There are hundreds of benefits of investing in mutual funds. Some famous benefits such as a professional management of fund, rupee cost averaging, power of compounding, diversification, etc. Then you’d ask me, why do I still have more funds invested in stocks rather mutual funds? Why do most wealthy people do the same?
A professional fund manager is tracking the economy, inflation rates, interest rates, foreign exchange markets, corporate performance, stock prices. Reading the news for you and doing many other things for a very small fee. Hence, they say mutual funds tend to perform better than common investor. After all, they do not have enough knowledge, skills and expertise in investing. Right? Let’s find out!
Today, I’m going to share out those secrets of investment industry that nobody talks about. I’m sure it will blow your mind. Few pointers will surprise you. I’m pretty sure you’re going to learn something unique from this post.
Let’s first discuss some problems that a Fund Manager has to face in their daily life then you be the judge.
Too many Restrictions in buying quality stocks: Fund managers have huge amount of cash with them, which belongs to retail investors and common people. Hence, they face a lot of restrictions in investing in certain companies. For ex. they cannot own more than a specific percent of the company, say 20%. Or they cannot invest in more than a specified number of companies, say 100 companies. Yet they should have at least 50 companies in their portfolio. Let’s understand these problems in details and what I derive out of it.
These restrictions are in place to protect the hard earned money of common people. However they play a vital role in the performance on mutual fund. Here are some examples.
Market Cap Trap
Most fund managers are restricted to buy small companies that have a very small market cap. For ex. an ABC Mutual Fund cannot invest in XYZ Ltd. company as the market cap of this XYZ Ltd. is less than Rs.100 crore. (Market cap simply means the total number of shares issued multiplied by market price per share). Lets say the share price of this XYZ Ltd. is currently Rs.15 and there are 5 crore shares issued. Hence the market cap is Rs.75 crores (the total price you have to pay to buy out the entire company).
Now this ABC mutual fund has limitation that they can invest in maximum of 100 companies and their AUM (Asset under management) is Rs.5000 crore. Which means on an average, they can invest Rs.50 crore per company. Hence they cannot invest in XYZ Ltd. because if they invest Rs.50, they’ll end up buying more than 66% of the company.
Even though the fund manager is convinced that this XYZ Ltd. is a lottery ticket and has got everything needed for growth, they cannot invest in it. However, as soon as the share price of XYZ Ltd. jumps from Rs.15 to Rs.50, ABC mutual fund is now eligible to invest in them but it’s not a good deal anymore. Poor fund manager has no control over this factor.
I’m a big fan of Small Cap Mutual Funds. If you’re willing to make money from mutual funds over long period of time then you can invest in small cap funds. They have the power to give you returns of more than 20%-25% CAGR. However, all these so called Smart Investors withdraw their money from these funds immediately when there is any bad news about the economy or if there is any market correction or recession.
We all know that the secret of making profits from stock market is to buy when everyone else is selling and sell when others are buying but very few actually follow it. You get to buy good companies at lower price during these times of recession and market correction. Even if a fund manager has got good skills, experience and all the tools to buy good companies, they have less AUM (funds to manage) during these times which means they cannot take full advantage of these opportunities because Smart Investors are withdrawing.
On the other side, when the economy is doing good and the prices of shares are at all time high, people pump in more money to mutual funds and the fund manager is forced to buy companies at higher price. Again, poor fund manager has no control over this factor.
“I will tell you the secret to getting rich on Wall Street. You try to be greedy when others are fearful. And you try to be fearful when others are greedy.”Warren Buffet
Inspection like a T-shirt
As Peter Lynch – one of the most successful Fund Manager of all time mentions in his famous book “One Up On Wall Street”.
“Whoever imagines that an average Wall Street professional is looking for reaons for buy a stock hasn’t spent much time on Wall Street. The fund manager most likely is looking for reasons for not to buy a stock. So that they can offer a proper excuse to their bosses if that stock happens to go up. “It was too small for me to buy” or “there was no track record”. “It was a non-growth industry”.Peter Lynch
With survival of their job at stake, rare professional fund managers has the guts to invest in something different. It’s because even fund managers has to answer to their managers why they picked a certain company. If the approach and thinking of this manager is different, lakhs of people lose out on an opportunity.
Hence there is this famous term, inspected by 4. Which means a particular stock in an ABC mutual fund will be inspected by 4 different people during different time period. If all 4 people agree to it only then the company remains in the fund or else the company gets no investment.
This strategy is used by T-shirt company where the quality of T-shirt is checked by 4 group of people and then it’s bought out in the market. However, it doesn’t work this way in finance. It takes hours of explanation to convince someone that the company has got potential. This explanation consumes a lot of time of fund managers they simply stick to large cap companies.
“You don’t lose your job buying IBM”
There’s an unwritten rule in Wall Street: “You’ll never lose your job losing your client’s money in IBM”.
Even if the fund manager knows they’re going to get only an average profit then too they’d stick to those large cap companies. It’s simply because they’re safe and easy to answer to their bosses. If IBM goes bad and a fund manager bought it, the clients and the bosses will ask: “What’s wrong with IBM lately?” But if a La Quinta Motors Inns or Relaxo Footwear goes bad, they’ll ask: “What’s wrong with you?”
That’s why security conscious portfolio manager don’t buy Relaxo Footwear. They buy IBM when it’s P/E ratio is all time high and ignore Relaxo Footwear when it’s share price is Rs.14. When the share price of same Relaxo Footwear jumps to Rs.600 and all the financial analyst is following it, they then buy it to gain few percent profit.
These are the fund managers who usually retain their jobs in long run. The ones who make good profit retire early. There are hardly any fund managers famous in India and this is probably because they play it too safe.
The biggest advantage, in my opinion, is nothing to do with either fund management skills or diversification. Rather, it is more to do with behavioral science. Human mind is a powerful instrument and responds to various stimuli differently. It also runs a constant tug of war where the opposing forces are short term gratification on one side and long term gain, pain on the other side.
Moreover, fund managers are constantly questioned about the monthly and quarterly gains where they often forget that the main approach is to look for long term.
We often find it hard to pick winning stocks, however the reality is that winning stocks find it more harder to pick us. Fund managers are heavily restricted and common investor are not really looking to take those opportunities.
Stock market as a topic looks so overwhelming at first and sometimes we think it’s not something we’d ever be able to understand completely. However, the answer is you never need to understand it completely. All you need is to understand just those selected companies properly and invest when you’re convinced. Once you select the right multibagger, you’ll reap the rewards much more than you can imagine. As you have seen in the last post, that the stocks can make or break millions for you. If you’ve read the last post on how to become rich by investing in shares then click here.
If you look at any wealthy person’s portfolio, you’ll see they have more invested in stocks instead of mutual funds. That helps them increase their wealth more. I encourage you to stay invested in stocks only once you’ve done your through research and convinced completely to hold it for next 10 years or more. Otherwise, it’s better to have short term mutual funds as it is just gamble to think short term for stocks as anything can happen in near future. However, in long term (10+ years), a quality stock can recover even from disastrous recessions.
Lastly, if you don’t have enough time to do your own research or don’t have enough risk bearing capacity to buy companies then you can and you should stick with mutual fund as you still get exposure to the power of compounding. And it works in your favor, almost every time.
Mutual Funds and stock investment are subjected to market risks. Please do your own research before investing.