Mimicking or Copying a Mutual Fund Portfolio: Good or Bad Investment Strategy? Explained!

“One of The Funny Things About the Stock Market

is that every time one person buys, another sells,

And both think they are astute”

                          — William Feather

When entering the world of stock investment, the first crucial step is selecting the right stock or mutual fund according to our needs.

While selecting stocks is a cumbersome move, as it involves careful research and analysis. We evaluate the financial health of the company by studying its income statements, balance sheets, and cash flow. Additionally, we also examine the industry’s prospects, analyzing growth potential and competitive positioning.

The process includes considering both fundamental and technical aspects, looking for trends, and assessing volatility. Furthermore, we use financial ratios like P/E and dividend yield to understand the stock’s valuation. So finally, we decide on a stock and invest our hard-earned money.

Now, you will have a fair idea of how to select the right stock for investment.

Table of Contents:

1) What does a Fund Manager do?

• Stock Selection:
• Portfolio Monitoring:
• Risk Mitigation:

2) Replicating the Fund Manager’s portfolio

• Choosing the Best Strategy.
• Choosing the Best Stock.
• Periodic rebalancing by fund managers:
• Mimicking the thought process:
• Costs and Taxes:
• Time and Effort:

3) Conclusion

Suppose you are willing to take part in Mutual Funds then, how do you choose the Right Mutual Fund?

While choosing a mutual fund we study the fund houses, read about the fund manager, see the past performances evaluate the alpha, and downside protection, compare its performance against its benchmark, and so on to choose a mutual fund.

If you are seeking further guidance on how to select a Mutual Fund then feel free to watch our video on:

Phew… Does a stock/mutual fund selection have to be this time-consuming and complex? There should be another question that is popping through your mind.

Why shouldn’t I try to replicate the outstanding XYZ mutual fund? After all, they have the holdings released to the public. Additionally, I could also realize substantial savings on expense ratios.

Is it necessary for me to opt for the mutual fund? Why shouldn’t I just invest in selective stocks directly held by the mutual funds and try to make substantial returns, if not surpassing those of the mutual fund returns itself?

Can I make more money by mimicking or copying a mutual fund portfolio?

Well, if you also had the same thought running through your mind, then this article is tailored for you to explain why this isn’t the right approach for investment.

1.) What does a Fund Manager do?

Before we dive into the details as to why mirroring a portfolio might be a bad idea, we should get to know what exactly the fund managers do. This will provide you with comprehensive insight and will further strengthen our claim in not replicating their portfolio.

i) Stock Selection:

Fund managers are like experts in picking the right stocks. They spend a lot of time researching and choosing stocks from a specific group they focus on. They use special data and tools, some of which others might not even have access to. The selected stocks go through strict criteria to make sure they meet certain standards.

Fund managers also have a big network that gives them important and timely information. After all this, they conclude and pick a small number of stocks from the many available. They always keep an eye on how the market is doing, what’s happening in different industries, and the financial details of the stocks.

This helps them make smart decisions to build the best portfolio while managing overall risks efficiently. The fund selection is the phase where most of the time and resources are spent so that they get to select the best stocks for their funds.

You may also check some of our previous articles on the PMS reviews where we have discussed the strategies used by some of the PMS to select the funds that they invest in.

ii) Portfolio Monitoring:

After selecting and activating their chosen stocks, fund managers maintain a vigilant watch, actively engaged in the day-to-day monitoring of their portfolio. This involves meticulous scrutiny of stock performance, constant oversight of management activities, and tracking geographical changes that might influence stock dynamics.

Fund managers remain deeply involved, ensuring a proactive stance in managing the portfolio to adapt swiftly to emerging market trends and unforeseen developments. This ongoing commitment reflects their dedication to optimizing stock performance and safeguarding investor interests through real-time assessment and strategic decision-making.

iii) Risk Mitigation:

A critical aspect involves nuanced risk management, including the assessments of various risk factors such as market volatility, and economic shifts, and keeping a tab on the various geopolitical events. They also take the most important buy/sell call and whether to reduce the stake or completely exit from the stock and vice-versa.

