If I switch mutual funds, will I lose compounding benefit?

Many investors worry that they would lose the benefit of compounding or growth if they switch mutual funds. A discussion on why is not true as part of the freefincal Q/A. As mentioned last week, I will respond to reader queries each Saturday. I was supposed to make a video response, but I don’t quite feel up to it. So I thought I will respond in text. You can use the form below to enter your questions for next week.

Debt fund for retirement

There are so many varieties of debt funds in the market. Which debt funds are appropriate for debt portion of retirement goal? Should we stick to only ultra short term funds only? – Eswar.

I would recommend sticking to EPF, PPF or NPS (pure debt allocation) for the debt component of a retirement portfolio. This si the natural choice for a salaried individual. A debt mutual fund can be added a few years later as the portfolio gets big

Ultra short-term funds can be used for any duration and is a good choice for those who want to minimise volatility.  Income funds that hold corporate bonds can also be considered (if comfortable). The key is to keep return expectations.

NRE vs NRO account

Could you please explain the merits and demerits of investing in direct mutual fund through NRE A/c Vs NRO A/c Vs Normal Savings A/c. Which A/c is better to use to benefit from any taxation perspective or any other benefits. – Arun

I sought the help of SEBI registered fee-only planner Melvin Joseph (part of my list) and he has the following to say:

An NRI is not supposed to keep a normal savings account, because he has to convert that account into NRO, on his becoming an NRI. So the option for NRI is to invest through NRE account or NRO account. In the case of investment through NRO account, he cannot repatriate the amount on redemption. Investments made through NRE account can be repatriated. Even though the tax rates are same for resident & NRIs, there will be TDS for NRE investors. If the person is planning for children education abroad and want the amount to be repatriated in future, invest through NRE account. Otherwise, both are same.

Excel Data Download

Data downloading from web to MS excel like MF NAV -Rajan

NAV data from AMFI is obtained via Excel using a url of this form:

http://portal.amfiindia.com/NavHistoryReport_Rpt_Po.aspx?rpt=1&frmdate=3-Apr-2006&todate=13-Jan-2017&mf=22&scm=119598

Notice the from date is 3rd April 2006 and To-date 13th Jan 2017.

The AMC code is 22 (mf=22) and the scheme code is 119598.

So we will have to change the structure of this url according to the choice of fund and from and to dates.

No programming skills are necessary. I just let Excel record a macro, use the code and change it the way I like. To make those changes, I simply Google, search in Excel forums until I have my answer 🙂

Here is a short video (no audio) explaining how to record the macro

Now over to titular questions:

Mutual Fund Reviews and Switching

SIP Portfolio review process, churning in and out really necessary? – Senthil.

Since long i have requested to you to provide detailed post on switching of funds after evaluating the funds. If v r in middle of Goal , how power of compounding effect there? How tax related efficent? Note: i have CAN and investing in direct funds but switching between fund house i guess not allowed too. I will be greatful to you if you consider my QUESTION IN your upcoming VIDEO Session. Thanks just an Example: i want to switch HT200 to MiraeA Large cap. – Jignesh.

To answer these two questions, let us first ask, “what is compounding?”.

Compounding is not the same as compound interest. At least not in the way it is used wrt equity!

Compound interest refers to interest for the amount invested in the first year and interest on the amount + 1st years interest in the second year and so on. That is interest on interest.

Compounding simply refers to any situation where there is no visible growth in the first few years, followed by spectacular growth later on. There are two ways this can happen:

interest on interest: like in fixed deposits

growth in value: of stocks.

Stocks, mutual funds or any tradable commodity does not offer interest and does not compound in the traditional sense.

However, in order to describe their growth rate and to compare with a fixed income instrument (that does compound), we use compounding formula.

This is essential to quantify the risk that we have taken. Read more: What is risk premium and why it is important

Here is an example of how to calculate the compounded growth rate with returns that are not the same year after year.

Does Switching affect compounding or growth?

NO. If we switch from one equity fund to another within the space of a few days, there will be no reduction in benefits. The returns will not decrease as many believe. It is just a transfer from one basket of stocks to another. As long as the switch is made between instruments of the same asset class, there will be no change in (future) risk or (past and future) reward.

Should we switch?

Well, we should always monitor our mutual fund investments, be it a SIP or lump sum. First, we need to decide the frequency of monitoring. Early on, once a year is enough. This means, that we do not worry about it in between.

Second, we need a review process.

Have a System!

