I’ve tried to summarize the key issues that I see with Mutual Funds in India (MFs)
(These are broad observations & there will always be exceptions)

1. The fund manager or AMC seldom eat their own pudding.

By that I mean they are often not co-invested with you (the investor) to any meaningful degree. There are exceptions, of course, and I’ve listed them here. Ideally, someone who is managing a fund ought to have his entire or majority of his investment portfolio aligned with yours. S/he may have started well before you so the companies may not quite line up, but the general idea is that he oversees a portfolio which is of economic interest to him & his family because his net-worth is fully invested in it – and he thinks in a similar way for his clients. This situation is the norm in separately managed accounts (PMS offerings) – but as always – it is good to ask and confirm.

However, in Mutual funds, it is not the norm, and thus harder to establish the alignment of interests. The ideal MF would demonstrate that the Fund manager(s) have a substantial portion of their networth invested in the fund, alongside investors, And, demonstrate that the asset management company (the AMC sponsoring the mutual fund) is also invested substantially along-with the fund. In the absence of this, at least one of the two should demonstrate their conviction. You should be able to ask this very direct question and if you don’t get an answer you like, you have to make a judgement call.

Seth Klarman, the legendary value investor who manages the Boston-based Baupost fund, wrote this in his 2015 letter to clients :

“Risk is also mitigated through alignment of our interests with yours. Baupost employees, collectively, are the largest client of the firm… Eating home cooking is a cornerstone to our approach.”

Recently, someone did a study on this very issue of incentivization – see this & this

2. Longevity, Diluted interest & quality of the fund manager

Longevity : MFs routinely lose fund managers to other AMCs. When a new fund manager takes over, he has to “own” the portfolio of his prior fund manager. Would he prefer to own the same portfolio or make changes? Would he definitively know why a particular company was purchased in the past? Maybe.

Diluted interest : AMCs run multiple schemes and often have one fund manager “oversee” multiple mutual funds, each with different histories and objectives.

Quality : Perhaps because of the high turnover in fund managers, MFs don’t care to emphasize the fund manager, giving at most a 3-4 line description about them. Typically, I’d like to know a lot more about the person, his/her influences / investing style / mentors / bio – and even a video interview. How hard is this in today’s day and age? You seldom get to know who is really managing your money, how long they’ll stay & this makes it hard to commit a substantial chunk of your excess savings with a fund that is best known through an offering doc & presentation.

Grey hair – in the investment business, grey hairs do count – It is valuable to me that a fund manager has seen two or more business cycles while managing money. If I am going to trust my savings to someone who has been managing money only since 2008/9 then I would like to know a lot more about them. How much are they co-invested? Do they have a mentor (ICICI’s Value Discovery ~14K Cr fund for example is managed by Mrinal Singh, who is only 37 but who is mentored by (and one could argue – overseen by) the highly respected value investor S Naren.

3. Over-diversification

Diversity is valuable, but beyond 20 stocks, the added statistical “value” to the excess diversity is not very material. Motilal Oswal’s funds understand this, and have some of the most unique MFs in India – holding what “appears” to be a concentrated portfolio of 25-30 stocks. Having 80-100 companies to track meaningfully reduces one’s ability to follow them as individual stories playing out and re-orients a manager to view them as statistical moving parts.

4. Too much turnover.

A turnover of 100% means that within a single year, the entire portfolio of holdings was sold & replaced with new holdings. There are many funds which have turnover in the 50-100% range, some even higher. Where possible, managers tend to sell after the 1 year point to reduce taxes. But this kind of turnover implies activity – a lot of it. What is the issue with this much “activity”? There are funds which do a lot of rotation (trading) and have good returns. Philosophically, this doesn’t quite align with how I’d like our monies to be managed. A turnover of 10% implies a holding period of 1/10% ~ 10Y. I’d like to see at least an implied 3Y holding period.

5. Reduced Flexibility

MFs are regulated, and cannot be particularly opportunistic. They tend to be on the higher side of the quality curve, investing conservatively. This is a good thing for most people. By investing in established, quality companies they reduce risk to their investor base. But this also means that they cannot often invest in companies that are turning around – or other situations where there may be a large unlocking of value possible. MFs are mandated to follow a set pattern. Most MFs “are” the market, and only barely beat the indices. Another way of saying this is that the majority don’t justify the 2% fees. A number of them do beat the indices, and are low risk – Value Research and FundsIndia are excellent resources to study MFs.

These issues are not unique to mutual funds in India – they are the norm world-wide. If you’d like to read more on this subject, consider David Swensen’s book “Unconventional Success” has an entire section on issues with most mutual funds. [Swensen managed Yale University’s endowment fund for almost 30 years, and is one of the 100 most influential institutional investors worldwide]

section from Swensen’s book

Next up : the best Portfolio Management Schemes in India