The Mutual Fund Show: Why Indian Investors Need To Be Prepared For Good News From U.S.

Indian investors need to be wary of a rebound in the U.S. economy, according to mutual fund industry veteran Sunil Subramaniam.
<div class="paragraphs"><p> (Photographer: Valentin Flauraud/Bloomberg)</p></div>
(Photographer: Valentin Flauraud/Bloomberg)

Indian investors need to be wary of a rebound in the U.S. economy, according to mutual fund industry veteran Sunil Subramaniam.

If the U.S. economy heats up, it will lead to tapering and higher rates, both of which can lead to money outflows from emerging markets, particularly India, Subramaniam, managing director at Sundaram Asset Management Co., said on BloombergQuint’s weekly special series The Mutual Fund Show. While it may be difficult to predict when that may happen, he advised investors to prepare for it.

One way to do that is investing in globally diversified funds, according to Subramaniam. Investors will gain from earnings growth of global companies as well as currency gains with such investments, he said. But he advised against country- and theme-specific funds.

In India, Subramaniam global economy-linked sectors such as information technology may be a good bet. And flexi-cap funds would be better. The mid-cap index is trading at a discount to large caps and it’s also difficult to predict which index would do well. It’s best to bet across market-caps and leave allocation to the fund manager, he said.

Nisreen Mamaji, founder of Moneyworks Financial Services Ltd., said if an investor has a timeframe of less than five years, a special situation fund would be better as it would take advantage of movements due to tech disruptions or regulatory changes. She recommended the ICICI Prudential Business Cycle Fund for risk-averse investors, she advised multi-asset funds, with the Motilal Oswal Multi Asset Fund being her top choice.

For an investor who looks at investing for more than five years, a pureplay equity fund is good to invest, as she believes that over a longer time period, the volatility in returns evens out and investors should try to maximise gains that equity funds provide.

Watch the full interview here:

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Here are the edited excerpts from the interview:

Why do you believe that good news on the U.S. economy could be a risk to the Indian markets, and thereby investments of mutual fund investors?

SUNIL SUBRAMANIAM: Prima facie, the answer lies in the word liquidity. The infra cycle I expected to support the Indian economic growth, but the liquidity has helped in that in a big way and this liquidity has been driven by the weakness in the advanced countries economy, notably the U.S. If you look at it something like $13 trillion has been printed in the G4 countries, primarily Japan, the U.S., and of this other 29 trillion was expected. So, the liquidity that has come in and the expected liquidity have driven up these stock prices. If you study this liquidity pattern, out of the 29 trillion over the next year, 9 trillion, which is 30% has to come only from the U.S. Now, the U.S. is obviously printing notes, quantitative easing to try to revive the economy, but what happens is, market participants don't care abut whether that goes to the U.S. economy. They revive the U.S. stock market, they revive gold, they revive the emerging markets. Why does this happen? That is because when the U.S. prints money, it’s fiscal deficit widens. When the fiscal deficit widens, the dollar weakens. So, when the dollar weakens, the other country's currency strengthens. So, along with this, they do rate cuts. Rate cuts are near zero in the U.S., already zero in Europe, negative in some countries in the Eurozone. So, for a typical hedge fund which accounts for a significant proportion of the flows into markets, they have low cost of borrowing and they have a higher return expectation from countries like India where the nominal GDP growth, leave aside the pandemic is actually the highest single digit and if you add inflation to that you can get nominal double digit. So, you're getting a huge interest rate carry trade that’s one, but this is enhanced by the currency strengthening of the emerging market which gives the additional icing to the cake that they already have on their hands. So, a double rally and so if you see the flow of money, of this liquidity intended to revive the U.S. economy, is actually leaking transmission into the emerging market. That's number one. Now, within the emerging markets, the fact that the recession led to commodity cycle weakening meant that commodity import in countries like India were an undue beneficiary of the kind of flows that went into emerging markets. So right through the post-pandemic quarter, other emerging countries have had some positive months and some negative months and that India, got a consistent foreign FDI inflow through those periods. So, if you actually put a percentage number to it, China and India are commodity importing countries, they would have accounted for 90% of the FDI outflows into emerging markets here. So, the Indian markets have benefited from this massive liquidity flow for these very reasons. Now, when will this flow get impacted or reversed is the question. It will happen when U.S. growth is returning, U.S. inflation then seem to be rising, then the Fed will hike interest rates, then target the liquidity and when that happens when U.S. interest rates rise, the dollar strengthens, when the dollar strengths, money flows into the U.S. So, the reversal of the trend about which country got the biggest inflow will arguably get the biggest outflow because on top of this, when the U.S. recovery happens, the commodity cycle will revive because U.S. will become an importer of commodities. So when commodities rise, then whatever little emerging market flow remains, will get shifted away from commodity importing countries like India to commodity exporting countries like Brazil, Russia, the Latin countries. So, there will be a net flow out from the emerging markets and second, a reallocation. So, the Indian market then is a big risk from the short-term liquidity. The longer-term pension funds will continue to invest because there's nothing damaging in the pandemic to the long term growth story, but in the short run. And for evidence of what I say, let’s go back to May 2013 — the last time a tapering was done, there was an earthquake. So, the point is not where the issue is. The issue is that the U.S. Fed who is the ultimate decider of this, denies this fact that they are going to taper. They are keeping on saying that this transient inflation that we see now it's not permanent but the equity markets are believing it right now and so the flows are continuing, but the debt markets are do not believe the Fed. So, if you see in the debt market the interest rates have started rising despite the Fed not hiking it. So, there is this disparity. Ultimately, the Fed can delay this by saying I don't see the data but when the data comes, the Fed has no choice but to follow that data. So, according to me, the Fed can talk down the taper talk and delay this process for some time but it's only a matter of when and not if. If you take a poll of the analysts, 45% of them believe that the last quarter of this calendar year October-November-December is when Fed will taper. Another 15-16% believe it will be in the following quarter. So, 16% of market consensus says that within the next six to nine months, this tapering is going to happen. So, I believe that that's the biggest risk. Now if the U.S. economic news comes bad, then the whole jolly ride of whatever is laid out as the normal growth will continue. The point is I can't say or guarantee that this will happen but take a year at the outset and you will definitely see that. Generally, what do we pray for? We pray for the world economy to recover because ultimately equity markets, follow the economy. So, while in the long run a U.S. recovery is good for Indian exports and all that, in the short run, I think, we want to be prepared for that volatility from the taper talk. Forget about when the taper happens. So, the markets always anticipate the future. That is my brief point that good news will lead to an early expectation of taper and markets tend to discount that and react ahead of that.

