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Why it is a bad idea to always look for outperformers while investing in mutual funds

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One of the most important features that any investor, wealth adviser or anyone in the financial media looks for in an investment product is its track record in “outperforming” the benchmark Index, and outperforming competing products.

This outperformance is measured as performance of the investment portfolio over time compared with the performance of its peer, or the benchmark index, usually over a period of three months, one year, three years, five years, and so on.

Since this is so important, it is also important that we learn the ins-and-outs of trying to outperform.

There is nothing wrong when one tries to do better than competition. Indeed, the capital market is an epitome of competitiveness. But the problem is when one tries to do it on a continuous basis.

The market consists of different types of investment products – some are large-cap oriented, some are mid-cap focussed, and so on. Some follow growth strategy, some are momentum driven, while some are value-oriented. It is important to understand the type of portfolio each one has, because only then can one choose a the right mix that is optimally suited for each individual’s preference.

A different approach to fund management would mean a different trajectory of returns. It is in this context that trying to be No. 1 at all points of time is not necessarily in the interest of the client, read investor.

An investor should ideally have a mix of products with different mandates, so that these products complement each other. Even though they may have different individual trajectories of returns, they together reduce the risk of volatility for the investor.

Let us understand the implications of estimating the relative stock price movements of 50-500 stocks over a period of time. A benchmark index sometimes consists of 50 stocks (Nifty50), and sometimes as much as 500 (Nifty500). And each company’s financial performance and its stock price movement is governed by hundreds of variables. It is simply too much to expect the fund manager to correctly guess the relative movement of all of these variables, and also the impact that these variables may have on share price movements, and correctly adjust his/her portfolio accordingly on a continuous basis.

It is this anxiety to outperform at all points that leads to the faltering of many portfolios. In the stock market, reasons and rationale are sometimes overtaken by greed and blind infatuation (we have seen this during every bubble phase). During such times, the portfolio that takes the maximum risks (sector concentration and/or valuation risks) seems to deliver the highest returns. But alas, this doesn’t last.

If an investor has all investments in the same genre of products, it is very likely that they will all rise (and also fall) together. On the other hand, if the investor chooses a mix of products, all of which are individually good but are managed with different investment approaches, then the chances are that these products would have different trajectories.

We are of the opinion that the way to handle this anxiety is to invest in a set of good products (as opposed to the best), each of which is different from the other. This way, the volatility of the overall portfolio would get reduced. The main thing to do is to periodically verify whether the respective fund managers are sticking to their stated mandates and are managing the risks in a logical manner.

Risk control – the primary task of a fund manager


Our view is that the fund manager’s primary task is to control three major risks that all investors should worry about:

  • Business risk (meaning the risk of the company losing its competitiveness in the market)
  • Management risk (pertaining to the ability and willingness of the management to act in the longer-term interest of all shareholders), and
  • Price risk (the risk of losing money permanently because of an exorbitant entry price)

As long as these are done with reasonable diligence, the results would follow. But the desired results would not be continuous.

The attempt, therefore, should be to remain steady, and never to be spectacular.

We would like to end with a marvelous quote from the great Seth Klarman: “Investment returns are not a direct function of how long or hard you work or how much you wish to earn… An investor cannot decide to think harder or put in overtime in order to achieve a higher return. All that an investor can do is follow a consistently disciplined and rigorous approach; over time, the returns will come.”

(E A Sundaram is Executive Director & CIO-Equities at DHFL Pramerica Asset Managers. Views are his own. Investors are advised to consult their financial advisers before taking any investment decisions)

Source: Economic Times