Why Mutual Funds Are a bad Investment Option!

 It doesn’t make much sense in investing in Mutual Funds

Mutual Fund companies and Wealth Managers have all the reason to make you believe that you are going to be a crorepati in 5 years

Let’ s start from the beginning

PART 1: Why active investing sucks for most people

Why do People invest in Mutual Funds ? Because they think some people who are smart will buy stocks on their behalf and make money. They will charge some fees for that.

Let’ s See how many of these Fund Managers have made us rich.

In the Large Cap space itself we have 70–80 Mutual funds and in the past year only 3–4 are able to marginally beat the benchmark Index. Just imagine instead of choosing the best Mutual fund if you choose the worst,what losses you had to suffer and on top that you would have paid the fund manager a FEES!! yes these people are smart to make money for themselves.

Only people making money continuously through mutual funds are the fund managers.

PART 2 : Why theoretically Mutual funds make money but practically it is not a very feasible strategy

Now we know ETF are as good as mutual funds if not better. So should we buy ETF ? Answer is NO!!

Why ?

Theoretically Mutual Funds /Equity Asset allocation looks the best performing asset but what does High Equity Asset Allocation Entails?

Financial experts these days swear by equity mutual funds .

They will throw in some CAGR numbers based on empirical data. So far so good . then they tell you that as you are just 30 years old so put in 70 percent of wealth in equity and in 10 years you will be rich.

Sounds good but let’s examine it how the real world works.

Let’s say a 35 year old works in some company and over the last 10 years after saving his hard earned money and paying off all education debt saves around 50 lakh.

Now 70 percent of it is 35 lakh..he decides to put it in equity MF.

His horizon is 12 years and he knows based on the CAGR calculation he will make almost 4 x of his investment.

Nobody told him how real market works .He knows they are volatile but has no idea what’s riding the volatility looks like..

In first 2 year at 12 percent he makes good 8. 5 lakhs and he is very happy.third year economy goes into major depression.

Market tanks 40 percent .

His 43.5 lakh is now just 25 lakh..he is afraid he might lose his job anytime as he works for a MNC which is suffering loses.

It’s all over the news that market can slide another 20 percent and equity is a failed asset and talks about great recession are doing the round.

He can’t lose everything he build over so many years. With so much paranoia…what does he do??

He books the loses because he can’t start all over again..His networth today is actually 25 lakh in equity that’s a reality not some unrealised loss…He is as good as someone who has started with 25 Lakh

The hope for gain is just a speculation.

What happens next..5 year fast forward..market has 2 great years and .last 10 year CAGR is 12 %. Experts tell how right they were and equity is best.But did our guy make money..nopes. People will label him as naive but that will be fate of most . Losses can drain the strongest mind

Just Looking at how much stock market was in 2000 and comparing it with 2019 does not mean anything. Being fully invested in the trough and crest can make anyone lose their mind. Look at the some of the worst stock market periods in history.

Dow Jones lost almost 80% of its value in 4 years! Took 25 years to reach old level

Japanese market has not recovered since 1989! Almost 30 years.

The intentions is not to scare people but to make them understand what kind of volatility we are talking about .Its not your merry go round but a Roller coaster ride!!

Just imagine losing everything in 2 years. Can you still stick to your original Plan. Do some introspection and then answer.

PART 3 : Alternative Strategy

What if I tell you can have the cake and eat it too!!

Yes it is possible to lower the risk of equity investment and yet take advantage of the growing economy.

How ??

let’s take an example. A person invest 10 lakh in Large Cap Mutual Fund. The Market

gives 10% return first year ,-40% Return year 2 and 50% return year 3 . How will the wealth of the Person look like.

End of year 1 : 11 Lakh

End of Year 2 : 6.6 lakh

End of Year 3: 9.9 lakh

What all did he lose?

  1. 4.4 lakh loss of wealth in a year. How easy would be to digest that!!
  2. After 3 years his wealth is same as starting year which means he lost time value .He could have earned Interest on 10 lakh in 3 years.

