Do mutual funds offer compounding benefits?

There is a new idea around that there is no compounding benefit in mutual fund investment. This seems to have started as one of those social media attention-getting statements and has taken on a life of its own. I see ‘finfluencer’ types repeating this as a great piece of revealed wisdom, implying that this is the reason why it does not make sense to invest in mutual funds and usually accompanying it is an invitation to take up that finfluencer’s advice. I guess everyone has to make a living, but please do yourself a favour and don’t make this piece of wisdom an input to your actual investment decisions. Let’s examine why. The idea that mutual funds do not offer any compounding is generally based on the logic that compounding only happens in compound interest, where the interest on a deposit is added back to the deposit. Unless an investment conforms to this and obeys the formula for compound interest, CI = P (1 + r/n)nt - P, then it cannot be called an investment that offers to compound. Well, indeed, mutual funds themselves do not generate interest income which is added back to your investment.

However, unless you’re into academic hair-splitting, this is also irrelevant. Mutual funds are a pass-through asset class and provide a convenient way to access the benefits of the underlying investment. For example, equity mutual funds are not themselves equity but give you the benefits of equity investments, fixed income mutual funds are not themselves bonds but the benefits of bond investments, gold mutual funds are not themselves gold but … etc. You can think of as many examples as you’d like. So the idea that mutual funds themselves do not generate interest income that is added back to them is meaningless.

The real question is whether the underlying investments that a mutual fund makes have any compounding benefit. Here, one must exit the academic world and enter the world of real business and the economy. Compound interest gets its name because the investment is made up of the original investment along with the growth it itself generates. This process of growth itself, contributing to further growth, is the root of why we use this term. All business growth and economic growth are built upon earlier growth. Otherwise, the amount we would have grown by would have stayed constant, like simple interest. During the early 1980s, India’s GDP grew in the range of $5-10 billion yearly.

In the last few years, it has grown in the range of $300-400 billion yearly. Look at businesses. Thirty years ago, the annual revenue of Infosys used to increase by roughly `30-40 crore every year (I’m talking of the 1993-95 period). In the last few years, it has been increasing in the `10,000-20,000 crore range. Why are these numbers increasing? What is happening? I’ll give you an example much closer home to me personally. I started Value Research three decades ago. In the earliest times, my revenue would increase by perhaps a few tens of thousand rupees yearly. Year by year, I have invested the businesses’ earnings back into the business to reach our current scale. Everyone who has done business firsthand understands this very well because they have experienced it and felt it day after day. There’s another factor that we must appreciate, which is the exponential rise of human skills. As time passes, people get better at understanding and doing things, technology develops, and so do skills and competence. This process, too, is accretive and exponential. Isaac Newton wrote, “If I have seen further, it is by standing on the shoulders of giants.”

All this is why investing in a mutual fund is a compounding process. The underlying business and economic processes feed growth back into the input, enhancing growth further. That’s the actual meaning of the term compounding when applied to investments and growth. The compounding of growth is not about an academic formula written on a blackboard but about how real businesses grow. There’s a term called ‘Duck Test’. Its Wikipedia page begins by saying: The duck test is a form of abductive reasoning, usually expressed as “If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck.” The test implies that a person can identify an unknown subject by observing that subject’s habitual characteristics. It is sometimes used to counter abstruse arguments that something is not what it appears to be. Real business and economic processes, as well as investments based on them, pass the duck test for being compounding processes. As savers and investors, that’s all that matters to us.

(The author is CEO, VALUE RESEARCH.)