The Mutual Fund Show: Lessons Learnt In Samvat 2075  

Nilesh: So, our jobs will remain the same; markets will go up and down, credit events will happen. We have to ensure that we are minimising risk and optimising return. I don’t think anything has changed from our job point of view. Of course, market conditions will continue to change but you can become a good batsman only if you score runs not only on batsman-friendly domestic pitches but also overseas bowler-friendly pitches.

Kalpen: Well, I’ll take it from where Nilesh left and say it in Gujarati; it’s Same-Vad. Here and here again, our message remains the same, nothing virtually changes. The environment keeps changing, prices keep changing, our behaviour keeps changing. We are cyclical but we tell the markets that you are cyclical. Thankfully, what we have seen is, in spite of significant turbulence, volatility, good news, and bad news; everything happening, investor flow continues to come into equity as an asset class and asset allocation funds as an asset class and that to me is a sign of maturity collectively as an industry. Investors, advisors, media and mutual funds all put together. I think gradually, we are making progress. It’s always good when in difficult times, you hold on, or you grow. I think I would be happy that this journey continues.

Nilesh: So, one, if we see over the year, large caps have done well, but just select large caps. Mid caps are more or less flattened, small caps are down. The key learning was to go for the quality, quality, and quality (emphasis on the need to go quality). In 2000, we made a lot of errors by buying non-quality businesses. Learnt from that and in 2002, we probably went wrong on the valuation side. Learnt from that and today’s hand on heart, I can say that the entire mutual fund industry, by and large, has come out with flying colours in avoiding kachara (garbage) stocks and buying quality stocks. There are companies after companies that are falling on the governance standard and many a time, murky foreigners are investors into it. But by and large, mutual funds have avoided them. So, there’s one focus and that is quality, quality, and quality and that’s the key learning from the past year.

Kalpen: The key learning is that last year when you asked this question, I mentioned that gravity exists and when valuations are high, incremental returns take time to come and quality companies survive good and bad times. Last year was the most challenging from an economic point of view from a regulatory perspective. The strong have become stronger even though their valuations continue to remain stretched but they continue to come better and better in terms of their execution. As Nilesh said, so many funds are closer to the all-time high in terms of net assets value in spite of this fluctuation and valuation. One more thing that I would like to say is that, risk or respect for risk is increasing and to me, that is a big learning for us as an industry as well as collectively as investors.

Recognising that where can you go wrong and trying to avoid that, versus where can you make more money. It’s a very unique balance to keep in mind and I think we are progressing in that journey.

Kalpen: What didn’t surprise me was that predictions aren’t difficult to make but what surprised us was while most conversations were around equity as an asset class, what did exceedingly well in the last twelve months was gold. The Government of India bonds were quality fixed income; good quality fixed return also delivered double-digit returns; very close to what Nifty was in a short period of twelve months. What was also surprising is that, globally, interest rates became less than zero; almost close to zero. So, these were new norms which we had not studied in school textbooks or the real world also. So, it’s going to be a very challenging and interesting phase going forward.

Nilesh: So, the extreme of the markets surprised me a lot. On one side, we have companies quoting below their cash value. The cash on their balance sheet and the market value of their investment today is more than the market cap of the company. The company has zero debt and the company is still reasonably profitable. So, it’s almost like saying Nilesh, you have a Rs 500 note in your pocket, I can see it, but to me the value is only Rs 400.

On the other hand, we have companies that have been trading at extremely high valuations. Despite corporate tax cuts which came unexpectedly, those valuations are still above their historical averages. So, the extreme polarisation of markets on equity where certain large caps are valued way above the historical average and certain small caps are valued way below their cash value; fair value. That kind of took us by a surprise. On the fixed-income side also, we saw the extremes where the duration side we could see great return because of the interest rates coming down and on the credit side, there were events happening one after the another where we came to know that the resolution process is different from liquidation. In the school, college we were always told that it is the equity guys who take the first loss, perpetual next and secured third and then the general secured and specific secured. In real life, we came to know that in resolution, anything can happen. The secured guy takes the maximum loss and equity guys can walk away. Now, this was a surprise. This was not what we were taught in schools or colleges. So, the extremes in the markets have surprised us last year.

Nilesh: You can’t play for (account for) irrationality. You can’t play for randomness. If something like that comes, it comes, and you have to live with it. It’s extremely important if we follow some rule of law. If that rule of law has changed, then it creates chaos. Now, in chaos also people can thrive but by large, we have seen that orderly behaviour is more important than disorderly behaviour. Now, last year we have seen many random events where things have happened unexpectedly. We have by and large dealt with it but over a period of time for the development of markets, it’s important that there is orderly behaviour.