So how to do equity investment in a smarter way:

  • We know equity are risky so we will eliminate the Equity volatility first.
  • We will Replace the Equity Risk with diversified high Yield low volatility asset classes
  • We will create equity upside synthetically

We have split the equity market risk into manageable and controllable risk in the form of long term real estate, corporate debt risk and individual debt risk which can be diversified unlike equity market risk which is highly correlated to broad equity market performance

Now to 10 lakh equity can be split in 3 asset classes:

  1. High Yield Debt: We will invest in diversified portfolio of bonds and Credit Risk funds .These

2. P2P lending: I have covered details of my P2P lending Portfolio in my blog  earlier posts. My portfolio is currently delivering almost 16% annual return

Peer to Peer lending, also known as P2P Lending, is a financial innovation which connects verified borrowers seeking unsecured personal loans with investors looking to earn higher returns on their investments.

3. REITS: Real Estate Investment Trust( REITs )invest the proceeds collected from the investors in real estate projects directly, while mutual funds buy shares or other financial products from the primary or secondary markets. According to Sebi rules, currently REITs can invest only in commercial projects in India. REITs can be a good investment option for the investors, as they invest in commercial realty projects, in which income flow is steady, thereby giving them good returns.

Now instead of 100 % equity our investor puts 50% in P2P lending,

30% in REIT and 20% in high Yield Bonds:

IF I put 9.3 lakhs out of 10 in these assets (assuming 15% return in P2P, 11% in REIT and 10% in bonds) . I will explain why only 9.3 lakh and not putting 10 Lakh

Net Return would be 5 Lakh * 15% + 3lakh * 11% + 1.3 lakh * 10%= 1.2 lakh

or in terms of return 13.3% return in my portfolio

Now comes the replication of equity upside. if nifty is at 11500 . I will buy a call option for Dec 19 with strike at 11500. What does it mean . I will explain!

A brief about options:

Call options give the holder the right to buy 100 shares of an underlying stock at a specific price, known as the strike price, up until a specified date, known as the expiration date.

For example, a single call option contract may give a holder the right to buy 75 units of Nifty Index at 740 Rs up until the expiry date in Dec,19 at 11500 strike . There are many expiration dates and strike prices for traders to choose from. As the value of Nifty goes up, the price of the option contract goes up, and vice versa. The call option buyer may hold the contract until the expiration date or sell the options contract at any point before the expiration date at the market price of the contract at that time.

The market price of the call option is called the premium (here 740). It is the price paid for the rights that the call option provides. If at expiry the underlying asset is below the strike price, the call buyer loses the premium paid. This is the maximum loss.

If the underlying’s price is above the strike price at expiry, the profit is the current stock price, minus the strike price and the premium. This is then multiplied by how many shares the option buyer controls. For example, if Nifty is trading at 13000 at expiry, the strike price is 11500, and the options cost the buyer 740, the profit is 13000 – (11500 +740) = 760 Rs per lot . If the buyer bought one contract that equates to 760 x 75 = 57000 Rs

If at expiry Nifty is below 11500, then the option buyer loses 740* 75 =55000 Rs bought.

Below is snapshot of 11500 Dec call option with price as of today

current price of 1 lot of 11500 Call option Dec 19 (75 Nifty shares) is 740*75 = 55000.

lets assume for 1 year(march 20) it is 70000 instead of 55000.

Now How will my Payoff look under 3 scenario tested earlier(for simplicity I have considered nifty base as 10000, and option price as 7% of Nifty)

We can clearly see :

  • Our portfolio returns have very less volatility. You dont lose sleep after year 2 fall
  • Out portfolio has higher total return than equity only portfolio.

Conclusion:

  • Equity investment are very volatile ,people need to understand the volatility risk and need to avoid exposure unless returns are very high in long run ( eg: small cap MF)
  • Avoid large cap equity exposure. Replicate it as much as possible.
  • Only take small cap exposure to an extent you can digest 50% loss in short term
  • Use P2P lending ,REIT and High yield bonds to create a robust portfolio.
  • Our portfolio has high Liquidity because of P2P loans and bonds. We can always reallocate higher share to equity if market crashes
  • RupeeCircle (use code PIND145 while registering to get portfolio analysis reports)
  • I2I (use referral https://www.i2ifunding.com/referral/ud8cwng83/invest ,add I2I50%DISCOUNT code while registering to get 50% discount )
  • Cashkumar (Mail me for referral) !
  • Lendenclub ( referral code LDC11989)

Drop me a mail if you wish to construct your portfolio!

Footnotes:

Index funds’ outperformance over large-cap peers boosts their appeal

REITs: An option to invest in commercial realty, now in India

Randomwalk

I dabble in Quantitative finance,Analytics P2P investing,Derivative trading and Product development.My goal is to help people create low cost optimized portfolio .

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