Sep 20, 2006

Mutual Funds and Wealth Creation - II

(Continued from Part-I)

Do Mutual Funds create wealth? Are they the ‘great saviours of the middle class’ as they are made out to be?

Let me try my hand at understanding a very interesting industry. This is going to be a longish post, and very boring…

Suppose I am an accountant. I have lots of friends – say doctor, engineer, lawyer, and banker and so on. All of us slog from morning to night, and earn something to keep our families from starving. Now, we work harder and manage to earn some more money. Since we don’t spend everything now, and dream of having a comfortable life when we retire, (and since our teacher taught us ‘the ant and the grasshopper’ story in our school) we decide to put some money away for the future.

We don’t want to lose our hard-earned money, and look for ‘safe’ avenues. We put money in Bank FDs, Post Office instruments like IVP/KVP, PPF and the like. We are assured of both, the return on and of our investments. What’s more, the Government even offers us some tax breaks on these investments. Life is good and we look forward to a peaceful life. The stock market is an alien concept to us.

Suddenly, a friendly canny businessman comes along and says, “Hey guys, I have this great idea. All of us save small amounts, and therefore can’t afford the big ticket investments individually. Let us all pool our money, and invest big time.” It sounds similar to the time that four of us friends went to a TV shop and bought 4 TVs at a time and thus, managed a decent discount, after some not-so-decent haggling.

So, the guy sponsors (sets up) a Mutual Fund and we give some of our money. He says he will appoint a professional Asset Management Company (AMC) to invest our money. To allay our fears, he says he will also appoint a board of ‘Trustees’, consisting of well known people who will make sure that our ‘interests’ are taken care of. He needs to sell his scheme to people all over the country and appoints ‘distributors’. He needs a place to keep his (our) shares and money, and therefore, appoints a ‘Custodian banker’. He promises us that we can take our money and quit whenever we feel he is not doing his work properly. So, he appoints a ‘Transfer Agent’ to help us buy and sell the units of our Mutual Fund.

Suddenly, the Government realizes that this guy who takes our money might be an evil fraudster and to protect us innocent people from his evil designs, it comes up with an evil more evil design – ‘The Regulator (SEBI)’. Now, SEBI is entrusted with the unenviable task of bringing some order into the stock market chaos. They respond with even more chaos. SEBI employs a hell lot of out-of-work lawyers, and comes out with tonnes and tonnes of paperwork, euphemistically called ‘regulations’ and ‘guidelines’.

One of their better ideas is to make every fund put a line in their ads: “Mutual Fund investments are subject to market risks.” (which is about as effective as the statutory warning on cigarette packs!!!). Now, our Mutual fund friend realizes that if he were to follow every letter of the ‘regulations’, he will never make any money, for himself or for us. So, he also appoints a battery of out-of-work lawyers and accountants like me, to help him fight the regulator.

He also needs to know which companies to invest in, and so brings along a team of ‘Equity analysts’ who do nothing but read up boring incomprehensible annual reports of companies and try to ‘value’ a company’s worth. That they get it wrong most of the time is explained away by saying that markets react irrationally, and so, unless they get it horrendously wrong, they get to keep their jobs (Equity researchers rank pari passu with Weather Forecasters, Crystal Ball Gazers, road side palmists, tarot card readers and worse of all, Economists). To complicate matters further, there are sell side analysts (whose bread and butter comes from selling their crap reports to gullible fund houses) and buy side analysts (bechare, they don’t even get to sell their beautifully bound well-decorated reports).

So, as you can see, Mutual funds are vehicles of wealth creation. They create enormous wealth for so many useless finance graduates (in the different roles mentioned above), either directly or indirectly. Whether they do add to your wealth over the years is something you have to find out by putting up some money into a fund. I’d recommend an open ended SIP from one of the top performing funds, though I must warn you: “Past Performance is not an indicator of future returns.”

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