Kalpen: When we stopped the fund around two-and-half years ago, when the frenzy stocks were going up was primarily because valuations were running far ahead and small caps have less free float.

So, the ability of good small caps to absorb more capital is limited. Now, just because prices have come down by 30 percent, is not an indicator that in the next year, prices will go back by 30 percent. They can languish for long periods of time. I’ve always highlighted this to all equity investors that when you want to invest in equity, look at the worst phase, accept that as a reality and anything better that you get is like a bonus.

So, there have been periods where for 5 to 6 years, categories have made no money. In context to where do we see opportunities? Right now, just adding some data that Nilesh had on polarisation; we were just doing this study that in Indian indices, the ratio of the most expensive company to the least expensive company somehow made around 33 times; in terms of valuation. The same ratio in the U.S. is about 20 times. So, that is a type of polarisation which in a way is good for fund managers who can build a portfolio and have the patience for 5 years going forward. So, should we open the fund going back on systematic investment plane. But NAVs have not turned up from there.

So, the whole idea is that, you can’t time when the turning point will come, but these are times where you are able to get companies of your choice without impact cost. If you are able to buy in large bulk, you are able to buy that. Hence, it allows the portfolio manager to build a good portfolio for the next cycle. So, we continue to make money only through SIPs in small caps. Mid-cap funds are open, multi-cap funds are open.

Generally, when asked that whether small caps or mid caps or multi caps, I still feel that recognising volatility, recognising behaviour of investors towards volatility, multi-cap funds always remain a good middle path because they can take advantage of all segments and build a portfolio with relatively less volatility. So even in the last year, when mid caps and small caps were negative, multi-caps were positive to almost double-digit returns. So, it allows you to participate. Small-caps stocks are best to buy when there is a lot of redemption in that category which we have not seen much.

Nilesh: If you want to try and time the market, please consult your astrologer, he will give you the right advice. We don’t have any abilities to predict the future. If you see our track record, we are a miserable failure in predicting futures. Despite that, we have made money for our investors and ourselves.

So, as Kalpen mentioned, small and mid caps today are below their historical averages. There are companies available below their fair value. Now, there is no guarantee that cheap cannot become ‘cheapest’. But when it is cheap, it is time to buy. Follow a disciplined asset allocation. It’s time to go overweight on small and mid cap and don’t go lump sum into small and mid cap unless and until you have the ability to take volatility, it’s far better to do systematic transfer plans over the next 6 to 12 months.

There are things that are changing so the growth suffered for a variety of reasons. But now, monsoon has been good. Oil prices have remained remarkably stable and subdued. Liquidity in the banking sector has improved since May 2019. Interest rates are being cut; 105 BPS points done; more will happen.

Transmission of credit is an issue but an 88 percent drop in credit flow to the commercial sector, hopefully, we are at the bottom. Hopefully we won’t take the blood out of the system but if there’s some blood, things will recover over there. Corporate tax rate reduction has been fantastic, it is a game-changer. Put all of these things together, along with valuations which are below historical average in small and mid caps, one can say that this is the time to be overweight.

They need a catalyst in terms of giving return and in terms of moving up. A strategic divestment of a government company in a true and fair manner will be one. If we can do some sentiment boosters like long-term capital gain tax exemption or a personal income tax cut again, it will act as a catalyst in the small and mid-cap stocks. If we actually see some of the troubled entities raising equity capital, then that will be a sentiment booster. So, we need a spark in the haystack in order to create the fire. A good fire that will burn all the evils and the negative returns. The haystack is ready, we need a spark.

Kalpen: I think all three were very dominant parts of the evolution of the fund industry as well as investors. It is a fact that we have more SIPs this month than what we had last month or twelve months back. So, we are seeing investors adding more SIPs. So, the fact is that many investors are getting disappointed with their three to four-year returns and getting out. So, in a way, getting good units moving away from weak hands and getting stronger hands who are investing in the future. This is part of every market cycle. Someone has to sell for someone else to benefit. So, that trend continues. But we are seeing more new money through SIPs coming in. It is a fact that the word risk is associated with credit. In the old days, it used to be credit-opportunity funds but now its credit-risk funds. But again, every asset class which can give you higher returns than risk-free return will have some amount of risk. I think that is a learning for us also on how you manage this risk, how you manage liquidity, how you respect cash flows over assets. Recognise that when things go bad, regulatory solutions also take time and this is the first time India is facing events like these happening at the same time.