Many investors do not have a system to review in place and get confused by what everyone else says

  • Have a reasonable, preferably low return expectation
  • Give the fund at least 3 years to beat the index
  • Check out my XIRR SIP tracker. You can track month by month outperformance. Does not have to be a SIP investment.
QLTE 1 650x334 - If I switch mutual funds, will I lose compounding benefit?
Month after month XIRR (return) of Quantum Long term Equity and its benchmark (Sensex TRI)
QLTE 2 650x333 - If I switch mutual funds, will I lose compounding benefit?
Cumulative outperformance of QLTE. As long as this number is pretty high, there is no problem with fund.
  • TheGrass is always greener: Wanting to invest in the top mutual fund all the time is plain immature.
  • Regret does not help! If you decide to switch and after you make the switch, the old fund may do better than your new fund!

Ignore Star Ratings and Do not Compare Peers

Peer comparison is inevitable during fund selection. We want funds that have a reasonable record of consistent performance.

Mutual fund selection is different from mutual fund review. Peer comparison during a review is useless, even if done right!

Peers 650x461 - If I switch mutual funds, will I lose compounding benefit?

Peer comparison is typically done the wrong way. A fund portal publishes results for a different duration that the one in which we have held the fund.

For example, we may have held the fund for 5 years and the peer comparison is made for 3 years or vice versa. Either way is incorrect because unless the durations are the same, it is like blind men touching the elephant.

The right way to compare peers is to calculate performance for all funds in the category for the duration and for the same investment dates of your mutual fund. For what it is worth, I am making such a tool (but don’t intend to use it!).

I have written about ignoring star ratings earlier:

Here is why you should ignore mutual fund star ratings

Part II: Here is why you should ignore mutual fund star ratings

The simplest reason being:

 Will you call yourself a bad English student, by looking at your Maths marks?

English (your fund performance), Math mark (star ratings). They are over different durations and therefore are different.

Now to answer the specific question:

Should I exit HDFC Top 200?

Well, I am an investor and here is a simple way to find out:

1: Go to Value Research T200 page

2: Click on performance tab

3: Set the from date (green box) to the date in which you started the investment

T200 650x604 - If I switch mutual funds, will I lose compounding benefit?

And see if that performance is acceptable for you. It is for me. My XIRR is 12.95%. I am happy with that. End of the review process.  If that is one-star according to others, so be it. I have better things to do than switch funds at the drop of hat.

If this is not acceptable to you, switch. I would recommend a complete switch out, else the folio would get cluttered.

If the “loss” due to tax and exit load is important to you switch “gradually”. Else switch out in one shot and begin investments in the new fund.

Remember: A few months later, your new fund maybe in the same state as your old fund. At that point, if you do not have a consistent and reasonable review strategy in place ……

Questions for Next Week

Use this form to ask your generic questions. Will respond to them next week

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11 thoughts on “If I switch mutual funds, will I lose compounding benefit?

  1. I think the basic premise on which this whole article is based is flawed, to say, the least. And the author’s rude comment like “So switch when tax outgo is lower or zero! Or don’t switch! No big deal!” is also uncalled for – at least on this elite forum. The basic fact of any investment decision is always to take into account income tax part and as pointed out by Marieswaran also the TDS part (though personally I am not much worred about TDS part as it will be adjusted against my ultimate tax liability).

    1. The basic premise is that the fund is not performing well and hence an investor considers a switch. It is common sense that one can switch gradually to reduce tax and loads. And is common practice that most people leave the old units as is and cutter up the folio. An immediate and complete switch is healthier than other options. You dont agree, you dont agree.

  2. Thank you very much Guru for taking my query.
    Well it is coincident or my good luck , but my goal and investment for such goal matching with yours. Started HT200 IN Jan2010 for my kid education and it is going on with Appx 12% CAGR. Also bonus to me that i clear my stand with HT200 now with your additional info.

    Thanks once again

  3. What is the way to calculate combined returns (CAGR) if one switches from Regular to Direct option? Or does it have to be calculated separately, considering them as 2 different funds??

    For e.g. If I’ve been investing via SIP for 3 odd years in Fund A – Regular Growth plan. This has given 12% CAGR and grown to a total amount of Rs. X.
    Now I switch this entire X amount from Regular to the Direct Growth option of the same fund and lets say after a year or so it shows me CAGR as 5%. How do I calculate my returns for fund A right from the beginning, considering this switch to Direct plan?

    Note: Valueresearch portfolio tool used to show this CAGR as 12% for Regular plan and once this switch is done to Direct plan, a CAGR of 5% is shown for the entire amount X.

Do let us know what you think about the article