How Frequent Changes to Mutual Fund Portfolio Affect Investor Interest?

Full and Actual Question from Mr.Sameer Mittal:

Does acportfolio of stocks in the mutual fund change frequently?

 

Answer:

Dear Mr.Sameer Mittal

A very fundamental and useful question as it touches the very foundations of investment philosophy. I will give you ten out of ten for asking this question. The real issue is not whether the portfolio is churned frequently, for the answer is yes, indeed the stocks in the portfolio change frequently; more important is to raise and ponder over the question, what is the necessity to meddle with the portfolio?

Legendary value investor Warren Buffett says, “If a share is not worth holding for 10 years, it is not worth holding even for 10 minutes!”, which means that only stocks that are worth holding for a lifetime should have found their place in the portfolio, in the first place! A frequent change in the composition of the portfolio is bad and detrimental to the interest of the investors in the mutual fund.

Next let us address the point, why does the fund manager meddle with the portfolio? The reasons are as follows:

1. Investors have a short-term investment horizon. They tend to measure returns based on the ‘Net Asset Value’ or ‘NAV’ of the units, which in-turn is entirely dependent on fluctuation in the prices of the underlying shares in the portfolio. The short term vision and unreasonable expectation of growth in the NAV exert extreme pressure on the fund managers.
2. The mutual funds instead of attempting to educating the investors, succumb to the performance pressure and resort to unwanted churning of the portfolio.
3. The fund managers also think they need to do something to justify their employment and the high salaries they are paid; how can one justify the employment and monthly pay-check if one has created a portfolio that need not be touched for a hundred years?

 

Mutual Fund Manager Juggling the Portfolio

Having understood that stocks in a mutual fund portfolio change frequently and the reasons for the stirring let us now study why it is not in the interest of investors:

1. The annual fund management fee which is about 2.25% is very high and pinches the pocket of the investor. On the other hand fund management costs of index fund or anexchange traded fund are less than 0.50%, precisely because there are no frequent changes to the portfolio.
2. The market dynamics are so violent and unpredictable, sometimes if you sell shares of a good company, the prices may undergo such an upward shift that you may not be able to buy the shares again - at least for a very long time; you simply miss the bus.
3. Frequent moving in and out of a company deprives the portfolio certain jackpot benefits like bonus shares, and extraordinary special dividends (for example Hindustan Zinc Ltd. declared 1200% special dividend on the occasion of Golden Jubilee celebrations) in addition to the regular annual dividends.

In conclusion the underlying shares of a mutual fund portfolio under go undesirable frequent changes which cost investors dearly.

With Best Regards

Anand

Please Note: This post is based on the question I had answered on the website ‘Quora’, which I thought could be useful to the visitors to this blog site also.