I think we've seen some central banks like Sweden already top of it, and I think the U.S. base effect kind of gets dissipated in the last quarter that you're talking about. Having said that, let's assume that is happening but at the same time, the Indian growth story starts rolling back hopefully without a third wave in which case, even if the Indian economy and the Indian earnings are rock solid, you still reckon that the outflows will be strong and severe?

SUNIL SUBRAMANIAM: The outflows are from FII which are the hedge funds which are trading on the carry trade plus the currency difference. The interest rate differential. When that is disappearing, there are smart people, they will have a risk because India is a risky country. So there will be a risk weighted dismissed the minimum return I need. So arguably, the long-term pension funds may continue to stay but the short-term hedge funds. Not only that, you take an ETF, in the emerging market ETF, it's an algorithm driven reallocation of the money among emerging markets. So, forget about human thought process, there are certain parameters and interest rates. That will be one of the things that feeds into that computer and you will see computer driven outflows—forget about human intervention because that inflation, U.S. inflation, U.S. interest rates and dollar all of these are individual vectors fed into the computer and the algorithm will say, sell India. So, human intervention and algo trading can actually trigger that kind of an outflow.

What is the risk therefore for Indian markets and how should average mutual fund investors prepare themselves for it?

SUNIL SUBRAMANIAM: I think the key point is to be first of all aware of this risk. The awareness itself brings across a calmness, because believing that this is a story that the bubble is going to get bigger and bigger and don't go thoughtlessly into it. So, pay thought to your asset allocation, that is the first thing. There is a risk looming ahead of you, prepare for it, number one. Number two, how to prepare for it? Try to benefit from it. First of all, is how do you benefit? When the world recovers, when advanced countries recover, put your money in a fund which is going to be in those countries. So, choose a globally diversified fund because, again choosing a U.S. fund is easy because the U.S. markets have delivered fantastic returns, it's easy but don't get carried away. Even the U.S. recovers but that's been discounted already by the U.S. stock market. It's the rest of the world. So, choose a globally diversified fund across sectors and across countries. So, there you will benefit and the benefit will be doubled. Not only will you benefit from the growth of the globe but you'll also benefit from the fact that the dollar strengthening and most of these global funds are denominated in dollars so that you will get a currency appreciation in addition to your actual earnings growth in those countries. So, a significant part of the allocation should be in globally diversified funds. Do not choose country specific, do not choose sector specific, that's number one. Number two, even within India, there is one sector which is linked to the globe rather than to India. That is the information technology sector because the IT sectors is business and because of the pandemic, in addition to just normal growth driving demand, the pandemic has shifted the rules of the game, that those users have to revamp their IT infrastructure to cater to so much work from home to so much cloud computing to all of that. So, I see massive IT sector reorganisation happening in manufacturing, BFSI and all those places. So, all IT companies- large, mid or small are poised to benefit. Normally a sector allocation is considered risky but at this point it is actually hedging your bets against this. So, sector allocation is what I would recommend, that's one point. At the same time, when you look at the other part in the domestic scenario, I would say that if you are either a very conservative moderate investor or you are an aggressive investor, because aggressive investors are willing to ride these risks and allocate. I would still say that keep a flexi-cap allocation because look at what's going to happen. Even now in the month of April and May, you saw FIIs start to pull out because there was news around Fed paper, and the bad news immediate on India. So, two months’ of FIIs have been pulled out but in