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Return potential of mutual fund schemes

Nov 28, 2016 by Dwaipayan Bose | 28 Downloaded
Picture courtesy - PICJUMBO

Stock analysts assign target prices to stocks they cover; for example, if a stock is trading at 100 and the analyst gives a buy recommendation with a target price of 130 over a two year horizon, the investor buying the stock at 100 can expect to make a profit of 30 over the next two years.

In Advisorkhoj, we often get comments like, “so and so fund gave 25% annualized returns in the past, how much return will it give in the next 5 years?” Recently, one of our users commented, “How will I know, if a mutual fund scheme is over-valued, under-valued or fully valued?” Both these comments and several other related comments in our blog are questions that are often associated with stock investing. These questions can be simplified to one basic question, “like stocks, can future price of a mutual fund scheme be predicted with a certain degree of accuracy? Equity mutual funds are essentially portfolio of stocks. So are these questions relevant for mutual funds as well? How will investors decide which mutual fund scheme(s) to invest in? We will discuss this topic in our post today.

Price of mutual fund units

The price of a mutual fund unit is also known as the Net Asset Value (NAV) of the unit. The NAV of mutual fund scheme is determined on a daily basis, computed at the end of the day based on closing price of all the securities that the mutual fund owns after making appropriate adjustments. The NAV is calculated by dividing the net assets (value of the securities and cash held by the fund minus the liabilities) of the fund by the total number of units outstanding.

Mutual fund units are priced at 10 at the time of launch and the NAV increases or decreases as the value of the underlying asset changes. Older funds have higher NAVs because assets grow in value over longer time; newer funds have lower NAVs for the same reason. Funds with high NAVs are not overpriced and funds with low NAVs are not attractively priced.

Can future value of a fund be predicted?

If stock analysts give target prices for stocks, is it possible to have relatively accurate price forecast of a mutual fund because a mutual fund, after all, is a portfolio of stocks. It may be theoretically, but it is practically impossible to predict the future NAV of a fund over a defined horizon with any degree of accuracy due to the following reasons.

  • If you see any stock recommendation, you will notice two points, the target price and the horizon of the forecast. An analyst can expect Stock A to hit its target price in 6 months, Stock B to hit its target price in 12 months and Stock C to hit its target in 24 months. By the time Stock B hits its target price, the target price of Stock A would have been revised and by the time Stock C hits its target price, the target prices of both Stock A and B would have been revised.

    Unless all the price forecasts of stocks in a portfolio have the same horizon, it is impossible to forecast the portfolio value over a defined horizon. A diversified equity mutual fund can have upward 60 – 70 stocks in its portfolio; the fund manager may have a target price for each stock in the portfolio, but the forecast horizons would be different. Therefore, it is practically impossible to forecast the NAV of a scheme over a defined horizon.

  • Investors should understand that, a mutual fund scheme is an actively managed portfolio. The fund manager’s objective is to deliver superior returns to the investors relative to the benchmark index of the scheme. From time to time, the fund manager will make suitable adjustments to the scheme portfolio in his / her endeavour to deliver superior alpha (risk adjusted returns).

    These adjustments may include profit booking in certain stocks, re-adjusting sector weights in response to changes in sector dynamics, investing in new growth or value opportunities, price-value gap in different market cap segments (especially in multi-cap / flexi-cap funds), making changes to cash percentage of the portfolio etc. Investors should understand that, these changes are not one-off in nature but are made on an ongoing basis (this applies to close ended funds as well). The portfolio turnover of a fund is an indicator of how frequently the fund manager churns the portfolio.

  • Sometimes fund managers are forced to make changes to their scheme portfolio due to inflows to the scheme (fresh investments) and outflows from the scheme (redemptions). Not all the stocks in the market have the same amount of liquidity and therefore, even if the fund manager wants to maintain stock or sector weights, unfortunately, he / she, at times, is unable to do so (especially in midcap funds). Since portfolio characteristics of a fund may change, any portfolio value forecast in such cases is irrelevant.

So, when your financial advisor tells you that, you can expect 18% return on your investment in a mutual fund scheme, what is he / she basing the estimate on? Mostly, it is based guess-work (sometimes educated) based on either historical returns or some broad market growth forecast with some alpha attributable to the fund manager factored in. Many a times, this guess-work can be fairly accurate, especially if the advisor is experienced and has good knowledge of market trends, but investors should understand the difference between the return of a mutual fund scheme estimated by your financial advisor versus the price forecast of stock given by a fundamental analyst or technical analyst.

Is your mutual fund scheme over-valued, under-valued or fairly valued?

A stock is said to be over-valued if the fundamental value of the stock is more than the current market price, under-valued if the fundamental value of the stock is less than the current market price and fairly priced if the fundamental value of the stock is same as the current market price. Unfortunately drawing similar conclusions of a mutual fund scheme is extremely difficult, to say the least, and practically speaking, in my opinion, impossible for the following reasons.

