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Mutual Funds - Why minimalism may be the best solution for mutual fund investors

09 Jun 2020

Minimalism in art, music and society is the use of the smallest range of materials and the simplest of forms in the creation of something. In mutual funds, it is the creation of a simple portfolio that delivers returns at low cost. A recent article by Prateek Oswal, head, passive funds, Motilal Oswal AMC, argued strongly for it. We explain why minimalism is needed and who it works for.

According to experts, there are two big reasons for embracing minimalism.

First, having a large number of funds gives returns on a par with what the index gives or below that. This goes against the purpose of a mutual fund portfolio, which is to beat the index. This happens because the underperformance of one fund cancels out the alpha or outperformance in the other.

“A portfolio with a large number of funds will tend to underperform the index but with active management costs," said Prateek Pant, head, products and solutions, Sanctum Wealth Management.

As funds move in and out of fashion, you also end up switching between them and incurring costs in the form of exit loads and taxes.

Second, managing a portfolio of many mutual funds needs time and expertise. The latter, especially, comes at a cost in terms of distributor or adviser fees.

Minimalism can technically be adopted with either actively managed funds or passive funds, which simply track the index. Oswal argued for a minimalist portfolio with just three funds. It would consist of two index funds, one covering India and another covering international markets, apart from one liquid fund.

In general, passive funds tend to have lower expense ratios (costs) and experts pair minimalism with them. “A minimalist approach works better with passive funds. When you go active, the need for diversification across fund houses and strategies is stronger," said Vidya Bala, founding partner and head, research, Prime Investor, a mutual fund research platform.

This is because active funds depend on fund manager skills, while passive funds just replicate an index. This is more pronounced in debt funds, which over the past two years have been hit by numerous defaults and downgrades. Since there are very few passively managed debt funds, minimalists tend to advocate low-risk liquid funds. These are less vulnerable to credit events (defaults) and interest rate movements than other debt categories.

But this does not mean you should do away with minimalism in case of active funds. You can take the middle path with two-three funds on the equity side and two funds on the debt side for a portfolio which includes active funds.

However, some experts remain wary of minimalism when it comes to portfolios of high net-worth individual (HNI) investors.

“For HNIs, there is alpha to be had in the mid-cap and small-cap spaces because here active funds are still beating indices. In addition, allocation to gold can also add value. About gold, a lot depends on the investor’s outlook towards fiat currency—whether he or she anticipates high inflation and money printing," said Nithin Sasikumar, co-founder, Investography. However, for retail investors who cannot afford advisers or manage complicated portfolios, Sasikumar favoured the minimalist approach.

If you do not have large sums of money and complex financial needs, a portfolio of a dozen mutual funds will do more harm than good. The market correction that has followed the covid-19 crisis offers a good chance to clean up your portfolio since redemptions of excess funds may not attract capital gains taxes. Embrace a simple portfolio that keeps your costs low.

Source: Live Mint BACK