The Mutual Fund Show: Active Versus Passive Investing Amid Virus Turmoil
It’s an ongoing debate—do investors make more money by buying and selling stocks to beat benchmarks or are they better off sticking to indexes?
Active managers choose stocks to buy from within a certain category based on analysis, while passive investors allocate money to stocks in proportion to their weight in an index and such funds are designed to offer more consistency, in a sense that they mimic market returns.
But severe volatility in the wake of the new coronavirus pandemic, which pushed the global equity market into a free fall, has turned mutual fund investors wary of active management, prompting them to think whether to opt for higher returns (and higher risk) or stable returns.
“If you look at history, we’ve done a bit of analysis that shows there have hardly been any schemes which have been top rankers consistently in the last 10 years, and that the ranking keeps changing. So, how do I pick that scheme which is right?” Vishal Jain, head–ETF at Nippon India Mutual Fund, said in BloombergQuint’s special weekly series The Mutual Fund Show. “That problem will always be there. In the quest of looking for alpha all the time, we forget the beta (risk).”
Several investors now are looking to invest through passive modes such as exchange-traded funds and/or index funds. Inflows into index funds, according to data from the Association of Mutual funds in India, hit an all-time high of Rs 2,076.5 crore in March.
“We have been index fund advisers for almost three years now. So, our recommended portfolio is disproportionately invested in index funds—Nifty 50 and Next 50,” said Gaurav Rastogi, chief executive officer at Kuvera.in. “Our understanding is that as markets become more and more efficient, it becomes harder and harder for any individual or for any philosophy or for any process to reliably beat the market over the long term.”
Watch the full show here:
Here are the edited excerpts from the interview:
Vishal, let’s start off with you. It may not be the right way to kick-start your passive investments, but are the current market circumstances leading more people to choose passive versus active at your house or maybe the industry?
Vishal: Absolutely. I think the kind of growth we’ve seen across our screens, especially you know the diversified schemes, such as Nifty BeES, Junior BeES and even products such as Gold BeES they are virtually all at peak havens and peak in terms of number of investors. We’ve seen nearly a 100% growth in the number of investors just in a matter of about three or four months. So yes, in terms of adoption, adoption is definitely picking up. I see a similar thing that had happened in 2008 when the markets had crashed, we saw a huge flurry of people coming into ETFs and huge amount of volumes that happened in the markets. I’m finding that the same kind of situation is happening even now, where at this point of time I mean, you’re uncertain as to how things are going to play out. You don’t know which sectors are going to do well; you don’t know which stocks are going to do well. But you’re still getting index at valuations which were three years back, and that is kind of propelling people to get into passive investing and getting into new index investing in that sense.
Gaurav, is the starting point of what the markets are doing right now have a valid enough reason, or should the rationale of going passive be different? I mean I’m guessing you’re a supporter of passive investing naturally so, can you can you dwell a bit upon this?
Gaurav: Sure. So yes, we have been index-first advisors for almost three years now. So, our recommended portfolio is disproportionately invested in index funds—Nifty 50 and Nifty Next 50... is a starting point the right way to think about index- active versus passive so of course it’s not.
But at the end of the day, you know what, whatever gets the horse to the water that’s a good thing. What’s also happened I think this crash is one reason but what has also happened is that if you look at the past 5-10 year performance, a lot of active funds in India have not been able to beat their benchmarks. So, there is an S&P index versus active report that comes out every year, and in the large cap space, I think 65% of large cap funds have failed to beat the benchmark. So what happens is people look at these things. People think about it, oh my god there is a crash I don’t know where to invest. Index is a good place to start with plus, they also look at this historic data, and they say, okay, you know what, for some reason, what we heard about the global markets, now we’re seeing the same story play out in India. Maybe this is a great time to invest in index funds. So, I think a little bit of both is happening. But yeah, it should not depend on whether you are in a bear market or a bull market. I think the rationale to whether you want to be an index investor or a passive investor should be independent of that.
