March 01, 2023 (MLN): Mutual Funds have no exception to myths like other investing. Some are widespread and reason for selective perception among investors of equity mutual funds. The article offers an opportunity to look into the reality of myths. The approach adopted and the frameworks employed are equally applicable to evaluate the truthiness of others as well.

The Mutual Fund Industry:

Mutual funds were introduced in Pakistan in the 1990s.  Ever since the industry has grown and evolved both in size and offerings. Currently, it offers a wide range of investment options to investors to meet their varied financial goals. 

The journey has never been smooth for the industry. It successfully weathered all challenges that came on its way, whether due to atomic detonation in 1998, the Cargill War in 1999, or the global financial meltdown in 2008. Each one helped the industry to groom itself around sound investment principles and to transpire into an organized discipline within the financial sector.

Fund Management Report is one example in this respect. The informatics aspects of FMR, such as investment objective, portfolio composition, risk profile, and fund’s performance vis-a-vis the benchmark index, are reflexive of the industry’s strict adherence to ethical standards with respect to managing investment of public money.

Myths Surround Investing in Equity Mutual Funds:

Despite governing by comprehensive regulations and the best practice adopted by AMCs, to promote the products, the mutual funds’ industry could not save itself from myths. Some myths that surround investing in equity mutual funds are:

1. Invest in a well-diversified equity mutual fund and stay long for a better return.
2. The concept of higher returns with higher risk does not hold true for investment in equity mutual funds as we-thought diversified portfolios not only mitigates volatility risk but also assures valuation growth.
3. No need for professional advice for investing in equity mutual funds
4. Equity mutual funds within the same category provide similar returns.

None of the above is false, yet correct within a context. When examined from a broader perspective, those start blurring. Translucency increases with an increase in political uncertainty and economic fragility.

Though ascertaining the truthfulness of each of them is beyond the scope of this article, however, the approach adopted & framework employed could be applied to evaluate the truthiness of others as well.

The Myth:

It is generally better to invest in well-diversified equity mutual funds for the longer term, NAV of funds can be volatile in the short term but tends to rise with the passage of time, thus offering better returns in the longer run.

The Reality:

The myth rested on the presumption that a team of trained professionals having vision, knowledge, and skills manages mutual funds. Moreover, the inclusion of quality stocks in a portfolio with diversifications smoothed out volatility in the fund’s NAV in the longer run, thus, increasing the likelihood of positive returns.

In reality, equity funds are no exception to being in losses. They report negative returns along with the market during a prolonged bearish spell on one or another pretext.

         (Source: FMR)      

Though this single example cannot be taken as a replica of equity mutual funds’ performance as a whole, yet requires substantial evidence for absolute denial. Thus, sufficient to dispel the impression that investment in equity mutual funds is truly risk-free.

The Abridge Reality:

The above discussions should not be taken as a prophecy that investments in equity mutual funds do not hold the promise of returns for investors.

The myth holds appeal to institutional investors, as a long investment horizon provides a reason for them to stay invested long in funds, and financial resources at their disposal to diversify risk and enjoy the luxury of cushion to absorb volatility in NAV. Moreover, AMCs are intellectually capable of keeping risks within limits with trained human capital and skills at their disposal.

What about individual investors? Who lacks most of them? Are there ways for them to be at par with institutional investors or simply left with no option but to redeem units at a price lower than the cost and realize capital loss? Answers locked in returns dynamics of equity mutual funds.

What individual investors should know about returns from Equity Mutual Funds?

Returns from equity mutual funds come from two sources. First, dividends disburse by funds and the second increase in net asset value.

Return from EMF = Dividend + (NAVt – NAVt-1)

It is to be noted that the major contribution to total return comes from appreciation in the NAV of the fund. Appreciation in NAV is the result of an increase in the market price of stocks in the portfolio due to an improvement in their financial fundamentals, an increase in the market value of the portfolio along with an increase in the benchmark index, or a combination of both.

Equity mutual funds expose to almost all types of risks of investing directly in stocks, such as market risk, inflation risk, interest rate risk, and liquidity risk. All of them affect both the constituents of returns.  

Although Fund Managers manage these risks on behalf of investees the one risk, i.e. the valuation risk of NAV, triggered either by systematic risk or failure of fund management strategy, is directly borne by investors in the fund. This is where individual investors may reap profit by capturing the valuation gap appeared between the point of inflection at the top & bottom.

However, this warrants investees’ active involvement in managing the valuation risk.

Although there is no one-size-fits-for-all strategy for identifying valuation gaps and capitalizing value build-up between the point of inflections, however, pursuing “Riding the Curve” may serve as a generic strategy for the purpose.

“Riding the Curve” is a valuation strategy that is exercised by investing in and divesting equity mutual funds at the point of inflection of the NAV curve. Investment in units of a mutual fund is made at the point of inflection at bottom of the curve and divestment of units of the mutual fund is executed at the point of inflection at peak of the curve.

Successful execution of strategy requires:

1. Ascertain the direction of the market
2. If the stock market appears to be bullish then invest in an equity mutual fund with a beta as close as possible to 1.
3. If the stock market appears to be bearish then avoid investment
4. Invest in an equity mutual fund when the bottom of its NAV corresponds with the bottom of a benchmark index.
5. If already invested in an equity mutual fund, hen divest when a diversion in NAV appears at its peak.

Pursuance of the Riding the Curve Strategy enhances likely hood of profitable investment in equity mutual funds with limited downward valuation risk. The chance of profitable investment with the security of principal may further be enhanced by investing in high-rated funds.

*The writer is a business graduate in Finance and MIS from IBA, Karachi with an MSc in Statistics from the University of Karachi and a fellowship in Life Insurance from LOMA, USA, and a certified trainer by the US-AID Programme. He has been associated with business schools as a visiting faculty teaching courses on investment, finance, and financial risk management.

He is currently engaged in investment research and policy with one of the leading life insurance companies in Pakistan.

Posted on: 2023-03-01T10:34:54+05:00