The Mutual Fund Show: Why Long-Term Returns And Risks Are Key To Investing

Salonee Sanghvi: I think this is a great topic that you have picked up because this is something that a lot of people fall victim to. You know, usually when selecting equity mutual fund, I think the worst way to pick funds is to look at what is the top fund of the last year and invest in that fund because when you try and chase that, not only are you increasing taxation, but you are also impacting your own return.

Just to give you an example, the best performing large-cap fund in 2020 was Canara Robeco, but it was not the best performing in 2021 or 2022. In fact, not only that, but it was also not even in the top five. Since equity is a long-term investment you know, I believe it's like a marathon, not a sprint.

In the last one year, returns are basically meaningless. In fact, I have seen point to point returns in general are not a great way of evaluating mutual fund performance because that entirely depends on whatever dates that you pick, the best fund would be basis that.

I recommend looking at a five-year rolling return compared over the entire history of the fund or versus a benchmark and the industry and also looking at the risks that the fund is taking to deliver those returns. I feel in the large-cap category, very few funds have outperformed the index consistently over a five-year period, except maybe Axis Bluechip, the fund has been around for 13 years. I think it has an AUM of around Rs 33,000 crores and a five-year average rolling return of 14%, plus the risk is actually lower than that of an index.

But ideally in the category, instead of looking at a large-cap fund, I would recommend looking at either something like an HDFC or a UTI or Nifty 50 fund or maybe looking at flexi-cap as a category. Flexi-cap often has a large-cap bias but there is a little bit of mid and small-cap allocation as well, which gives you that additional return without substantially increasing the risk profile. So that's what I would think.

Salonee Sanghvi: That's correct. Yes, we look at mostly index funds or flexi-cap funds rather than the category overall.

Anand Dalmia: I think for the benefit of the viewers, let me explain what a large-cap fund is, because sometimes people think about fund or stock which is really large in market cap is classified as a large cap.

The top 100 companies by market cap are the companies that are classified as large-cap for the purposes of categorisation and then a large-cap fund, 80% of the investment needs to be into this top 100 companies for the fund to be classified as a large cap.

Now as you know, I agree with Salonee, given the lack of choices for a fund manager, it is very difficult to create alpha especially as the fund size is increased and probably, I would recommend that if you like large cap, then the passive is a better way to invest. Look at some of the index stocks and just go and invest there. Probably, even as Warren Buffett would say, it's a better way to beat the returns or create alpha.

Now, I think if someone wants to invest in large caps, go for passive, that's what we generally suggest. Now, you have very, very few levers to play around with, before getting into fund specifics. So one is, how well do you use the 20% remaining in your mid-cap and small-cap and you make money out of that.

Second is, how well you play your sectoral plays, because you need to have a sectoral bias or value bias, even in the large-cap category, to make certain returns. We have generally seen a lot of large-cap players sitting on a lot of cash and a 6-7% as a category they sit on cash. That's the other lever.

It's not by coincidence that Nippon has done well, if you look at it, firstly, they have the lowest cash which is there, around 1-2% while at the category level, you'd see around 6-7% is cash. Second is, I would say it's still a very actively managed fund. If you look at the churn ratios, around a 60% churn ratio indicates that it's a very actively managed fund and they have taken certain contra bets or value bets, if I can put it that way.

For example, hospitality as a sector, while most of the guys would be less than 1%, they took a big bet on it, around 6-7% of the entire holding is in the hospitality segment. So, I really like Nippon as one of the players in that segment.

Salonee’s choice is also something that we really like, Axis. But Nippon is equally good because firstly, the fund manager has been there for a long period of time. That is something that you know, we really evaluate whether the fund manager has performed consistently and has been there for a period of time and has he consistently performed and as you know, Sailesh is now the CIO of Nippon, so a very celebrated fund manager who manages this fund.

So, at Wisdom, it was part of our RICE portfolio, we have these proprietary models and we create something called a RICE portfolio and Nippon large-cap was part of that, so we are happy that it topped the charts. So, we like Nippon, we like Axis, I think both of them are pretty good. HDFC top 100 given that it's number two this year, and you asked about it, I would say now that Prashant is not part of it, we would just like to wait and watch for some time before you know we go back to HDFC top 100. But Nippon and Axis are probably something that we would recommend in this category, if you still don't want to go with passives.

