The Mutual Fund Show: Are Floating Rate Schemes Still A Good Bet?

Mrin Agarwal: Well, you just keep seeing these phases. There was a bit of institutional investor rein-in that happened. 

I also think that with the sort of stability that we are seeing around bond yields and the fact that we are really not seeing inflation runaway, as we are seeing it happening in the developed countries, maybe investors just felt okay, (that) maybe there's a little bit of rate hikes left. 

I always do feel that floating rate funds are also looked at more from a surplus parking perspective. They are really not for longer term investing. So, it could also be people moving back into equities with the equity market rebounding. 

It could be people investing back into other debt funds as well. But it's really got to do with the fact that you are seeing inflation and the bond yields also falling a bit and being kind of very steady.

Suresh Soni: So, within the fixed income, first of all… We have seen rising interest levels. So, what you have had is post-Covid a sharp decline in the interest rates which was done by all the central banks in a synchronised fashion. India joined that as well. 

We had a large cut in rates and over the last six months, the central bank is actually reversing that and we have already seen an interest rate hike of 140 basis points. 

When that happens, when interest rates rise, the fixed rate securities or the typical conventional bonds suffer because if you are holding a bond at 7% yield, market rates have gone up by 100 basis points, you will have to sell that bond at a loss so that the buyer gets 8% yield. 

So, in order to protect against these kind of fluctuations, what you have is either you can choose to go into a liquid fund or …you could choose the floating rate funds, where essentially the interest rates float along with the market. 

So, what do these funds do? About two thirds of the portfolio… is invested in the bonds which have rates due to the benchmark rates at that point of time. You can think of it like your home loan EMI. So, if the rates go up, the interest rate on your home loan goes up. Similarly, if the interest rates in the market rises, the interest rates on the floating rate bond also rises.

Therefore, irrespective of the market environment, generally the floating rate funds reflect the current prevailing interest rates. 

You said the category has lost some amount of AUM… The category was about Rs 30,000 crore two years back. By March this year, it touched a high of about Rs 80,000 crore and from thereon, of course, we have seen a withdrawal of about Rs 15,000 crore from the funds…

But what has happened is in the last six months, as Mrin was also saying earlier, we have seen some amount of withdrawal from fixed income funds in general. So, other than liquid, the fixed income mutual fund industry has lost about Rs 80,000-90,000 crore. 

Floating rate funds have also lost about Rs 15,000 crore. But this is a category which has generally done well for investors over a period of time. 

If you look at the past returns performance in calendar 2019- 2020, it generally reflected the market interest rates. Even if you look at short-term returns over the last few months, it's done fairly well. So, this is something which is suited for people who have got, let's say, a time horizon of about six months thereabout. They can park their money there and can get market-related interest rates irrespective of the market conditions.

Mrin Agrawal: These are good options because again when we are looking at the YTMs and all of that, they are pretty much in line with the ultra short-term space as well. So, it's not a bad option because with the macroeconomic worries still there and certainly, it's not the end of the rate cut cycle. So, from a six-month to one-year perspective, it is a good investment.

Suresh Soni: ETF is a category that has emerged globally, and India has also seen the strength, which if anything has accentuated in the last five to seven years, primarily by having the long-term pension fund money coming into the space. 

If you look at it, this category was very small until about 2015 thereabouts. Post that, EPFO or Employee Provident Fund Organisation was allowed to invest into the equity market, and they chose to invest through the ETF route.

As of today, they would probably account for more than 50% of the industry AUMs, and they do bring in consistently close to about anywhere between Rs 6,000-8,000 crore every month into the market. 

So, one component of the ETF rise has also been the institutional participation. The other, of course, has been the investors themselves being a little more aware as well as some of the advisors advising investors in certain categories to look at ETFs. 

So, ETFs and index funds are two different variants of the same passive strategy and we have seen flows in both of them. 

Having said that, the active fund industry has continued to grow. So, it's not at the cost of the active fund industry. 

We have continued to see strong flows in the SIPs, as you rightly said. SIP flows are between Rs 12,000-13,000 crore every month. That has continued. 

In addition to that, we have seen various months where lump sums have also been fairly strong. So, we have seen steady flows into the active industry and also increasingly, investors’ appetite coming into passive.

Mrin Agarwal: Certainly, I do believe that in the large-cap category, the ETFs are a better bet. 

For the last couple of years, one has seen that the passive strategy has worked better than the active strategy. 

But when you look at an overall category level, sometimes of course, you do see that the index has done better than the category averages. 

But when you look at individual funds also, that's where people are kind of missing the bigger picture. Within each category, you will find funds which are outperforming the indices, I would say more so in the mid-cap and the small-cap space as compared to the large-cap space. 

So, typically, what I have advised investors is to invest their large-cap monies through the passive strategy. But certainly, where mid-cap and small-cap is concerned, look at a combination of both the active and passive strategy. 

I also want to bring out another point where you know that while the passive strategy allows you to invest at a low cost, a lot of investors actually ask me that is it safe to invest in index funds. This is what I would like to say, that you need to separate the low cost factor away from the safety factor. 

For some reason, there is this whole thing saying that index is going to be safer than investing into an active fund, and that's where I think a lot of flows are also coming in over there. 

But yes, it's important that when you are looking at a passive fund, looking at an ETF, just buying any ETF is not good. 

Obviously, you need to diversify. Most people tend to just go and buy four or five Nifty 50 funds and do not look at the other ETFs. So, obviously, you need to follow all the rules of investing, which is diversification even if you are building a passive portfolio.