Just a follow up to you. The past data would probably show and as you mentioned some numbers I think the SPIVA data throws up that even before the market fell, I think about 80% if I’m not wrong, that’s what the data suggests that about 80% of large-cap schemes were under-performing that benchmark which is the BSE100. The question is, it’s also factor of how the Indian markets have been constantly hit by one event after the other, and to a lot of people India remains largely an active market with lots of price discovery still there to be done, because of these events, this has happened and it may change in the future?
Gaurav: A fair question, but it’s not true though that I think 2014 to 2019 massive rally, 2019 was a fantastic year so, not necessarily true. I think what’s happened is that India’s also become a hyper-competitive market. Some of the informational arbitrage—where certain people because where they sat in the ecosystem would get information before others—that has been mostly weeded out. Plus we have how many AMCs? We have at about 40+ AMCs all of them employee really smart portfolio managers. So that cost of generating that alpha, the cost of saying that you know what my process is reliably better than everyone else’s process. That’s just the first condition.
It has to be reliably better than everyone else’s process the second condition is that no one else can be able to replicate it. That’s a very high bar to maintain. It becomes harder and harder for any individual or for any philosophy or for any process to reliably beat the market over the long term. This is not just what we see in indexing. We see it in and even small cap had its day. Now, small cap funds are under-performing. Value investing—the 2000s were a roaring time for value investing. 2010s have been the last decade for value investing because one example could be a valuable bounce back this that India they can do a lot of storytelling. A simplistic example is there are too many people who are doing value investing, so there is not much alpha left so. Our understanding is that as markets become more and more efficient, which is happening in India volumes are going up, number of people who invest, they are going up. It’s becoming a highly competitive market in the portfolio manager space, enough portfolio managers, enough AIF managers, enough PMS managers out there that it becomes very difficult for an individual to come in and say hey, I have a differentiated investing philosophy which will ensure that I will learn disproportionate returns over the long term.
Vishal, what’s your judgement of whether things can be different again? All of this is conjecture right because we do not know at the current time, almost anything is conjecture because we don’t quite know what the post-Covid world would look like. I’m just wondering, at the case for the longest time in the last decade as well, I kept on hearing about how India is slightly different than the rest and therefore the ushering in of the passive investing will not happen immediately. It will happen after five years once the size etc. grows large. What is your response to how the last 10 years would have been and whether technically for technical factors the next five years can be different and therefore, maybe active investing could outperform?
Vishal: See, I’ve always been saying, I mean I’ve been doing passive investments, you know from the 1996. I think SPIVA (S&P Dow Jones Indices Versus Active) reports have started coming out from 2000-01 or so. I think even at that point of time majority of the active fund managers were under-performing their respective benchmarks. I think what you need to see is the changes that have happened in recent past. SEBI has now come out with two sets of very important guidelines which came out in 2018 where the first thing that they did was they changed the benchmarking of the price index to the total returns index. So, historically all benchmarking was done versus the price index and the 1-1.5 % dividend yield that was there was never shown to the investor, and that was being kind of pitched as alpha generation when it was never alpha in that sense. It was basically a dividend yield which was coming in and reflecting in the NAV... that’s the first thing that happened.
Second thing in earlier instances, you found schemes were having a large-cap scheme; you would possibly invest maybe 30-35% in mid-cap stocks. So, when the growth came, obviously that was being touted as alpha but it was never alpha,it was risk that was being taken at that point of time in those schemes. SEBI has now very clearly come out with scheme categorisation where they’ve defined what should be the top hundred companies and therefore, those are large-cap, what are mid-caps and what are small-caps. Therefore, because of these categorisations suddenly data is now popping up and showing that there was not much of outperformance happening on the active side and therefore, why pay so much money to an active fund manager? I think this was always there. As Gaurav mentioned these SPIVA reports have always been showing that they’ve been underperforming, even in earlier points of time. But because the Indian markets were growing and because the industry was growing I mean it kind of didn’t pop up in that sense, people are okay if you’re giving 12%-13% return and if the index maybe was giving half a per cent more or half per cent less, it didn’t kind of matter at this point of time but in such markets, yeah it starts making a huge amount of difference. People are starting to become cost-conscious and the problems, whether it was 15 years back or even going ahead is going to be there.