June, they’ve comeback strongly against that but when my point is that in that period mutual funds have stepped in and bought domestic. There is a whole of last year where there were sellers because they were facing redemptions. So, my point is that FIIs may sell what they bought which is safety-oriented stocks but mutual funds will not necessarily buy that safety but they will buy the Indian growth oriented stocks. So, you will see a correction in some sectors and mutual funds buying in some other sectors. So, the overall Sensex may not fall as much, but may not rise as much either. So, the reallocation of portfolios and if you then look at what the market has been discounting—the large-cap and the small-cap indices are today at the same one year forward P/E which means what is the market doing? The market is saying that large-caps are expected to benefit so FIIs have put in money but small-caps because the free float is very less, even a small amount of mutual fund that a Robinhood investor buying has taken up the small-cap future EPS expectations to phenomenal levels. Now, is that sustainable over the next 12 to 18 months? You’ve got to think, whereas the mid-cap index is trading at a 31% discount to large cap. So, I would say keep a flexi-cap, where you can keep around 50% in the mid-cap because mid-caps have larger free flows, they have a more diversified sector, the small-cap sector is still industrial driven, it is still cyclical. So, I would say keep a flexi-cap approach so that mutual funds will allocate to the right sectors within the large-cap. I would not recommend you to go sector-wise there but keep your story around the fact that a mutual fund manager can read these tea leaves a little bit better and would do the right sectoral allocation and mid-caps still carry a significant amount of a discount to the other two indices so that your downside risk and your margin of safety is higher in mid-caps today. Finally, I would say that at the end of the day, let's not forget that long-term FIIs will still be putting in money. So, the infra thing which I spoke about in our last show so strongly, do not ignore that because ultimately from a longer-term perspective that is relevant. So, keep a small allocation to that infra thing because ultimately that's the driver. That is going to be the beneficiary of the driver from the India post-pandemic story. So, I’ll put out a small chart to show that this is the ideal allocation. This would hedge all risks and if it's very conservative, then you cut out all of this story short and put your money in dynamic asset allocation. The fund manager chooses less equity, so that you know that mentally he is in your space. So, if you are a moderate investor, this is the way I would recommend.

One last question and that is, this permission that has been given to mutual funds to increase, I think up their remittances in the global markets. Can you talk a bit about that? Do you reckon that more and more AMCs will make use of this and would that be net beneficial as well?

SUNIL SUBRAMANIAM: Yes, I think this is also driven by investor interest. I think SEBI has been observing that even direct stocks through the equity traders has been going up and I think mutual funds have been expressing to SEBI saying you’ve put these restrictions but I'm getting inflows. So, why do you do that? So, SEBI has been a very practical regulator. It listened, looked at the ground and it's also taken recognition of the fact that today global diversification is an important part of risk management for an investor and it's that recognition which is coming through. So, I think this is a good news because it helps to spread the play out and more and more AMCs—especially those with foreign partners or foreign AMCs like we have a Singapore subsidiary, so we are able to launch funds from there. So, those will definitely benefit—there's definitely a positive because at the back of the mind, you’re then worried that you will hit the cap and then you have to start fresh inflows and all of that. Today that worry is at ease. I think it will open up the space for investors to have lot more options in terms of funds to choose from.

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Nisreen, if investors want to prepare themselves for possible global market strength, but simultaneously, maybe some weakness in the Indian markets, is there a way that investors can prepare themselves for it?