So, that’s again a very good evolution and there’s a fair sense of maturity on how investors are recognising this. Balance funds clearly have a need for monthly dividend. See, the need for monthly dividend flows is an important need for a lot of Indians who need cash flows every month. My father after he retired last year, is asking me for monthly dividends till now. I thought it was only theoretical, but it is an important need. Now, is balance funds the right answer? I don’t think so because the volatility is very large. So, if rightly structured through systematic withdrawal plans, that need also can be highlighted. One more very big category for me is the emergence of the dynamic asset allocation funds.

So, over the last two years with such extreme market volatility, these products have still given positive returns because when valuations were very high, they kept lower equity exposure. Last two years when valuations started normalising a bit, they started gradually increasing exposure; most of them have 50 percent in debt/arbitrage which means if markets fluctuate further, they can invest furthermore in equity. So, that’s a very beautiful category for investors who cannot absorb fluctuations and I think that category is also growing fairly well. So, that is an addition to the list that you highlight.

Nilesh: Obviously, SIP flows have been robust and that’s a great maturity shown by the investors and distributors. Somewhere Mutual Fund investor’s ‘Sahi Hai’ campaign has also played a great role in it. In terms of credit risk acceptance, yes, of late the acceptance levels have increased, but certainly, we could’ve done a better job in communicating that risk upfront. It’s far better that people learn by knowledge rather than by experience. Overall, if you see, for the Mutual Fund industry, last year has been fairly good in terms of flows despite market challenges.

Despite some of the randomness which was difficult to predict and clearly as an industry, we have to come together for the development and improvement of the market. The market is a very critical thing. In small-cap as Kalpen mentioned, many a time your flows you won’t be able to deploy justifiably. Many a time, on credit side, despite having a structured mechanism or a security, the difference between liquidation versus resolution could create its own challenges. No matter how hard you try to ensure that you deal only with good companies, there could be practices which require a nudge here or there. So, we have our path cut ahead. We have to ensure that (like in the past) we add value to the customer’s portfolio.

If I can’t outperform benchmark index if I am not adding alpha over the benchmark index, then there is no reason why I should exist. Second, we also have to ensure that these returns are sustainable and for that, deep markets are necessary. Third, we also have to ensure that the customer’s returns and fund’s returns are similar. Many a time, customers chase momentum, many a time they get disappointed when bad news comes out. So how do we ensure that customer and fund return is similar? So, we have our task cut out as well. We just have to ensure that we keep on doing that task as diligently as we worked over the last two decades.

Nilesh: So one key learning is that you need to ensure that your documentation is in the right place. So, there is a willingness to pay and there is the ability to pay. The ability to pay is a bit easy to calculate, not that easy but with the willingness to pay, it is easy to calculate. There is no thermometer that says what is the promoter’s willingness to pay?

India as I mentioned, rules of law don’t necessarily decline. We have 40 lakh cases of cheques bouncing in the court of law. Now, clearly in that environment, we have to work. So, ensure that your documentation is in the right place, ensure that you have done the research on the ability as well as the willingness to pay. More importantly, communicate with your clients so that they are aware of the risk taken; they’re aware of the mitigation, which is happening, and if there is a loss, they are more than willing to accept it.

Kalpen: When this question is posed to me, I think like an investor. What matters to me? Low cost, so passive funds position in the low-cost bucket, assurance of low cost, but also assurance of zero alpha, because they are going to give you passive beta returns and there’s nothing wrong with that. One year ago, the debate was that alpha is dead. One of the biggest surprises this year is you know, many funds have notched up significantly large alpha.

We have seen funds between 5 percent to 13 percent alpha. Of course, one year is not an indication, still. I have always believed that good fund managers will create alpha, bad fund managers will create negative alpha and there is something in between- which is beta. There is room for both. Rather than getting trapped in the debate of passive versus active or low cost versus high cost. I think an investor should, depending on his own belief system and understanding, take that view. No matter they say that cost matters a lot from a compounding point of view, but if you are able to identify good fund managers not just by looking at the last one or three year returns, but understanding the behaviour of the fund manager in bad times more so, the balance that the fund managers bring to you, in their communication and in their honesty and how they have performed across market cycles asking what are your investment principles, if you can choose the right fund managers and give them a long runway, a long period of time, I think you still have room for alpha.

Like I said, if you see the polarisation, the polarisation itself will somewhere create room for alpha. So, I feel that the debate will continue but gradually that category also is of more demand. Provident Funds; because of the mandate by the EPFO, started off with passive funds but a lot of them are also investing in active funds. Over time, I see three buckets getting created. One is alpha products at regular cost, zero alpha products at very low cost and there is something in between which is affordable alpha which will be products which quote for the rules of alpha managers but not at the highest cost- somewhere in between. Then, different customer segments depending upon their needs will pick and choose. So, I see that; at 10 percent Indian penetration, Indians still don’t have the ability to beat the inflation in their portfolio. That debate is important, but it’s important to start investing and I think all of it will co-exist.

