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The Mutual Fund Show: Investors Shouldn’t Be Scared Of Investing In Mid-Cap Funds 

The worst performing mutual fund of the year could turn out to be the best one, says Motilal Oswal Aashish Somaiyaa.

Indian rupee coins are kept in a box at a fruit vendor’s shop in Mumbai. (Photographer: Prashanth Vishwanathan/Bloomberg News)
Indian rupee coins are kept in a box at a fruit vendor’s shop in Mumbai. (Photographer: Prashanth Vishwanathan/Bloomberg News)

Taking cues from previous trends while investing in the stock market may not be a wise move. An index that has given consistent returns in the past could be on the verge of a correction and the one that has under-performed may be poised for a rebound.

“People tend to look at the returns over the past quarters or years, and then choose a fund to invest in,” Aashish Somaiyaa, chief executive officer and managing director at Motilal Oswal Financial Services Ltd., said in BloombergQuint’s weekly series The Mutual Fund Show. “The worst performing mutual fund of the year could turn out to be the best one.”

While advising investors not to hinge their conviction on past performance, Somaiyaa said underperformance of the Nifty Midcap Index should not be used as signs of avoiding. “Nifty Midcap Index, on an average, has always delivered on a CAGR basis 4 percent higher returns than large-cap funds. But in the last year, the Nifty midcap index has underperformed by delivering negative returns of around 6 percent compared to 10 percent positive returns seen by the Nifty Index.”

Somaiyaa expects the Nifty Midcap Index to outperform large caps due to mean reversion, which could be achieved either by the correction of the Nifty Index or appreciation of the Midcap Index. For new investors, he suggested multi-cap funds as the preferred option.

Watch the video here.

It seems to be from market behaviour over last few days there’s something or lot of factors are holding investors back because almost every rally is getting sold into. Even good global days aren’t turning out to be good days for Indian markets and that holds good for mutual fund NAVs as well.

Aashish Somaiyaa: I had the opportunity to meet lot of investors, advisors, distributors etc. Fortunately, because of interactions we kind of get to know what people are thinking and what are their beliefs and what is making them act in a way that they are acting.

For example, one of the things that I am personally quite disturbed about is that, December 2017 was a record month. If you see mutual fund industry aggregate, then it got Rs 45,000 crore of gross inflow and after adjusting for redemptions we got some Rs 27,000 crore of net inflow in December 2017. In April and May, we are struggling to be around Rs 2,500 crore. So, at an aggregate level what you can figure is that industry was big buyer in December 2017 and January 2018 and net-net, the industry isn’t really out there in April 2019 or May 2019. Rallies are getting sold into. But the question is what rally we’re really talking about.

The intra-day rallies perhaps.

Aashish Somaiyaa: When I listen to people and when they speak about rally, I have seen that there is behavioural bias, there is heuristics which people follow which is called surrogation. They’re forming impressions by seeing Nifty and you know that the correlations of Nifty, small-cap, mid-cap... everything is completely broken. So, from December 2017 till now may be the Nifty has gone up and people are making their decisions about where the market is by seeing Nifty. One of the observations that people make is that Nifty is at all-time high. We aren’t sure of the huge earnings recovery. So Nifty PEs are also high, and lot of funds are under-performing the index. This is people’s thought process about the market.

But what are people’s thought process about their own portfolio? Their own portfolios are not at all-time high. I don’t think that their PEs are higher than Nifty or something. And if you are stock picker then I am sure that on EPS growth you are doing better than what Nifty has been doing. A lot of companies which we own are showing 15-18 percent kind of EPS growth even now.

When it comes to the observation on the market then people think it’s all-time high, but when it comes to their own portfolios, it’s not at all-time high and it’s underperforming the Nifty. It has not done what the Nifty has done. So, people are seeing the Nifty but acting in a portfolio which actually has no correlation or the broken correlation with the Nifty which is the big problem. People aren’t able to relate to what is market, what is Nifty and what’s happening in their portfolios. They’re two completely different things.

Even in mutual fund portfolios, we haven’t seen the NAVs going through the roof...

Aashish Somaiyaa: All mutual funds have a particular strategy and I don’t think that strategy results in them buying the top 5-10 stocks of the Nifty. Secondly, mutual fund industry doesn’t track or actually follow the top stocks of the Nifty necessarily. They all are paid to be stock pickers and for stock picking you have certain criteria. Those criteria might not have led you to buy top 4-5 stocks necessarily. I think even the mutual fund industry is full of funds which is, say multi-cap, a lot of corpus in small and mid-cap, a lot of corpus in large plus mid-caps and they are witnessing something different versus what people are acting on by seeing Nifty is completely different.

It’s like the weather app, which says that the temperature is at 14 degree and then below it says what that feels like. You know maybe the Nifty has gone up to 12,000 or 12,100 or wherever it is, but it doesn’t feel like that. The feel comes from your own portfolios.