It’s not that the fund managers are mad, they’re extremely intelligent people. As Gaurav said, the competition is too huge. How do you pick the right guy? I mean today if a guy has done well, I mean alpha changes hands. If you look at history, I mean we’ve done a bit of analysis so we’ve got a heat map, which shows that there have hardly been any schemes which have been top rankers consistently in the last 10 years, and that the ranking keeps changing. So, how do I pick that scheme which is right going ahead? That problem will always be there. In that quest of looking for alpha all the time we forget the beta. In the quest we’re looking for the right fund, the right sector, the right stock, the right fund manager, the right PMS, the right AIF. My basic bread-and-butter which is a market, I kind of lose focus on that.
I understand, I mean just trying to play the devil’s advocate that let’s assume that large-cap funds, very difficult for them to outperform given the very nature of the composition, well-discovered space, lots of competition etc., and lots of money chasing those many number of stocks. Is there opportunity for active to do slightly better? Is there a category like multi-cap? Because there you can choose between different market caps and the options are there or you don’t reckon that could happen as well? Please feel free to share your thoughts.
Vishal: See, I don’t think a segment matters whether it’s large-cap or mid-caps, there will always be people who will outperform. How do I pick the right guy? The issue is, how do I pick the right guy. If you look at data, there will be so many active fund managers, so many schemes that have outperformed the benchmark but if I wasn’t holding the scheme, how do they matter? It’s academic. Even in the mid-cap space I mean there will be so many schemes that will outperform. The thing was that, was I holding that scheme not. Did I pick the right guy or not. I think those odds are something that every investor needs to see. Nobody is sitting here and saying that you should not have your issues active against passive or passive against active. At the end of the day, you have to figure out how you use both these strategies in building a portfolio.
Now if I’m an investor, if my basic objective—look, why am I investing in the market? I’m investing in the market because I want the equity market returns. I believe that India is a great country and I believe that we’re going to see a huge amount of growth in the next 10 years, and I just want to sit on the equity returns. If I want to do that,the easiest way for me to kind of build a portfolio is by a low-cost index fund or a low cost ETF and maybe have 75-80% of my portfolio in that and maybe 20% have it in an active fund—where I still believe that maybe there is a fund manager that outperforms. Here, what you’re doing is that in the quest of getting market returns, you’re kind of hedging yourself because you’re linked to the index and you’re not linked to the whims and fancies of a fund manager.
On the contrary, there could be another investor who says that look I’m happy to take the risk of an active fund manager and maybe his portfolio should be you know70% active and 30% passive. So it just depends on your kind of need. I mean, if your basic need is look I want to beat inflation, I want equity market returns, then just buy in and buy an index which has low costs and settle the best companies that are there at that point of time, whether it’s today, or its 20years down the line—you’ve got the best companies that are there in India and what can go wrong in that?
Gaurav, you have some hard data as well at times, care to share some? I mean, you mentioned a brief bit about the large-cap index funds but I think 10-year histories might show some very interesting things that because people might argue against a year of history, people may argue against 3-year histories but are there data points which validate this thing of people needing to actively look at passive investing?
