Lesson From 2008

A long and terrible year has come to an end. For mutual fund investors, this has easily been the worst year ever. This is hardly surprising given the way stock prices have collapsed across the board.

The mainstream equity category of diversified equity funds halved investors' money, falling an average of 55 per cent during the year. This 55 per cent loss represents more than Rs 60,000 crore of losses for investors who had invested in diversified equity funds.

This was actually slightly worse than the two large-cap indices, the Sensex and the Nifty which are both down about 53 per cent during the period. This is unusual-the average diversified equity fund generally beat the indices by a wide margin.

The depth of the collapse in 2008 has led to a certain fatalism among fund investors. People have just thrown up their hands, figuratively speaking, and abandoned any attempt at looking more deeply into what went wrong and what went right. Or at least, what went more wrong and what went less wrong. The 55 per cent is merely the average of the funds. There's rather a large range hidden within this. The worst fund is down about 80 per cent and the best one just about 35 per cent. The 80 per cent is not really an extreme case-in all there are eight funds that are down by more 70 per cent. At the other end of the performance continuum, there are about 10 funds that fell 45 per cent or less. This is not a small difference. If you started the year with Rs 20 lakh, the worst fund would have reduced it to Rs 4 lakh and the best one would have reduced it to about Rs 13 lakh.

Of course, the above numbers apply only to the worst-case investors-those who made their entire investment a year ago. Hopefully, there are many mutual fund investors out there who have imbibed the correct mantra and have been around for a longer-term. Such investors will appreciate the fruits of choosing good funds better. Over the past three years, the best funds would have grown your 20 lakhs to between Rs 25 lakh and Rs 28 lakh while the worst ones would have shrunk that amount to around Rs 10-12 lakh.

The best part of the story is that differentiation between the better and the worse is as predicted. Funds that were more aggressive, that dabbled more in smaller companies and took more concentrated bets are the worst performers. In fact, the three worst funds of 2008 were in the top five in 2007. This slide from the very top to the very bottom is not unexpected. It holds an old, well-worn but fundamental lesson-mutual funds that do the very best in bull runs fall suddenly and sharply when the good times turn to bad. It's an inevitable side-effect of how equity fund managers generate excessive returns during bubbles.

In many ways, the real surprise of 2008 was how debt funds fared. Debt funds are supposed to be stable and conservative so these surprises came as a shock to their investors. While I've discussed debt funds in detail in past weeks, it must be pointed out that the crises faced by these funds during 2008 fall into two categories. Interest rate changes, while unexpected, are very much part of the game and will remain so. But the liquidity freeze in October and November was a structural problem that is unlikely to happen again.

All in all, 2008 may have been a terrible year, but given what happened in the underlying markets, it did follow a pattern. Moreover, it was a year that clearly points the way forward for fund managers and investors.