So, don’t act on your portfolios by seeing what’s happening in the Nifty because the chances are, for example our portfolio has better fundamentals than the most stocks in the Nifty which isn’t at all-time high. On a relative basis, in fact it has corrected very significantly because our portfolios haven’t done what Nifty has done. We have gone through time correction and price correction in some stocks. So, we’re not at all-time high and we aren’t expensive which is what people think about the Nifty. I think people just need to stay put, stay the course and not get overly focused on what is happening in the index.

What does one do when you look at what’s happening in the broader end of spectrum? There are multiple studies, charts that show how past few years have been for the Nifty vis-à-vis the small- and mid-caps, one or two standard deviation which points towards there being a possibility of an uptake if there is mean reversion. It’s difficult for a mutual fund investor to go out and buy into mid- and small-cap funds currently because there is a crisis of confidence. What would your advice be?

Aashish Somaiyaa: My net advice is that your conviction shouldn’t depend on performance. For example, people draw conviction from past performance. Look at it this way: Just because 2015-16 were great years for mid-caps and small-caps, in 2017 you buy mid-caps. Now just because 2018 is a great year for top stocks of the index or for the index itself, don’t come in 2019 and say that now I will buy large caps. So, you need to have that kind of consistency of thought process and you can’t keep swinging based on what happened last year.

Coming to the point of mid-cap versus Nifty itself, if you take long period averages like you go back 15-20 years and you take one-year rolling data. So, on any day see what the one-year performance of the mid-cap versus Nifty is. You will find that, on an average, Nifty Midcap has done 4 percent more than Nifty or Nifty has done 4 percent less than the Nifty Midcap on an average.

Today we are at a juncture and today it would have aggravated further, where forget Nifty Midcap being ahead of Nifty, Nifty Midcap is behind Nifty by some huge double-digit number like 20 percent or some such number. Imagine that there is the pendulum. The mid point or the center point of the pendulum is let us say +4 and right now this pendulum is somewhere around -20 so it can bug you by going -21 or -22 or whatever it is but ultimately any pendulum we know that it exhibits and it is most physically relevant object of the mean reversion. So, now if you buy Nifty or large caps, for the pendulum to come back to the center either the Largecap Index has to correct or the Midcap Index has to mean revert but either way you are better off where you are.

If we look at the last five years then it shows that how the Nifty has one-way rally but the mid- and small-caps have corrected and therefore, a mean reversion by itself would mean that if those indices could do well and therefore those funds which have higher proportion of small- and mid-caps which is either a mid-cap fund or small-cap fund or multi-cap funds will do better than large-cap funds.

Aashish Somaiyaa: Let me simplify it. My short point is don’t form your impression and don’t act on your portfolio by seeing the Nifty and thinking that Nifty is at an all time-high and Nifty PE is high. So, the first point is that has nothing to do with your portfolios because your portfolio does not own Nifty. In fact, that’s the reason why you underperformed last year and that’s the reason why your NAV is not at an all-time high. And that’s the starting point of all the issues that I am not doing what the Nifty is doing.

From here on, most of these funds which are multi-cap or mid-cap, they will outperform the large-cap, or they will outperform the Nifty at least. The reason is the concept of mean reversion and for the mean reversion to play out either the Nifty has to correct, or the broader market has to appreciate. So, whichever way it’s better that you don’t act by seeing where large-cap or the Nifty is and it’s better that you stay put where you are because irrespective of what happens from here on you are better off where you are rather than trying to jump into index or jump in to large caps. When mean reversion happens, it doesn’t mean only the Midcap Index has to go up. It also means that may be Midcap can go up or may be the Largecap can come off a bit. But in both cases, you are better off not jumping around.

For somebody who wants to make fresh investment, would you believe that in these times when there is a bit of underperformance but also confidence shaken scenario and there are number of factors that are keeping investors back. Do you believe that should not keep people back and people should invest in small- and mid-caps funds?

Aashish Somaiyaa: Yes, it is very well-known. First is that depending on your return expectations and your risk-taking ability, most important point is that, we all say that we should buy when there is blood on the street. Now, here is a special situation because actually the Nifty is showing something else and small and mid-caps are, there are days, when they are cracking by 1-2 percent. So, if we are not going to buy now and those articles which we forward to each other on twitter and social media and all those folklore of stock markets that we keep quoting to each other if we are not going to act on it now then I mean is that just meant for forwarding or writing smart stuff. What is the use?

So, I think, short answer is that people should look at it right now. If nothing, then they should buy multi-cap funds. And my limited point is that don’t see what happened last year and hence decide that now I will buy index or large caps which does not make sense. You need to see where there is pain and you need to enter that part right now.

What should people do when they look at the funds and the recent performances and the recency bars that we speak about? I think there is some study which you observed which shows that in a lot of cases, in Indian context, it has shown that the best performing funds and the worst performing funds must not necessarily repeat there in a very short period of time as well. So, let’s start off with whether investors are better served not buying the best performing funds of the previous three years. Is that good statement or good starting point?

