FundsIndia Explains – Why there is no fixed return in mutual funds

When first-time investors in mutual funds approach us, the first question they ask is what is the ‘returns’ that the fund will give.

As investors we all like certainty in the returns we get from our investment; whether such ‘fixed return’ is an optimal choice or not is a separate point to debate. In this article, we’ll try and explain why mutual funds cannot offer fixed returns. It is better for investors to digest that piece of truth before investing. Mutual funds is a pool of money collected from investors for investing in various asset classes such as equity, debt or gold based on their objective.There is no promise to give a fixed ‘interest’ on the money collected. The money collected is deployed by fund managers in stocks, debt instruments or gold ETFs, all of which are market-linked instruments – that is their prices move up or down in the market.

There are several factors that affect the performance of these underlying instruments and therefore the performance of the fund that holds those instruments. Let us look at some of them.

Expectations and returns: Take the case of equity funds. Equity funds hold a number of stocks in their portfolio. Since these stocks are traded in the equity market, the prices of these stocks move up or down. This is not only based on how well the company is performing, but also based on whether more investors have a positive or negative view on the company. The stocks of those companies that are expected to do well are more in demand by investors, in expectation of better performance. Stock market analysts forecast how well the company is expected to perform and assign an estimated price for such growth in the company’s sales and earnings. If such upside seems high, the stock is in demand. The vice versa is also true. These factors are called a company’s fundamentals and are the key driving forces of the price of stocks.

Now, not all analysts have the same view of the company and not all of them have the same estimate of the fair price of the stock. Hence, the market is constantly trying to discover the price. News and corporate actions help the market move closer to such a price discovery. For example, if the actual financial results of a company are lower or higher than anticipated by the market/analysts, the stocks react negatively or positively as the case may be.

All these lead to gyrations in the price of the stock in the short term. But over time, it derives value from the direction of its performance – in terms of sales, earnings and return on equity.
Now if these are the factors internal to a company, there are also a number of macro events – inflation, country’s debt, political relationships within and outside the country that also have an impact on the markets. These in turn may have a broad-based impact on stocks and lead to an across the board rally or broad-market correction.

A fund manager has to take into account these micro and macro factors while investing, reviewing or exiting a stock. He may exit some stocks and enter new ones too.

Considering these, there is no way a mutual fund will be able to tell you what returns it can deliver. You may take comfort from past returns or at best understand if the current portfolio holds potential.

Debt funds too cannot guarantee returns for similar reasons but we will explain it in a separate article.

Thus, market-linked instruments are subject to gyrations that make it impossible to predict their returns. But the fact remains that mutual funds have delivered returns far higher than the ‘fixed return’ products like deposits over the long term. But these returns have come of a back of lot of gyrations in the short to medium term. The 2008 crisis or the 2000 dot com bubble all caused stress in the markets.

As a result of the reasons discussed, SEBI does not allow mutual funds to assure any returns or income. This prepares the investor to have realistic expectations from mutual funds.

While volatility and uncertainty of returns from mutual funds can worry you, the same volatility can be used to your advantage if investments are done systematically. The short-term gyrations can be averaged by using SIPs. Any event based volatility and subsequent fall in the market can also be used as averaging opportunities, consequently leading to greater than optimal returns when the market recovers.