Salonee Sanghvi: Given the category flexi-cap itself, by regulation, essentially the fund manager can invest in any segment that he or she feels, so it could be entirely in mid-cap or small-cap if so they wanted. But I think in reality what happens is, usually a large-cap bias, 70 to 80% would be in large-cap and then a little bit additional would be in the mid and small-cap category.

So, I feel like that flexibility is great because that's where the fund manager can really perform. I think last year we did see that value had done really well as a factor and which is why we see across the board HDFC funds have done really well or in the last one year, in fact, if you look across all categories. But as I said, you know we usually look at funds over the entire history of the fund to see how they kind of do across different time periods.

So, in the flexi-cap category I like Parag Parikh flexi-cap fund, the managers, I think are very clear with their strategy and very focused on what they want and there's also some amount of exposure to international equities, so that's great for diversification as well. It's again a 10-year-old fund with an AUM of almost Rs 28,000 crores and they have had a five-year average rolling period of 17%. So, this essentially outperformed the benchmark, but it doesn't take any additional risk, the risk levels are the same. So, I feel in that category this could be a great fund to look at.

Salonee Sanghvi: So, I feel it's not really the size, it has definitely grown very fast over the last few years. But if you look at other funds in the category, some which have been around for longer, there also the AUMs are higher.

I think one of the largest issues in the last one year was seeing Nasdaq fall substantially and since PPFAS, has had an exposure of almost 25% to international equity that was substantially hit as well.

So, I feel the large reason for the underperformance in the last one year was because of the international allocation and not because of the size per se.

Anand Dalmia: So, which is probably one of the most recommended categories these days just given the flexibility and as the name suggests, you can invest any amount of percentages in any of the categories, which is mid, large or small.

Historically as you know, a lot of the current flexi-caps are the funds which were historically multi caps. So, when the new regulation came around saying that every segment, large, mid and small to have 25% minimum and some of the larger funds, they took the mandate of flexi-cap and converted or rechristened their existing, multi-caps to flexi-caps.

HDFC is actually one of those, which was historically a multi cap, now a flexi cap. And if you look at 2022, the reason why probably they did well, for many, many years Prashant Jain kept on talking about his PSU bets, so in between you know, there were two years when everyone said HCFC fund has finally stopped coming because he could see the value in PSU companies, and then 2021 and 2022, once the PSU cycle started turning around, 2022 was a great year for PSUs, that's probably one of the reasons why the fund performed so well in 2022. Thanks to PSUs.

However, you know the ones that are historically multi-caps and now become flexi caps, we are seeing the problem that Salonee highlighted that 80%, like HDFC has 80% in large cap. Now I want a flexi-cap but 80% of it is still again in large-caps and one of the reasons is, if you have a fund which is Rs 30,000 crore plus and you want to invest in stocks, then you have to have a large exposure to large-caps otherwise how many stocks do you have in your portfolio. So, I think the larger-ones are the ones which will find it difficult to create a lot of alpha.

Sometimes you can go right on your sectors, but if you have a Rs 30-40-50,000 crores flexi-cap fund just like the Kotak or HDFC, for you to get alpha will not be that easy because you need to have an orientation towards the large-caps, whether it is 60%, 70% or 80%, it has to be there.

Now what are our recommendations, I think Parag Parikh is one that everyone likes, and you know, we are a fintech company, so, we believe in the power of technology, and we believe that long-term. As Nasdaq had 30% correction, if there is value somewhere, then it has to be Nasdaq and if I have to invest my own money, I will tend to do it in Nasdaq.

So, we believe that that Parag Parikh has done very well over the last three-four years, while this year it's not part of the top five, it has done very well and I think their thesis of diversification, thesis of value, thesis of international diversification is something that we really like, and we would recommend that.

The other one that we really love is again, a small one, which is the Quant flexi cap. Quant has done very well across the segments and one of the reasons is I think they can catch the cycle very well. You know, like Adani was missed by probably everyone on the street, every AMC that we know was looking at it but could not catch it, and I think you know Quant was one of them because they look at only data and then they take a call rather than what's the perception and stuff like that.

So, I think they have been able to catch cycles very well. Their churn ratios are one of the highest, but I don't know what happens to this fund in a downturn, real downturn, because we did not probably seen it as it is a new fund, but I think they have done exceptionally well across categories in the last few years and we started believing in the thesis that they have, which is using a lot of data to make their decisions and using data exclusively to make the decisions and I think if there were two funds that we need to probably recommend it will be Parag Parikh and Quant in this category.

