The Mutual Fund Show: Why Advisors Recommend Index Funds Or ETFs Over Large Caps

Tarun Birani: I have some data to share based on SPIVA study. I think SPIVA is authority around the research around the ETF versus active versus passive. Based on their research, in last 10 years, approximately 70% of the active funds have underperformed their respective benchmarks. So, again, I looked at some hard numbers from a trailing return data also. From a three-year perspective, I can see out of almost 30-35 funds, only six have outperformed, let's say a Nifty 50 in the large-cap category. In a five-year category, five years trailing returns, I could see only one or two winners outperforming the Nifty. So, this clearly is telling us that there is a challenge happening and most of the large-cap funds are not able to outperform. Based on the SEBI categorisation of large-cap funds, 80% of your investment should be in top 100 stocks. So, the space is more or less same for everyone. So, the efficiency is very high and due to this most of these stocks are high-research stocks. So not much can be done. I think where one can do much larger is in terms of, let's say sector plays, but Nifty again is doing very well in terms of capturing all those trends very quickly. So, we are seeing that most of these top indexes are actually doing better than these large caps, and my suggestion also would be to continue, at least in the large-cap category, with the index funds.

Santosh Joseph: Over the last three to five years, a clear direction that it's pointing to how ETFs or index funds have kept in line with the performance of the market in general and therefore, the reduction of the dependence of large-cap funds to deliver that kind of return. Now, let's not even get to the costs because we all know how different the costs are when it comes to performance. We are talking about two things here. One, meeting the expectation of a large-cap space with the diversified fund or a large-cap index fund, which is also an ETF. Second, is it possible to actually outperform or create an alpha?

Now, let's break this down and say, to create an alpha, I think it's expecting too much out of a large-cap fund, because of the contours of the way we are now after the rationalisation of the scheme has happened. The universe remaining the same, numbers also, like he said, Nifty and the top 100 stock which is a static list of universe also are the most liquid part of the F&O stocks, and they have the ability to go through large amount of transaction with very less impact on the price of the stock. Now add a layer to that saying that this is where everybody is buying and there is huge amount of liquidity and even the large-cap funds are also buying the same thing and index funds also buying into the same thing.

Now, we are saying alpha generation is not a realistic expectation over there, number one. Number two, if you want to trail or sort of shadow the large-cap index, there are better alternatives than just a large-cap fund. So, on these two counts, we made a reasonable assessment saying that there is a case today to believe that if the client is not very particular of investing in the physical mode or is okay to take the delivery of the ETF in his demat account, then he will be able to get the benefit of the large-cap fund through an ETF or an index fund with practically no extra fuss or cost.

Santosh Joseph: You should be happy to get the index return, and you know, give you the comfortable feel.

Santosh Joseph: See in general, like you said, I would go with you saying it is strict no-no, because I think many investors when you look at thematic funds, you are trying to ride a wave. You are trying to be better than the market. You are trying to go down the path away from diversification into sectoral or a sort of a concentrated approach. Now, within that the reason why we say no-no in general when we are talking on forums like these is that I do not know what the investor is thinking number one, and I do not know what is the expectation that they have. For example, if I take the banking and the financial services, they are a large part of the index in itself. Now, if I take that as a thematic versus something else is a thematic story that could be chalk and cheese, in terms of difference, in terms of their exposure in the market in itself. That's why it's generically a no answer, but for a savvy-seasoned investor, who knows slightly better, now, we can't even say the same thing in similar thought for an IT sector, which is again, a big part of our economy, a big part of diversified portfolios, but if someone knows to play it, someone can understand the nuances or someone can understand the whole opportunity it presents, for example, you look at this particular calendar year, metals have done very well even though there's a sharp correction that's ensured after that. But still, if someone was able to play that entire rally well, and if you are someone who understood the metals as a space or maybe you are into that business or you know that, there is an opportunity, but for general investors stick to diversified funds, where all these will be well represented by your fund manager or the scheme that you are in, in the right proportion or measure. So therefore, thematic tends to get a little aggressive for the person who does not know why he is getting into it and for the seasoned guy, it's a nice opportunity for him to rather than go for the whole buffet choose the one meal that he wants to go after.

Tarun Birani: I think most of the points Santosh has already covered, I also strongly believe that there is no need to do so much of experimentation where you have the normal diversified funds that are able to capture a lot of stuff for you. But again, let me try to bring in another perspective. This has more to do with a financial planning angle. So, I feel there are three needs most of us have, one is a safety need, another is stability need and third is the aspiration need.

Safety and stability needs are mostly taken care of with most of your market driven products, which are more diversified, and your normal Markowitz theory talks about high-risk high reward, I think that is where I think most of your safety and stability or your goals like your retirement goals or your children's future goal, all these things you can take care of.

But I think the third part is the aspiration part and aspiration is where you look at high-risk bet, concentrated bets where you look at let's say investment into a specific sector, which you understand. So, since you mentioned that somebody who has a large enough portfolio, I would say where safety and stability is already taken care of and one one is extremely bullish on a sector, let's say I am working in a healthcare sector, I understand where in 10 years, this healthcare sector is going to move in, where the technology sector is going to move in. I worked with some folks who bought Esops in the technology sector, and they have been holding Esops of large quantity, again, very concentrated, that's a problem area. But that is again, where one can look at if you are superbly bullish and your safety and stability is taken care of. I think then you can look at some part of allocation in that expiration thing but what normally people do and let's say, if I look at last one year, where your most of the high growth tech stocks were like, every evening going up by 10% - 5% and people get crazy and they forget the safety and stability, put all the money there and today I see all these guys are sitting with 70-80% mark to market loss on their portfolios. So maybe one can take that as a different perspective from the financial planning angles. But what Santosh said that I completely agree with.

