Parekh, who himself started a Mutual fund, said that mutual funds have brought in a lot of volatility in the markets. Investment management was a profession but due to the urge to make quick money it has become more of a business. The strategy for most of the mutual funds now is to time the market rather than invest in sustainable good businesses.
An ideal mutual fund should have the following characteristics:
- Long-term investment horizon
- Give prompt exit to investors (within 24 hours)
- The fund managers should be competent with years of experience
- Assisted by strong research analysts
Parekh explained why he is against open-ended mutual funds and stated that long-term vision could not be supplemented with an open-end structure.
Open-ended mutual funds are those which can issue and redeem an unlimited number of units. This means that for one to be a buyer, he can directly claim new units from the asset management company (AMC) rather than waiting for existing unit holders to sell their holdings.
The author explains because of this open-end structure, when the markets start falling, investors exit their holdings of mutual funds. Since the AMC needs money for payout, they sell their portfolio holdings at a lower value in the bear market. This gives momentum to bear markets. On the contrary, for investors who want to buy mutual funds when the market is booming for them, the AMC needs to purchase at higher prices and hence invest at inflated prices.
AMCs also spend on marketing. This provokes them to build investment products that suit the trend in the market. For example, during the IT boom, most of the new funds had IT as their prominent holdings. This gave rise to Herd Mentality.
He strongly states that because of making the mutual fund industry a business rather than a profession, the whole purpose of mutual funds has become outdated. Money management needs to be a profession rather than a business of growing assets under management (AUM).
A Fund manager should be evaluated based on the performance of existing funds rather than how big AUMs he/she is managing. The next anomaly, according to the author, is benchmarking the returns. The benchmark should be absolute returns rather than some index.
The solution to this as per the author is banning the open-end funds. Closed end mutual funds are the best investment tools for retail investors and the investment industry as a whole.
In a close-ended mutual fund, there are a fixed number of units that can be bought and sold. Consider this like a stock where there are a fixed number of shares that are issued in the market. The next set of issues can come only via an IPO. This helps portfolio managers to create the ideal long-term portfolio, as they are now not afraid of selling their holdings in case of a redemption request. If an investor wants redemption, he needs to find a buyer, just like how stocks are traded.
The chapter makes us aware of the various mental heuristics that many of us possess in our investments.