NISREEN MAMAJI: Basically, we're looking at an investor, saying who's investing for more than five years or less than five years and break them up into two categories and also depending on their risk tolerance. So if your timeframe is about say less than five years, you should be looking at some amount of debt of course and a diversified fund. What I would recommend is for a category of less than five years you can be looking at maybe a special situation kind of a fund which would take advantage of movements because of tech disruption or regulatory framework, etc., a fund that I would recommend is the ICICI Prudential Business Cycle Fund which is based on these themes and is currently invested into a corporate lending, banks, infrastructure and metals. If your risk tolerance is a bit lower, you can also go for a multi-asset fund which will include gold, international equity, debt, as well as domestic equity. So possibly a recommendation would be the Motilal Oswal Multi-Asset Fund which is currently about 63% in debt and 11.5% in international equity. Also, if your risk tolerance is a bit on the lower side, you can look at index funds which will be basically a passive strategy which would be mirroring the index. So, any of these kind of funds or strategies for various types of risk tolerance, investors would be okay but if your tenure is more than five years, you could always look at a large and mid or a small-cap category because in the longer-term the volatility tends to get evened out and you could participate in the potential of higher returns by going in for either a small-cap fund or a large and mid. So, that could be possibly my recommendations for that.

Let's assume that there is a risk averse investor who wants to invest for a period of 10 years and we know that in a really long term, even the riskier part of the equity side does well but the investor is risk averse. What would you recommend? A large-cap equity fund, a flexi-cap fund or even if the investor is risk averse, it would be okay to go out and buy maybe a good small-cap as well and why?

NISREEN MAMAJI: Maybe for less than 10-year category, I would suggest a multi-cap, a multi-cap fund which has a large-cap bias. So you are not going to miss out on the possible potential returns of a mid or a small category but at the same time because you're risk averse say 70 to 75% of your investment will still be in a large-cap so the possible choices could be Canara Robeco Flexi-Cap Fund which is currently about 74% in large-caps or the Parag Parikh Flexi-Cap, which is about 71% in large caps. So, that way you won't have too much volatility and your risk tolerance will not be crossed and if you are investing for the longer-term, then definitely you should be looking at a little more of mid and small caps because otherwise you'll miss out on the rally and the outperformance potential of a small-cap or a mid-cap category. So maybe in the small-cap, I can recommend the UTI Small-Cap which has been recently launched and I think that you could possibly see some outperformance there. In the mid-cap category one can look at the Axis Mid-Cap, and also I think that you should also be looking at a value strategy because in the longer term, a value investor will possibly do better. So, one of the funds that I could possibly recommend is the L&T India Value Fund.

You don't foresee any risks with a newly started fund. Wouldn't an established fund with a track record be better on the small-cap side?

NISREEN MAMAJI: Basically, performance is not the only criteria when you select the fund. You would also look at the processes, the people and the AMC itself. Since UTI has already been in the industry for so many years, the fund manager himself is managing even the UTI equity fund which is now called the Flexi-Cap Fund. Therefore I typically would not recommend an investor to only look at performance while you're making that selection. So, even if it's a new fund you can select that fund.

Final question Nisreen, a lot of people have been sending this in, wanting to know that if indeed rates in India were to go up, how is it that they can take advantage of that phenomenon via the use of mutual funds? Do you have any thoughts? Let’s assume that the investor believes that rates will move up. How can an investor take advantage of that?

NISREEN MAMAJI: One thing is that, if you can be invested in various strategies if you go into the shorter end of the curve, say a medium-term plan, which has a duration of about two to three years, then you would be able to manage the interest rate volatility. With the interest rates going up, the yields will go down. There's an inverse proportion between the two. Another strategy could be an accrual strategy. So maybe if you are in a credit risk fund, which is purely going to be an accrual whereby you would get what you are promised in other words the yields of maturity, would be an indicator of what to expect and you wouldn't take too much of a risk or you can also with the interest rates moving in this fashion, go into something called an equity savings fund, which will have about 15% of equity. So of course if you are introducing equity in this category then you have to have a slightly higher risk tolerance and you have to be open to a little more volatility. But I believe that this could be a good option, the equity savings category could be a good option to a fixed income investor. If your risk tolerance is even a little higher, then you can go for something like a dynamic asset allocator fund, whereby the fund manager himself will decide the proportion of debt or equity into this particular fund. So, say currently the ICICI Prudential Asset Allocators is about 36% in equity and the rest is all in fixed income whereby you don't have to keep on churning the portfolio or rebalancing the portfolio, you can leave it to the experienced people to decide whether they need to be in equity or debt but bear in mind that with equity, your risk tolerance should be a little higher. So, if you’re purely a fixed-income investor, I think maybe the shorter end of the yield curve would be safer for you and also to go just with an accrual strategy.

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