  • As discussed earlier, the price of a mutual fund unit (NAV) is derived from the price of the underlying assets. The underlying assets may be over-valued or under-valued. Theoretically speaking, if all the stocks in the fund portfolio are over-valued then we can say that the fund is over-valued, but from a practical viewpoint, that is never going to happen.

    Some stocks will be over-valued, while others may be under-valued. At a portfolio level, however, it is not possible to determine whether the fund is over-valued or under-valued, because valuation baseline differs from stock to stock. A friend of mine told me that, he looks at aggregate P/E ratio of a fund. To me P/E ratio of a fund is mostly an irrelevant metric. P/E ratio of a FMCG company will be high, while that of a public sector bank will be low. Does it mean that the FMCG stock will give lower returns than the public sector bank, or vice versa? If P/E ratio of a fund is calculated as weighted average P/E ratio of different stocks, what does it tell us?

    In my opinion, it is a confused financial metric, which serves no useful purpose. If P/E ratio of a fund is 15, while that of another on 24, it does not tell you if one fund is over-valued relative to the other, unless both funds have exactly the same sector weights, which is highly unlikely. My friend asked me, if the P/E ratio of a fund can be compared to the P/E ratio of a benchmark. Again, they are comparable, if the sector weights are same, otherwise not.

  • Fund manager’s investment styles will result in different valuations of stocks in the fund portfolio. Valuations of value stocks will be lower than growth stocks; valuations of GARP stocks will be somewhere in between. Can we say that, value investment will always give higher returns than growth investments? Growth funds have beaten value funds over different time-scales and value funds have outperformed in other periods. Growth stocks have the potential to appreciate faster, while value funds have the potential to give bigger capital appreciation but the value investors need to wait longer. The decision to invest in growth or value funds should depend on the investor’s needs

  • Determining if a stock is over-valued or under-valued involves a fair amount of subjectivity. If you follow the market closely, you will see that, analysts often have conflicting views on stocks. Some analysts may give a sell recommendation for a stock (obviously, they think that the stock is over-valued), while others give a buy recommendation for the same stock (believing that they are under-valued).

    Similarly, different fund managers may have differing views on the same stock. In my opinion mutual fund investors should trust their fund managers to make the best decision in the interest of the shareholders. Even if, one or two decisions of the fund managers (they are humans like us, after all) turns wrong, the diversified portfolio of mutual fund schemes should be able to absorb the negative impact of a few wrong decisions. If you, as an investor, are not happy with the fund manager’s performance, you always have the option of exiting your investment and seeking other opportunities.

Deciding which fund to invest in

We have discussed thus far that, there is no analytical way of knowing, which fund is going to give highest returns in the future. So, how will you decide which fund to invest in? Three considerations can help you choose mutual funds for investment.

  • You should define your expectations very clearly. There are three factors that you need to consider in defining your investment expectation; your investment goal, investment horizon (time you have to realize your goal) and your risk tolerance

  • The fund manager has a very important role in growing your investment value. This is where historical returns are important. We have discussed a number of times in our blog that, rolling returns is the best measure of a fund manager’s performance. A fund manager, who has delivered stellar in the past, can be expected to deliver strong returns in the future. The fund manager does not work in isolation; he / she needs strong organizational capabilities to function effectively; therefore, the asset management company (AMC) should also be an incremental important consideration in fund selection. Here, you may like to read Why there are big differences in returns of top and poorly performing mutual fund schemes

  • Many investors and financial advisors pay too much attention to returns and scant attention to the investment strategy. I will urge investors and financial advisors to pay attention to the investment strategy. The investment strategy of a fund has several important details. An investment strategy may articulate a theme, e.g. consumption, demand recovery, manufacturing etc. These themes are often aligned to the current economic situation. Investment strategy also has details on investment style, e.g. Growth, Value, GARP etc

Conclusion

In this post we have discussed how some of considerations applied in stock trading or investing are not relevant in mutual fund investing, because these two asset types (stocks and mutual funds), though similar, has some different fundamental characteristics (stocks are underlying assets of a mutual fund) in many other respects. We also discussed some considerations that investors need to apply when selecting mutual funds for their portfolios. There are a large number of products in the market, which can make the investment process confusing for investors. Investors should take the help of financial advisors in making the right investment for their financial goals; at the same time, investors should also educate themselves, so that they can be better informed about their own investment decisions.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.

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Dwaipayan Bose

An alumnus of IIM Ahmedabad, Dwaipayan is a Finance and Consulting professional, with 13 years of management experience, mostly in MNCs like American Express and Ameriprise Financial, both in India and the US. In his last role, he was the Chief Financial Officer of American Express Global Business Services in India. His key interests are building best in class organizations, corporate governance and talent development

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