Mutual Funds to be Avoided - A retail investor's perspective
[A] Introduction:
Mutual funds' asset under management (AUM) in India is 39.42 trillion Indian rupees (INR) as on March 31, 2023. Indian mutual fund industry has come a long way since its inception. With nearly 62.8 million SIP accounts, the awareness of mutual fund is increasing day by day.
The industry is one of the most well regulated (SEBI is the regulator) and is quite reasonably transparent. SEBI is working day and night to keep it that way. The trust that it has gained amongst the investors is quite high.
But with nearly 26 types of mutual funds under various categories like equity, debt, hybrid, solution oriented etc., an average mutual fund investor is left with too many choices to choose from.
This article is written in as simple language as possible to help the retail investors understand that there are some types of mutual funds, that are generally not meant for an average investor. Though I do not mean to imply that these are useless types of mutual funds, they are generally meant for a seasoned investor, who understands and can digest the risks, that are associated with these types of schemes.
Some mutual fund types are a bit obsolete, in terms of their ability to generate consistent alpha. Such types of mutual funds will also be covered here.
Please note that the arguments presented below are not merely my opinions. They are based on certain sets of data. But given my tendency to ignore the unnecessary referring to the data, I have avoided going too much into the statistic.
[B] Types of Mutual Funds that a retail investor may generally ignore:
1. Large Cap Funds: Large cap funds invest in top 100 companies in the market (in terms of market cap). Such funds are actively managed funds. But, it has been observed that since 2018, not many large cap schemes have been consistently beating their benchmarks. On the other hand, the schemes, that mirror Nifty50 or Sensex are doing really well.
Plus, the passive schemes, that mirror Nifty50 or Sensex, are passively managed. Hence, their expense ratio is really quite less, compared to that of large cap funds.
In the last three years, almost 80% of large cap funds have underperformed their benchmark.
This happens as the fund manager has only 100 companies to invest in. There is also a limit that the fund manager cannot invest more than 10% AUM in one single firm.
2. NFOs: New Fund Offers are generally a big No-No for a retail investor. Most of the Asset Management Companies (Mutual Fund Companies) tend to come up with a new NFO. Each time, they claim to be having a new idea or a theme that will generate extra ordinary returns.
As people always want to buy something "new" (like a car) even in the mutual fund space, it becomes obvious that the AMCs tend to offer something "new" after some time gap to mop up more and more money.
One should generally invest in an old, time tasted mutual fund, which has a proven track record across market cycles.
NFOs do not come with any track record, and hence, there is no point in investing in an NFO, unless the idea behind is totally new or worth considering.
3. Sectoral and Thematic Funds: The funds, that target only certain companies in an industry or sector, are generally very risky. Every sector goes through cycles, and one needs to time the entry and exit, to really benefit from such funds. Examples of such funds may include infrastructure funds, pharma funds or Information Technology Funds. While these funds will do really well when a sector goes through a boom period, it may take a very long time to click for this sector, after its cycle is over.
Generally, diversified funds like Mid Cap or Mid and Large Cap funds are better. I have not named flexicap funds or multicap funds here, as they are the ones, that will be discussed next!
4. Flexicap Fund: Now, this is not something that many people will buy or agree with! The flexicap funds (earlier called multicap funds) are the ones, that invest across the market caps and industries, without any bias. Like large cap, mid cap and small cap. They are generally all season friends.
But, off late, many flexi cap funds have started behaving like large cap funds. With astonishingly high AUMs, the fund manager seems to be "hugging" the Sensex or Nifty50, in order to avoid taking risk. A fund manager of a flexicap fund is expected to take that extra risk and generate the alpha, for the investors. But, instead of that, many fund managers, simply keep investing in large cap stocks.
Why not invest in a Nifty50 Index fund instead of a flexicap then? As the expense ratio of the flexicap is generally very high.
5. Multicap: As per new rules, a multicap fund is the one, in which, a fund manger must invest at least 25% AUM in large cap, mid cap and small cap. This looks good on paper as the investor might get exposure to all types of shares. But, generally, a fund manager, who is good at picking large caps, might not be equally good at picking the small caps (a rare skill). That puts your hard earned money at risk.
I personally do not prefer the focussed fund too, where a focussed bet of a fund manager will decide the fortunes of investment.
6. REITs: Real Estate Investment Trusts, are the types of funds that invest in real estate. They are very advanced types of instruments, generally meant for the HNIs, who have high risk appetite and understand the complexity of such products. The amounts to be invested in such schemes are also very big. Thus, a retail investor might avoid investing in them.
7. Most of the debt funds!: A retail investor rarely understands the duration risk as well as credit risk, that are associated with the debt funds. The classic example of Franklin Templeton should be good enough to remind the retail investors about the risks of investing in risky debt funds. Generally, a retail investor should invest only in liquid, or at the most, ultra short term fund or a money market fund. The funds like dynamic bond funds should generally be avoided by a typical retail investor.
[C] Conclusion: In this article, I have shared my ideas about the types of mutual funds, in which, a retail investor should not generally invest. Of course, if you understand the risk reward ratios and feel that you can take the bet, go on, it is your money, in the end.
One category that I have not discussed in small cap funds. But generally, such funds are meant for long term investors only. But many retail investors are now becoming mature to tolerate the risks, associated with small cap funds. Still, a faint hearted person should stay away from the small caps.
