Mutual Funds or Investment Funds are clever inventions of the financial world.
The way how these funds work is they collect money from the investors and invest it into the market on their behalf. The profit made from the dividends and interests is passed on to the investors of the fund, subtracting the expense fee of the fund. These funds let people diversify their investments without making them spend significant time to research stocks and bonds and understand complex financial instruments in the market.
The fund manager is responsible to researching the market and deciding the appropriate financial instruments to invest in. Good decisions of the fund manager yields profit to the investors and attracts more investors, making the fund even bigger.
People often tend to search for the funds with aggressive returns on an assumption that they will keep giving the same results. Though past performance does not guarantee future outcomes in any field of life, this cannot be more true for Investment Funds. In fact, there is some research showing that it is very difficult for Investment funds to sustain high returns if at all possible.
Here are a few reasons why a winning Fund do not remain a winner for a long time:
1. Migrating Managers - As a fund starts showing high returns, the demand of the Fund Manager goes up and all the competitors try to approach the manager to get him manage their fund instead. Due to this, a lot of managers leave their funds and start managing funds elsewhere. This lead to loss of the initial vision and investment style / strategies of the fund which now is handled by some other manager. 2. Asset Elephantiasis - This problem is faced by almost every fund which starts generating promising returns. The good performance of the fund leads to its increase in its visibility, and hence more people start pouring their money into the fund. The manager has following choices in this case:
a) Keep the cash. This is risky because in case the stock prices keep rising, the overall return of the fund will be diminished due to the un-invested cash.
b) Increase the quantity of already owned stocks. These stocks have already shown good returns and are probably already being sold at inflated prices. Buying more of these means the manager is buying them at inflated prices which is violation of rule 101 in investing, i.e. never buy stocks at inflated prices.
c) Buy new stocks. The reason why these were not already a part of the portfolio was probably because these were not at par as per the manager's strategy. Forcing the manager to buy these could eventually degrade the returns. This is also a very effective way of spreading the manager's attention too much.
As you can sense, none of the above 3 possibilities look good. This is a serious problem faced by the fund managers and a possible alternative to this could be investing in close ended mutual funds, which limits investors' entry or exit from the fund until maturity of the fund.
3. Rising Expenses -
As you can sense, none of the above 3 possibilities look good. This is a serious problem faced by the fund managers and a possible alternative to this could be investing in close ended mutual funds, which limits investors' entry or exit from the fund until maturity of th.kly add up and now the fund needs to perform significantly well as compared to the market in order to just offset the expenses of the fund.
4. Sheepish Behavior -
As the fund grows with some good record of performance, its capital also increases. As a result, the Fund Managers start becoming more cautious and conservative which results in deviation from the strategies which brought them there. They start replicating their portfolios with more safe options and as a result many big funds tend to converge towards holding same set of securities even in same proportions resulting into similar returns to that of other funds.