPIVA) report shows, as at the end of 2023, 86% of the large-cap equity MF schemes, or schemes that invest in large-cap stocks, had failed to beat the returns generated by the BSE 100 index. About 71% of the tax-saving schemes had failed to beat the returns generated by the BSE 200 index.

And so the story goes across different timeframes and across categories of funds. Which is why I said that if only good index funds and ETFs were available on the BSE 500 or the NSE 500, investing would become so much simpler.

Now that leaves us with one issue. Even without agents and advisers mis-selling equity MFs, you could end up with investments in more than 10 MFs. This can happen over a period of time as you stop your systematic investment plan (SIP) on one equity MF and move on to another one. If this happens a few times over the years, you can end up with more than 10 schemes.

In such a situation, investors are not comfortable with selling out of the scheme on which they have stopped investing through SIPs and moving that money to the new scheme. This is because when they do that they need to pay tax on the capital gains made. Here’s the thing. You will have to pay tax on the capital gains at some point in your life. So you might as well do that now.

Of course, the tax is a cost. It is the cost of keeping things simple and not unnecessarily complicating them. It is also the cost of chasing performance across different equity MFs over the years. Something that can be easily done away with if broader index funds of the kind that I have talked about become available.