What returns should you expect from equity mutual funds?

We'll start this article by telling you about one of the founder's experiences with a mutual fund agent before starting his advisory service. I was sitting in the CAMS office with a friend because he had to submit some documents. While I was waiting, a broker came up to me and told me to invest in the HDFC Equity Fund. I asked him what kind of returns can I expect from this fund, and he answered that since the past five years, the fund had given returns over 20%, and you can expect the same. When he made this forecast based on past returns, I lost interest and walked away saying thank you.

Now let me highlight one crucial factor: historical returns are not indicators of future returns. Whenever you invest in mutual funds, the disclaimer always says that mutual fund investments are subject to market risk and part returns are not indicators of future returns. But why does the literature of mutual funds show their historical returns if they are irrelevant? We will answer this question towards the end of the article.

There are many examples of funds performing very well in the first 10-12 years, but post that, the performance declined, and the returns from those funds were not as expected. You can't simply rely on the historical returns as they are mostly irrelevant. However, you require some return expectations when you invest or do your financial planning. You need to know the kind of return you can expect so that you can invest a particular amount in a fund to meet your future goals. Since I've made it clear that the past returns are irrelevant, on what basis do we form return expectations?

To understand this, there is a framework for estimating a return. This framework will help you get an approximate rate of return that you can expect from the equity market/mutual funds. However, this will only be applicable for the very long term (at least 5-7 years plus). The above framework is based on the fundamentals of the economy. We will develop a small formula using those fundamentals, but before that, let's understand a few other concepts.

For those people who do not know, the finance theory says that equity returns are based on two factors – EPS and P/E ratio. Suppose the stock price is Rs. 1000, and EPS is Rs. 100, it will mean that the P/E is 10. If the EPS grows to Rs. 110, the stock price grows to Rs. 1100, and the return is 10%. But, if the EPS grows to Rs. 110 and the P/E also increase to 11; the stock price would be Rs. 1210 and giving a return of 21%. Therefore, we have to forecast EPS growth and P/E expansion to forecast returns.

Look at this formula:

Return from a diversified fund = Real GDP Growth Rate + Inflation + P/E Expansion delta + Market risk premium + Fund manager alpha

This may look too complicated, but it is a pretty basic formula in reality. The last two items are fund specific, and We will discuss those later. The first three items are grounded in the principles of fundamental analysis. GDP growth and Inflation are the real drivers of the EPS growth of the overall market (the market represents the country's economy), and this growth combined with the P/E expansion determines the market returns. Let's use 2017 data to determine if it worked in India or not.

Our GDP growth in 2016 was more than 7.5%. International agencies forecasted that India would grow somewhere between 7.6%-8% given the stage of economic growth and our demographic profile; there are enough reasons to be optimistic about our growth prospects. Let us now discuss Inflation. The RBI set a long term inflation target of 4%. While a 4% inflation target is laudable, our view is that it may not be feasible because of two factors. We are dependent on imports to meet our energy (crude oil) needs. Over the last couple of years, we had a bonanza in the form of low oil prices, but as long as we are dependent on imports, Inflation is not within our control. Also, our agriculture is monsoon dependent. While the rain gods were benevolent this year, our dependence on monsoon makes it difficult to target and control Inflation. High Inflation in the past was also due to certain structural factors, which the Government is trying to address through reforms. Combining all the elements, our estimate of medium to long term inflation rate is around 4.5 - 5% (slightly higher than the RBI target).

If we combine the above two, i.e. Real GDP growth rate + Inflation = 7.5 - 8% + 4.5 - 5% = 12 – 13%. Now, we need to look at the P/E expansion. All we need to do is take the data for the last 10 years and see the rate at which the P/E has grown in our markets. We took Nifty 50, and the P/E expansion came to be around 1.9%. However, if you took the US markets when it was an emerging market, the P/E expansion was nearly 3%. Though India is an emerging market, we cannot be very optimistic about having a P/E expansion of 3% or more. So we take 1-2% as the P/E expansion rate. Therefore, you can expect 12-13% + 1 – 2% = 13 – 15% returns from the equity markets.

This article discussed an economic framework for determining a reasonable rate of returns from Indian equities over a long investment horizon. Please note that our economic estimates are based on certain assumptions. If these assumptions change over time, you should revise your estimates accordingly.

As an investor, you should also layer on this economical estimate, fund-specific characteristics, e.g. if you invest in small and midcap equity mutual funds, you can expect a few extra percentage points of returns commensurate with the risk associated with small/midcap stocks relative to large-cap stocks.

Finally, you can also expect some alpha from the fund manager. Remember, at the start of the article, we said we would discuss why we have references to historical returns in mutual fund literature later in the post. Historical returns have little relevance as far as future returns are concerned. Still, relative to market benchmark index returns, historical returns can give investors some sense of the alpha generated by the fund manager. The higher the alpha your fund manager creates, the greater your wealth creation will be over a long investment horizon.

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