Tarun Birani: In 2021 starting almost 100-plus NFOs were flooded in the market and almost 75,000 crore plus of assets have been added in these NFOs. I think most of these have been added because of these re- categorisation rules which SEBI has come up. After that most of these fund houses had to fill their gaps. Somebody doesn't have a flexi-cap fund, somebody doesn't have a multi-cap fund, so on, and I think with the popularity of most of the index categories, fund houses are in rush to fill in these categories wherein let’s say, a Nifty 100 is not there, a Midcap 150 is not there. But if I look at from an investor perspective, my biggest question is, is it a unique offering? I think unique offering is very critical for me and I think 90-95% of these NFOs are something which is already available in the market. I don't find anything unique in most of these offerings which are coming in these NFOs, and I think from a performance point of view also, these NFOs have not done that great if I look at the hard data. What I would always strongly recommend is to look at attribution. What are that fundamental attributes of that scheme? What is the asset allocation this NFO is looking at? What is the investment objective this NFO is looking at? Does your existing fund, which you are owning, is there anything different which this NFO is giving you? I think then only you should see a need. So, let's say if you don't have a Nasdaq, and let's say NFO of a Nasdaq fund is coming and I think there were some challenges in terms of global funds also in the market. So maybe one can look at a Nasdaq fund NFO. That could be always explored. But most of the time it has been driven out of need for a fund house to raise AUMs, not looking at an investor angle. Again, another challenge I have seen most of these NFOs are launched when the market is in momentum. I have never seen these NFO launch when the markets are doing bad or in a bearish mode. So that is again a reason to garner most more and more AUM. I have seen most of the fund houses try to time their NFO when the markets are at the peak level. So may or may not be the great time for investors to invest in. So, my suggestion is look at these three-four fundamental attributes. If you find something very unique, and something missing in your portfolio, then only look at it otherwise, it's completely avoidable and I never recommend an NFO.

Tarun Birani: Yes, yes, because most of these are filling the gaps. That's what I am seeing right now.

Santosh Joseph: I am sorry to disappoint you, we are going to go towards some sort of consensus here. I think the way the SEBI is structured now the application of new fund offers and even the launch of new fund offers, there is little leeway in terms of what an AMC can do but fill in the gaps of the bouquet of services that you already have. Now I still see that many don't have multi cap and I am certain that in the in the next few days when you know embargo lifts and SEBI provisions are a little bit easier to come by, a lot of multi caps will come because everybody converted their erstwhile multi cap into a flexi cap and I think we have discussed this in the past and so therefore, from an investor perspective, I think is there something new under the sun is a big question mark because if it is new and if it adds value, then there is a reason for us to get excited about a new fund offer.

Now for a mutual fund company is good because for them it is new because they don't have it in their basket, from an investor there is a peer group available. Now how do we mix these two? The challenge is, like what Tarun said, that usually these NFOs come in the markets are very buoyant and a lot of momentum in the market. Now we also have to understand that even investors like to invest only in a point or a momentum driven market. You go to an investor tell him when the markets are down and beaten, they are not going to give you one rupee even if it's a large-cap fund or a small-cap fund. Now you can make 100-slide presentation about value, about the benefits of long-term investing and benefits of investing in a down market. Those all won't go down and won't be appreciated. But from a perspective of launching a fund, you always want the right mix of the product in itself being something that the AMC wants and also the market momentum being in the right space. So, I think the AMCs are doing best what they want to do that is come out with a fund that they want.

Now, when you look at this, today, the reason why some of us can look forward to some of the NFOs though it is not a blanket sanction for all the customers because there are very good peer options already with attribution, with enough of background of performance. Is that a classic example? You know you have a new mutual fund entrant right now White Oak launching a flexi cap fund, I am sure when their approvals are there, they will be out with the fraternity and the investors to come out and talk about their fund. Likewise, I think I read about Edelweiss coming for their focus fund. When you look at these two things, what is it tell you that a particular fund house feels that they can do well in a particular space which they do not already have an offering or the new AMC is coming or the new opportunity and of course, there will be a new story to believe that why they will do better in that category or that space now, if it augurs well with the investor at that particular point of time, if there's money going in, can they consider to give money to a new fund offer. Considering the fund is going to be beginning on a new track record, then you actually rely on the pedigree of the mutual fund company, pedigree of the fund manage, pedigree of the reason of this previous fund offers whether they are there to collect money or because they can add value to the subject or the scheme objective that they are going after. So, there is no easy answer for this... If the investor is fine, and the story that fund houses presenting matches with the investor profile particularly, I think that's the bottom line, if it matches with the investor profile though it is a new fund, because sometimes you have this luxury that you forget to take those 30-90-100 days to even deploy the funds and in markets like these you want a lot more spread-out investment time horizon than the money going in at 80-90% invested level straightaway. So, there are benefits and you know, disadvantages of it. But I think one could take an individualistic view on these new fund offers that are going to you know, begin right now.

Santosh Joseph: We don’t actually anticipate or watch out when these things come, we actually go through every one of them before we say a no. So right now, I have heard about the Vito Flexicap Fund, which is going to be their maiden equity and NFO and I am sure for them there will be a lot of expectations to get that fund right and do a good job for it because they come with a background of a great stellar fund management team and also a successful track record in the PMS side of the business. Now there's also Edelweiss, which has also got its own set of funds, trying to do a focused fund. Beyond this, I know, there are many more they're holding back to you know, communicate more to us to figure out what their offerings are.