As captain of the ship, they will have to navigate the complex financial landscape and strive to generate optimal returns for investors while managing risks prudently.

2.) Replicating the Fund Manager’s portfolio

Now that we understand the role of a fund manager, wouldn’t it be wonderful to replicate their success akin, to their mutual fund portfolio? We shall try constructing each element of the mutual fund portfolio and see what we end up with.

We will also get to know what the risks and challenges are and if this is a suitable risk-reward for us to go ahead with such a portfolio of stocks.

i) Choosing the Best Strategy.

All right, our first step is crucial: selecting the optimal strategy. Our aim is twofold: to mitigate future risks while outperforming the markets. We begin by compiling a list of various strategies available in the market: Value funds, Growth funds, Balanced funds, Flexicap, Sectoral funds, Global/International funds, and so forth.

However, should we simply combine all of them into a single mutual fund? Not advisable.

Such an approach would result in over 200+ stocks, making it exceedingly challenging to manage effectively. Each type of fund tends to excel during different market phases, depending on prevailing macroeconomic factors. This is precisely why these funds are kept separate.

Each strategy mentioned carries a distinct risk appetite, and investment objectives, and caters to a different set of investors, each with specific goals in mind. Fund houses offer different funds for each purpose, making it unwise to consolidate them all into a single fund.

Hence attempting to single out a single strategy would only lead to confusion regarding what to select and what to leave out, ultimately leaving us with nothing but uncertainty

ii) Choosing the Best Stock.

When considering replicating a mutual fund’s portfolio, a critical decision arises regarding whether to purchase the entire set of holdings or focus solely on the top holdings. Opting for the former choice, which involves acquiring all 30 stocks in the fund, could lead to two potential issues.

1.The first issue is that it is next to impossible to have all 30 such stocks with the same weightage. Imagine the fund having high-valued stocks like MRF, Page Industries, and Honeywell in their portfolio and you have a budget of 15K per month, how would you even fit in such stock?

Even if you have an investible amount of more than a lakh this wouldn’t be possible. But you can take advantage of these stocks if you choose the mutual fund rather than stocks as they offer wide diversification at a smaller price.

2.The second issue is that the allocation for each stock would be reduced, potentially hindering portfolio performance. Over diversification, in this case, dilutes returns, as spreading resources too thinly across numerous holdings may limit the impact of any individual stock’s performance.

However, mutual funds manage this issue through rebalancing and allocation strategies. While individual investors may transact in smaller amounts, mutual funds allocate significant sums, even if it means a minimal percentage allocation to a single stock. This allows them to maintain balanced portfolios while still achieving sufficient exposure to each holding.

Conversely, opting to invest solely in the top stocks held by the mutual fund presents its own set of challenges. Such an approach may result in a highly skewed portfolio, with a few select holdings dominating the allocation. Consequently, the portfolio’s daily movements could be extreme, both upwards and downwards, heightening overall risk.

Additionally, this strategy reduces diversification, leaving the portfolio vulnerable to adverse market conditions.

How important is diversification to our Investment Portfolio?

To enlighten yourself more on diversification we recommend you to watch our video on:

Moreover, focusing solely on the top holdings may overlook opportunities presented by lesser-allocated stocks in the mutual fund’s portfolio. These stocks, although not among the top bets, may exhibit strong performance and contribute significantly to the fund manager’s strategy. By excluding these stocks, investors risk missing out on potential gains and limiting their portfolios’ growth potential.

So, whatever the stock selection strategy we tend to miss out on the collective benefits as a whole and so this may not prove to be a worthy portfolio

iii) Periodic rebalancing by fund managers:

When selecting stocks for a mutual fund portfolio, fund managers carefully consider prevailing market conditions. They conduct thorough market analysis to identify investment opportunities and adapt to changing dynamics.