Nilesh: Ultimately, cost should be linked to value and as Kalpen nicely explained, you have regular alpha, affordable alpha and low alpha. What people haven’t noticed is that, even in index funds, people have created negative alpha. So, there’s no guarantee that index fund itself will deliver index return. At the end of the day, I exist because I am adding value to my customers. If I don’t add value, then there’s no reason for my existence and I’ll have to continue to work to add value. When our sizes were small, the markets were inefficient, and it was easier to add value. It was like a batting pitch; anyone can score the runs.

Now, we have reached the third day, the pitch has deteriorated a bit; whether it has become bowler-friendly? But, you can still bat. You still have a lot of opportunities to add value to your customer’s portfolio and who knows, on the fifth day, we’ll have to reinvent ourselves. There’s always concentrated portfolios, long shot portfolios, liberated portfolios, off-shot portfolios. So, the flow will go to those people who can add value. Now, is your value proposition lower cost? Is your value proposition higher return? By taking higher risks, by managing risk, whichever way it is. But money will flow to those guys who will add value.

Nilesh: Absolutely, the customer is the king. He will decide whether it is low cost or high return with high costs. It is they who will decide. I am a service provider. I am at their mercy, they are not at my mercy.

Kalpen: Look at the data, now, it is close to 1 lakh crore size of the passive pool. On a base of around 13 lakh or 14 lakh of equity. Gradually, the size is increasing. But even passive will have to work hard.

Kalpen: I was just doing an article for BloombergQuint a few days back. It took me three weeks to write it; trying to reflect on what’s new. Sometimes you don’t find value in new. There’s value in old. One big learning that every year is coming to me with grey hair is, there are so many things we don’t know but we have an illusion that we know and because we have the illusion that we know, we think that our portfolios will outperform.

So, I tried to do this combination of four asset classes; I called it the ‘I don’t know’ portfolio which is the Indian equity, a few global equities where a lot of innovation and scalable companies are, Indian bonds; because bonds are in India are at 7 and 8 percent versus 0 everywhere else and a little bit of gold which we have always held. When you keep these four over the last fifteen years, the long-term return is very similar to the best performing asset class with lesser fluctuation.

So, this is nothing but an asset allocation at play where you don’t try to outrun markets or preempt markets. The question is, which asset class is relatively cheaper today, where the risks are known and, in the price, and owned a little bit more of that through some bit of asset allocation. You are also saying like in an IPL team, you also need a Pollard or a Gayle who can come and score faster runs and some bit of international diversification also because there are opposite co-relations between these four asset classes. That allows you to earn similar final returns that you would’ve earned but at a much lesser fluctuation.

The value at lesser fluctuation that I have learned is, it allows you to stay put. It does not take all your attention towards minor NAVs and what should I do. You can continue you’re your work, with your passion and earn more money and give it back to the portfolio and it will continue to compound. So, my biggest learning and advice that I give to myself is, be conscious that a lot of things will happen and have not been able to predict. Have a reasonable mix of asset classes and overweight that asset class which is not so much in favour or not so much popular and build your portfolio accordingly; which are long term drivers of wealth creation.

Nilesh: Deepawali is a festival of light. So, like in your home, do light a lamp of knowledge in your life. There is no better power than knowledge. Second, Deepawali is a festival of Laxmi Mata. In the Indian culture, we have been told that don’t rush after money but in this particular context, I have preferred the American culture where Warren Buffet says that, ‘Money is not everything in life but make sure you have made enough money before you make such a statement.’ I am sure our kids are going to take good care of us but why take the chance? So please invest in building your financial freedom.

That’s a tribute to Laxmi Mata, that’s actually the message of Deepawali. Deepawali is also a festival of joy and while money doesn’t necessarily buy joy, a lot of things which money buys can give you joy. So, be a long-term investor. Be a regular investor, continue your SIPs and as Kalpen emphasised, be a disciplined “asset allocator”. Whether there will be a Yorker, half-folly or a bouncer, who knows? But as long as you have the discipline of playing each ball on its merit, you will score runs. There is no point in taking the risk of hitting a Yorker out of the stadium. Wait for the half-folly. Eventually, it will come into the market. Hit it to secure yourself so please enjoy the festival of lights by gaining knowledge. Please pay a tribute to Laxmi Mata by managing your wealth and prosperity appropriately and please enjoy your life by being a long-term investor, regular investor and a disciplined “asset allocator”.