What is the benefit of mutual funds beating the index to a common man?

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A viewer on our YouTube channel asks, “What is the benefit of a mutual fund beating the index? How it is going to benefit a common investor?” On the face of it, this seems like the answer is obvious, but that is not true because of how the real cost of investing in a mutual fund is packaged.

This question can be rephrased differently: “As long as I get returns, how does it matter whether I buy active funds or passive funds, direct plan funds or regular plan funds.”

Consider a bar of soap costing Rs. 50. We rarely think about the different players involved, from the manufacturer to the merchant and their profit margins. Suppose the cost of manufacturing one bar is Rs. 5. For the soap to reach the “common man”, at least two “intermediaries” are necessary.

A wholesale network should buy the bars in bulk from the manufacturer and sell them to retail merchants. The manufacturer sells it to the wholesaler for Rs. 20 for a profit of Rs. 15. The wholesaler sells it to the retailer for Rs. 35 for a profit of Rs. 15. The retailer sells it to us for Rs. 50 for a profit of Rs. 15 (excluding taxes).

Just because we are not directly paying the manufacturer and wholesaler does not mean they don’t get paid! Now, how is all this relevant to mutual funds? The NAV that gets published every day is equivalent to the price of soap. The NAV of a mutual fund deducts the total expense ratio of a mutual fund daily before publication.

The amount deducted in an actively managed fund is at least five times higher than a passively managed fund (index fund or ETF). In a regular plan MF (active or passive), the amount deducted is higher because commissions need to be paid to the sales guys (intermediaries).

First, let us confine ourselves to the active vs passive fund debate.  You buy a bar of soap in a local shop or online. You open it, and it is half-used and all squished up. What would you do? Tell yourself, “I asked for a soap bar and got one. Does not matter the state it is in”, or would you seek a replacement or a refund?

Now, let us cut to workplace bonuses. You work tirelessly 20 hours a day for a whole year; finish your products flawlessly and well before time, but get the same amount of bonus as employees who put in half your effort. How would you feel? Would you shrug it away, thinking, “all employees should be rewarded the same?”

If you wonder how this is all related to mutual funds, consider how active mutual funds operate. Suppose an active mutual fund underperforms a benchmark like the Nifty. Do they refund us a portion of the management fee? Do we get compensated in any way for placing our hard-earned money in a product (managed by experts) that has failed to beat a basket of stocks that any one of us can put together by simply looking at market capitalization?

We ask for a refund or replacement when a bad product has been delivered; we feel aggrieved if our efforts are not appreciated and consider employment elsewhere. Then should we happily accept a fund manager getting paid at least five times more for failing to beat the index?

An active mutual fund has only one objective. It costs more for only one reason. The fund house claims they have what it takes to beat a benchmark. They may not refund* management fees if they fail but should we happily accept underperformance at a higher cost? Who do you think is paying the extra cost? The common man or someone else?

* A fund that does this would be a good idea, but the industry is unlikely to bite.

The primary reason for choosing passive funds or index funds should not be the cost. We have reported time and time again that only about half the number of active funds in any category have managed to beat representative benchmarks. This means your five-star rated “best fund” will not remain so for long. See, for example, Four consistent midcap mutual fund performers.

Trying to remain invested in the best funds at all times would be like trying to chase our own tails. It may get some returns but at what cost? Just because we do not see the pre-expense NAV does not mean the costs are absent!

The situation with regular plan funds is worse. Even today, many distributors claim, investors can buy regular plan funds for free, and the distributors are compensated separately by the fund houses. This is like saying the cost of soap is Rs. 50 to you, but you do not pay my profit margin; someone else does.

Again the primary reason for choosing direct plan funds should not be the cost. SEBI has made it quite clear that distributors should not provide investment advice. Then there is the conflict of interest. Why would you ask a barber if you need a haircut?!

So, What is the benefit of mutual funds beating the index to a common person? The high cost that the commoner pays to an active fund manager is justified only if they manage to outperform a simple index or at least an index fund.

Sure the common person only wants some good return. If this can be obtained at a low cost, it is obviously the better choice. If this can be obtained by getting rid of an intermediary (sales guys in regular plans) and conflict of interest for guaranteed higher returns (relative to regular plans), it is obviously the better choice. Time for the common investor to put on a thinking cap.

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M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored three print books, You can be rich too with goal-based investing (CNBC TV18), Gamechanger, Chinchu Gets a Superpower! and seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations based on money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association, IIST Alumni Association. For speaking engagements, write to pattu [at] freefincal [dot] com


About freefincal & its content policy Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication. Freefincal does not publish any paid articles, promotions, PR, satire or opinions without data. All opinions presented will only be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)


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