Mrin Agarwal: Well, one, of course, you need to really see how each of these funds tie-in with your goals. 

Second is really to have diversification between large, mid and small-cap. This is where I feel that if you're not really able to do it on your own, then obviously you have the flexi-cap option available. 

But if you're planning to do only passive, then certainly, you need to build in that diversification on your own. 

The third thing is not to go overboard on one particular category. Again, there is some trend chasing happening even on the ETF side. People are not really aware of how smart beta funds work. So, there is some amount of trend chasing that happens in some of these categories as well. 

The main thing is really about seeing how it ties in with your financial goals, with your risk, are you diversifying, and if you're looking at smart beta funds, then what is the reason for looking at it.

Suresh Soni: I would like to argue that well-managed active funds could outperform index, and even in large caps.

Suresh Soni: Quarter on quarter, to say that my fund will outperform, it's difficult to do. If you have a good process, then over a period of time well-managed funds outperform. So, if I look at long-term performance of our own fund, over a period of time, we have generated alpha. 

What happens is markets go through cycles. There are times when the market really is very narrow. Those are the times when fund managers, who are typically stock pickers, find it difficult to beat the index in those brief periods of time. 

But more often than not, market movement is broad-based and those are the times you are able to, as a stock picker, create alpha. 

But it's tough to say that every quarter, active funds will outperform passive. But if you are looking at a time horizon of five years or 10 years, fund managers will be able to create alpha for you and they have done that even in the large-cap funds. So, I wouldn't want you to write off the large cap funds as yet. 

Mrin Agarwal: There's a lot of interest in this category because if you look on a YTD basis, it's giving you 11% return, pretty much the highest return among all the categories. 

You are looking at large caps at around 5%, and you are seeing the small-cap category giving you around 11%. So, the heightened investor interest–especially from retail investors–is because of the fact that it's given a great return YTD compared to other funds.

In general, our advice is the same across market cycles–whether you are in a rising market or falling market–that very importantly, please tie it in with your goals and your risk-taking ability. Just because you are seeing 11% return right now YTD, is not reason for you to get into it because you should have the ability to stick in it for the next 10 years and stick through the volatility that you are going to see in this segment. 

So, while small-cap funds, even if we look at longer term periods–I shared some rolling returns data to show how the small-cap funds have really outperformed the index and on the long term. 

But at the same time, they also come with the highest amount of volatility. So, the advice is the same as I said–across market cycles, please invest in it according to whether you can really take that sort of volatility through the investment period and have a long-term investment horizon. Again, look at a fund that has got a good track record and has been consistently performing. 

I know rolling returns is not easy to get and that's why I provided it for the show. But it is one of the factors that you should consider.

Mrin Agarwal: Unfortunately, I don't know of any place where you can get it. I mean we use tools to get it ourselves.

Mrin Agarwal: Yes, yes, I would highly recommend that fund houses should provide rolling returns data.

Suresh Soni: I do think that a lot of us have some tools on our website, which allows investors to be able to calculate rolling returns. They can pick up a time horizon, they can also do goal-based planning. 

To have it in a mandatory disclosure in advertising would probably confuse people, probably even more because you already have a number of other data points which are coming around the returns. 

…Now coming to the categories itself, the market leadership keeps changing over a period of time. So, if you look at 2018 and 2019, large-cap funds were the best category, 2020-21 mid and small-cap made a very strong comeback because they were the ones which fell the sharpest as well as they had the fastest recovery. 

So, over a period of time, the leadership between market caps will keep changing and therefore, I think it's best as Mrin was advising, to look at a judicious mix in the portfolio. 

Over a period of time, if you're looking at a long-term time horizon and you are willing to ignore the intermittent volatility, probably mid and small cap is a great option for somebody who is closing his eyes for 10 years and allocating. 

So, these are the companies which will have higher growth rate. Some of them will also get rerated and therefore, you will get that benefit. They come with their own share of volatility, which is why you have to have a long time horizon. 

If you can't actively move between mid, small and large cap, then I would have simple advice: please look at flexi-cap funds, let the fund manager do that job for you, and overall, I think you will come out ahead.

Mrin Agarwal: …Essentially, we use a lot of tools and I actually believe a lot in quantitative analysis. 

Based on that, I would recommend the DSP Small Cap, SBI Small Cap and Axis Small Cap. So, these are a couple of funds that I would recommend. Again, these funds have been pretty consistent in the long term as well. 

Now, on the ETF space and if somebody really just wants to build a passive portfolio, then I would say pick up a Nifty 50 fund. 

Of course, when you pick up a Nifty 50 fund, the main thing that you need to be looking at is the tracking error of the fund. Thankfully, now tracking error of each fund is available on their fact sheet, so you can check it out there. 

Mrin Agarwal: So, the tracking error basically tells you what is the consistency of–I wouldn't say performance–but the consistency of non-divergence of the fund with the index basically. 

So, a lower tracking error is a better thing basically and essentially, you are looking at funds based on their expense ratio.

But, typically looking at just tracking error is good because tracking error itself would take into account the fund ratio, the expense ratio. So, of course, looking at tracking error is very important when you are looking at the ETF.

I think a good basket of, let's say, a Nifty 50, Nifty Next 50 or Nifty Midcap 150 should actually be good enough for anybody to really start off. 

I still do think that in the small cap space, active fund management is going to give you a much better return. So, just sticking on with these on the index funds is a good idea.