Aashish Somaiyaa: I have seen that we are in a world where a lot of investments are happening Do It Yourselves and it’s happening digitally. I have seen this tendency and if you see some of numbers which are published by the digital platforms, you will find that a lot of money goes into the funds which has done well in the last one year. So, there is those kinds of tendency.

The point is that if you are going to chase what was number one last year, there is a certain reason why it was number one. It is operating in a certain market context but you and me and everybody knows that in last 1.5 years, the whole operating context in the market has changed. For example, the correlation between the Nifty and the mid-cap and the small cap is broken. There is huge diversion in the markets. Within Nifty also top stocks are doing something and the rest are doing something else. There is some kind of polarisation in the market, and we know all this. We know that the operating context has changed.

It is in the basic nature of the market that different styles of managing money get amplified at different points in time. So, if you are perpetually going to pick up something based on how it did last year then the chance of the same thing being number one next year is practically nothing and there is no correlation. If you say that, you will pick the top funds based on last year’s performance then what is the chance that it will be top fund next year.

Some best performing funds of last year don’t necessarily end up having same ranking.

Aashish Somaiyaa: If you say that which funds did the best, number 1,2,3 in that three- year time frame some people say that I am very smart, I will not sort by one year I will sort by three years. Even you sort by three years and picked up best performing fund, then what is it’s ranking in the next three-years and you can see there is no correlation.

It’s the conclusion that you shouldn’t necessarily avoid the worst performer. They did not necessarily be bad because they might have temporary period of underperformance.

Aashish Somaiyaa: This is not a sales pitch, but I will give an example. Let us say 2014, 2015, 2016, 2017, the strategies that we used that helped us to outperform the market significantly like 8-10 percent of compounded alpha. 2018 calendar was not good, and we actually underperformed. So, what you need to keep in mind is that anybody who is an active manager in order to beat the market, they position their portfolios in a certain manner which will help them outperform over a period of time.

Now sometimes what you do to create that alpha, when the market context changes those very same things might snatch back some of your alpha because the index is also full of some good companies and some not so great companies, their prospects change, the operating environment changes. So, sometimes what you do to produce the alpha when the market context changes those same things might result in some of the alpha getting pulled back.

Now if somebody is style biased investor, meaning he is consistently following a certain style, so his style is consistent, but the operating context has changed and hence the rank has changed. So, then the idea is that okay in that case you buy the underperformer or else you backed somebody who is sticking to the strategy which might work out. But if you see somebody who is consistently changing their strategy or so called playing the markets then backing the underperformance may not work necessarily.

The short point is that, there is no easy answer. You have to get under the skin of that fund and figure out what was producing the outperformance and what is causing the underperformance and hence what will bring it back. I think, the message out of that is two things. Don’t go by what has happened last year. And second is, there is no short cut, you have to get under the skin and understand what is causing the outperformance or the underperformance and hence if the operating conditions changes will it result in certain improvements.

If we look at the last five years, the last five-year CAGR shows that the large-caps index performance compared to mid and small-caps marginally underperformed. May be 2018 onwards the large-cap index has done materially better than the mid and small-caps. How does one apply the principal of recency bias and not looking at that to figure out? If an investor wants to make a portfolio allocation right now let’s say he convinced with the argument that when markets are tough is when you go out and buy because you get good NAVs. How does he decide what the percentage allocations is between small, mid-cap/multi-cap funds?

Aashish Somaiyaa: I am a big votary of mid caps. When we say small cap, we are actually still buying companies which are about at least half a billion or 1 billion dollar market cap and upwards. So, I am not going to get into the nuance, we are not actually into the micro caps or the shorter end of small caps, we are not into that. Across the board, we buy a billion dollar, half a billion plus those kinds of number, let’s say 5,000-10,000 crore so that’s the first clarification.

So, I am a votary of mid cap in that sense because in our country some of the biggest brands are still mid-cap companies. There are some insurance companies, some apparel companies, the biggest luggage maker is in India, there are some private sectors banks, footwear. Huge amount of companies, consumer facing companies, no debt on the books, great companies, a lot of them are actually mid-cap companies. And you know, as a country, we are mid cap. So, it’s a growth-oriented market.

After the pain of the last couple of years, you know today if you are in the small and the mid-cap fund the chances are that your last one-year return is negative, last two-year return is zero and last three-year return is double digit and last five-year return is also double digit. But after the pain of last two years it is still significantly better than the large cap.

Over a long period of time, it is ultimately small and mid cap, which beats the large cap. So, you must have reasonable allocation and more so now. I am labouring this point again and again because right now people are more prone. I meet a lot of people they are more prone to make these judgements, let me not buy active, let me buy index, let me not buy small and mid-cap, let me buy large cap. Now that’s what I am trying to clarify that all those decisions are being made based on what happened last year. But the long-term picture has not changed actually.