For instance, during periods of economic expansion, they may favor growth-oriented stocks, while in times of market uncertainty, they may seek defensive investments. Fund managers regularly monitor market trends and periodically rebalance the portfolio to maintain alignment with the fund’s investment objectives.

For example, if a fund aims for a balanced portfolio with exposure to various sectors, the manager may adjust sector weights based on market performance. This proactive approach ensures that the scheme’s portfolio remains well-positioned to capitalize on market opportunities while managing risks effectively. This is where the professionals tend to differ from us. We may never catch the sector rotations which the fund managers can to some extent and take advantage of buy/sell stocks

iv) Mimicking the thought process:

All said and done, you may believe it is still possible to somehow mimic the portfolio despite all the above facts. But one thing that cannot be mimicked is the fund manager’s thought process.

Every stock the manager buys goes through multiple research and filters and some teams research for days together to come up with a strategy and finally decide on the stocks. They are well aware of the market dynamics and have a clear-cut plan as to when to buy and when to sell the stocks.

However individual investors like us will not be able to match this acumen of the fund managers when it comes to the perfect buy/sell prices.

The fund house’s strategy, holding period, and other internal risk management frameworks play an important role in the stock selection decisions, along with the weighting assigned to individual shares and sectors, which we as individuals cannot replicate.

Investing in different companies can have varying outcomes, with some showing short-term triggers and others exhibiting long-term growth potential. Fund managers adjust their holding periods accordingly.

For instance, one may target IPOs for immediate gains, while another may view them as long-term investments. We may never be able to gauge their thought process and even if we try to speculate it there are chances that it may go on a downward spiral rather than helping us build a good portfolio.

v) Costs and Taxes:

This exercise of mimicking a mutual fund may result in higher trading costs and taxes than a mutual fund portfolio. Here’s how.

We need to frequently buy/sell the stocks as and when the fund manager makes a change to his portfolio. So, this will only increase your brokerage unnecessarily, which can significantly add up over time. These costs put together would definitely be on the higher side when compared to the expense ratio of the mutual funds.

You will be required to pay the short-term capital gains tax for all the stocks that you have held for one year or less. This is in addition to your brokerages. This may become a major chunk of your taxes.

You will also be required to pay additional taxes on the dividends you get from your stocks. This burden is nullified in the case of mutual funds as the funds just reinvest the dividends from the underlying stocks and do not have to pay taxes.

Thus, the tax burden associated with replicating a mutual fund adds to the overall costs and may not necessarily result in a better risk-reward ratio. Finally, you should also consider the time and effort involved in the process.

vi) Time and Effort:

There’s a saying that “Time and Tide wait for no one,” and it applies to us as well. The process of emulating a mutual fund consumes significant time in selecting all the discussed elements. Additionally, it demands a considerable amount of mental and emotional energy to meticulously monitor the portfolio every month and rebalance it to align with the actions of the fund manager.

This effort can be draining, especially for those who are not well-versed in finance or lack the necessary experience in investment management. It may also be taxing and may detract us from other pursuits of life.

Therefore, while attempting to replicate a mutual fund’s strategy, one must weigh the investment of time and effort against the potential benefits and consider whether this is worth the time and effort.

3.) Conclusion:

Fund managers play a crucial role in simplifying the investment journey, leveraging their experience and expertise to navigate the complexities of the market. With specialized knowledge and the support of skilled research teams, they offer investors a range of options tailored to their financial goals, risk tolerance, and investment horizon.

While mimicking the portfolios of the best mutual fund schemes may seem appealing, it’s important to consider the trade-offs involved. Striving for simplicity and ease in investment decisions is key. The challenges involved in mimicking a mutual fund portfolio, undermine the convenience that mutual funds aim to offer investors.

A more practical approach may be to accept the modest expense fee associated with mutual funds and leave the art of wealth building to the seasoned fund managers.

Happy Investing!