Gaurav: It’s a very interesting question. So, there is a way to glean this insight, it’s called a replication portfolio. The idea is very simple. On Kuvera we have over six lakh users. We have the historical portfolios. So, when someone comes on Kuvera, the first thing they do is they consolidate their existing portfolio. So we have people who have been investing since 1995, we have people have been investing since 2005 and we have every single transaction they have made in the past 3 years, 5 years, 10 years 15 years or however long they were an investor so it’s almost like, there is no look back time period here where you can argue one year it didn’t do well but three years it did well. So then what we do is we look at all their equity transactions. They invested in an equity mutual fund, they invested in large-cap mutual fund, a small-cap mutual fund, a multi-cap mutual fund, in an ELSS mutual fund. We take all those transactions and we say what if all these investors just invested in an index fund, they just bought and sold a Nifty 50 index fund, right? So, say for example you have an investor for 10 years, I will take your small-cap investments from five years ago replace that with an index investment. We do that for both your buys and your sells. So, wherever you are buying equity funds, we are replacing that with an index fund buy—same amount and wherever you’re selling an equity fund, we’re replacing that with an index fund sell of the same amount. So, that becomes your replication portfolio.
Now, the question is for how many investors would you now have a larger corpus? Because you spent so much time trying to identify the right fund, to invest in and then you invested in that fund and then you churned your portfolio then you said, Oh, this one is not doing well anymore I’m going to buy another fund, or your portfolio exploded and suddenly you had 20 funds in your portfolio, which by the way also happens, versus this replication portfolio which is a simple portfolio where you always invest in an index fund and you always take money out of it. What we found is that somewhere between one in six and one in seven portfolios, actually outperform the index replication. That’s how difficult it is. You know index comes across as a very humble; a very simple instrument right? There is no alpha, no fancy words that are associated with it. There is no portfolio management premium, there is no alpha, and there is no stock selection, there is none of the buzzwords that gets investors pumped up, I’m doing something. When you actually look at this data, this really simple instrument—just because of that simplicity, just because it doesn’t take too many decisions, just because an index is a simple replication of a market cap weighted companies which are doing the best in India, it still manages to outperform the large majority portfolios. Keep in mind that even your small-cap transactions are being replaced by Nifty 50, not the small-cap index. So, even if you say small-cap have done slightly better than Nifty, even that doesn’t help you. So, the replication portfolio is in our opinion, one of the strongest kinds of data points that you can say.
Maybe you are different, maybe you are the next Warren Buffet, maybe you will be able to do this but just look at the odds and just see and maybe those odds might change your mind. Will you buy a lottery ticket that odds a winning?
There’s an answer in that question as well, right? That if somebody fancies himself to be the Warren Buffett or the next Warren Buffett, then he might probably not be choosing mutual funds to begin with because you might be betting on his prowess to choose stocks, but that’s a pertinent point. Gaurav, the indexes in cricket analogy is like Cheteshwar Pujara, right? It’s not glamorous or doing anything like that but does the work.
Gaurav: Jack of all trades, master of none.
Let’s try and figure out what our viewers should they do in terms of building a portfolio and I want to start with you because you have such a large bunch of investors that you mentioned. And then I would be getting in Vishal’s thoughts on what do they advise if they do? I’m sure mutual fund houses don’t advise, but Gaurav that’s why I starting with you or somebody who has got a portfolio- the size doesn’t matter but let’s say the person is invested in average for the last five years in mutual funds. Do you have any thoughts on what should be the composition of active versus passive, even if you are completely biased towards passive but what component of active versus passive would you advocate?
So, if I look at the equity part of our recommended portfolio, so almost around I would say 60 to 65% of that goes into index funds—India-based index funds. We have an exposure to value and to a small concentrated portfolio which is very rule-based. That’s purely because we know that for the longest time value has worked and value is actually undergoing kind of a massive correction right now. It’s a smaller allocation, it’s about 20% is what goes into that. Then we also have an allocation that goes into international funds. Starting in 2017, this was our kind of portfolio breakdown for our equity side of the business and not much has changed to be very honest. It’s about 65% index; about 22% is a value biased focused fund. Then about remaining 13% is international exposure.