Anand Dalmia: This is a year when people should probably look at mid-caps because you know, large caps, I think, it's very difficult to create alpha or to really create returns that you want. It may still create alpha if the indices don’t perform at all. But we would say that if you're a long-term investor, if you have the risk appetite, probably now's the time to look at mid-caps and enter mid caps.

Some of those mid-caps as we go to this stripped trillion economy that everyone is talking about, and we strongly believe that it should happen at some point of time, that too very quickly, I think, mid-caps are a category that should outperform and give you very good returns.

I think within that category, we really like Quant once again a lot, for the same reasons. If you look at smaller funds at this point of time, Rs 1200 crores, Rs 1500 crores funds, and if you look at the churn ratio 200% plus churn ratio, very actively managed and we like the thesis, the more time you spend with them, the more we like the thesis, in terms of when to enter or when to get out of the stock.

This was one of the reasons historically HDFC was not doing well was, for Motilal was not doing well, which we really used to like in the past, was that they were holding on to their winners for too long, till those winners became losers. So, there's a time to enter the stock and while you hold it for a long period of time, there's a time to book profits as well. So, we like the thesis of Quant, I think we would still recommend this year as well.

The other one in that category that you know we generally like is Kotak. We like the thesis, the value, the sectors that they choose, and generally something that we recommend to our clients is the is the Kotak mid cap. I would say I personally have a small bias towards that given it is one of my close friend’s fund and I get to talk to him more than some other fund managers, so I get more fascinated.

So, I think within the small-cap category, you need people who are completely bottoms-up stock picking, who are nimble on the feet, we have a thesis and not very large funds. Very large funds are difficult to deploy in small caps. So, these two categories we like.

Some of the names that historically did well or now doing well like the likes of DSP. We have seen that when you pick too much of a sector and the sector doesn't do well it starts impacting you. You don't get out of it because you are too wedded to it. So, we like guys who churn it a bit more and are nimbler than someone who just gets stuck to it and there are two or three years when you don't make money. So, as we continue to talk about Quant and Kotak as our recommendations.

Salonee Sanghvi: I think mid-cap is definitely a very good category and unlike the large-cap category, there is a lot more room for fund managers to generate alpha in this category. I feel a lot of the stocks in the top 100 stocks are maybe over analysed, so it's again a little harder to get opportunities there but in the mid and the small-cap there are a lot of opportunities that are available.

Quant as a fund house is definitely on our watch list. In fact, we have a similar philosophy in-house where all of our investment decisions are completely research-based and backed completely by data without any human bias entering the entire decision-making process. The only issue that we have is that because they were launched in 2018, when they took over Escorts, it's too short a history to really judge how the fund is going to do in a different time period and as Anand mentioned, it's not really seen as a real bear market for us to judge how they would do during that time.

So, I think Quant is on our watch list, and in fact, it’s not just the mid-cap category but across your flexi-cap, mid-cap and small-cap we do like Quant fund, but right now it's a more wait and watch approach to see how they do and generate a little bit more history before we will look at recommending those.

I think barring that, Anand mentioned Kotak emerging equity, that's another fund that we like and another fund that we also like the Edelweiss mid-cap fund. We have seen it has done quite well over the period of time, especially based on the risk that it has taken. So, I feel mid-cap is an investment that one must definitely have in the portfolio, and we would recommend maybe Kotak equity or Kotak emerging equity and Edelweiss mid-cap in the segment.

Salonee Sanghvi: Yes, we don't look at funds which have less than a five-year history at all because we believe that an equity cycle is at least five years. So that's the minimum amount that a fund needs to be around for us to judge how they have run.

Salonee Sanghvi: So, you know, I feel that in equity investing there was this whole ‘buy and forget’ mindset that was there, but I feel like that's no longer something that you can afford to have. As important as picking the right fund, it's equally important to check your portfolios and rebalance when necessary.

I feel if a fund has underperformed over two or three years, underperformed the benchmark, the category, then one needs to evaluate on why it has underperformed and maybe exit the funds if need be. In the case of these two funds, it's not just the last one year that they have been underperforming, but it has been there for a longer period of time. So, I would recommend that one should ideally avoid these funds and exit if they are holding on.