The idea here is simple. We add a fund to our portfolio only if it can bring in what is called uncorrelated risk. If I’m adding a fund to my portfolio but that fund has an 80% correlation to my existing portfolio, I’m only increasing my headache because now I have to track more funds without actually getting any benefits of either diversification or excess returns. An excess return is anyway who knows what will happen in the future? The only thing you can bet on is, is it diversifying my portfolio or not? So that’s how we have structured it. And then depending on the different risk appetites of the investors, you either own 60% of this equity basket or 80% of this equity basket or 30% of the equity basket and remainder is debt where we choose liquid funds.
Vishal, what about you? I mean you briefly mentioned it at the start, not at the start of the interaction but somewhere in the middle of the interaction about what you believe an ideal mix would be. Care to elaborate a bit on that, Vishal?
Vishal: As I mentioned earlier, I mean at the end of the day, it depends on an investor’s need and the risk profile based on what you should kind of look at building a portfolio, but as a manufacturer, our job is to ensure that we give all the building blocks, and that’s something that we have been focusing since ages and luckily those building blocks are something that investors can use. So, one way to kind of build a portfolio could be through having an equity, Gold and debt in your portfolio and it’s very easy for you to build such a portfolio using an ETF. I mean, we have been talking to investors in the last one-and-a-half to two years even saying that to build an asset allocation portfolio and especially have gold also in the asset allocation portfolio, but at that point of time you know very few people bought the storyof gold because it had kind of not done too well in the last five-six years. But look at the way it has played out in the last two or three months. I mean as Gaurav mentioned it’s extremely important for you to have some kind of an asset which is kind of non-correlated with assets that you have in your portfolio- that’s the only way for you to kind of reduce risk. So by adding something like Gold ETF into your portfolio, you could have reduced risk to just to a huge extent, especially in times like this. So therefore I think that you should build your portfolio, you should have a right asset allocation mix of equity, debt and gold depending on your risk profile.
If you’re extremely aggressive in terms of taking risk, obviously you should be loaded more towards equity, lesser towards gold and to debt. If you want to be a bit conservative, then you can have a right mix of equity, debt and Gold. Maybe have 50% equity, 25% debt and 25% Gold so that becomes a kind of right mix in your portfolio. The best part is that we have all the ETFs to be able for you to create a kind of portfolio that you want, and I think that’s something that we keep focusing on and ensuring that we’re able to create those building blocks for investors to use.
Vishal, Gaurav if there is anything that I have missed out quick 30 seconds that you may want to enumerate?
I think one question that maybe that keeps coming with investors is should should I invest in an ETF or an index fund? What should I invest in? I don’t know if that makes sense for you to look at then second thing is ETF versus so many things in the ETFs. There are so many things in the market.
Yes please continue, Vishal.
I think one question that keeps coming all the time is that should I invest in an ETF or should I invest in an index fund. I think from the first thing that you should look at is that you should have passive investments as a part of your portfolio. Doesn’t matter whether it’s an ETF or an index fund, they are just two different formats. Now if you have access to a booking account and a trading account and you are a regular investor in the stock markets, it’s easier for you to buy an ETF through that route because it just comes into your demat account, you just call up your broker say that you want to buy a Nifty ETF or a Nifty BeES or whatever you want, and it comes into your demat account just like a stock. It’s very easy.
If you’re averse to investing in the markets and you don’t have a broking account or a demat account, then you can definitely get into an index fund. There are so many Nifty Index funds that are available in the market. What you should obviously be looking at, you should go for an index fund which is low cost and has a lower tracking error. That’s one way to choose. In an index fund, it’s very easy for you to also kind of create an SIP. So, if you’re if one of those guys who wants to keep investing small chunks of money every month, so an index fund would be a better route than an ETF. Though there are a lot of online broking firms which are now providing a facility to which you can do SIPs and ETFs as well. So depending on your preference, depending on your comfort, you can go for either formats, but please ensure that you have passive investments, low cost funds in your portfolio I think that’s very important.