by Anand Saxena
But really how bad is the situation? Pretty bad it seems. “An incredible 96 percent of actively managed mutual funds fail to beat the market over any sustained period of time. And they are not the same every time66.” This data, of course, pertains to the U.S. but is not expected to be much better in India as well. In fact, I tried to do a lot of research about the funds which were quietly killed by mutual fund companies but was unsuccessful. It is one of the better-kept secrets of the mutual fund industry.
The message thus is loud and clear. Though the equity investments, especially mutual funds, remain the best bet for long-term wealth generation one mutual fund is not the same as the other due to the reasons discussed above. The question is then how can one avoid these bleeding costs to maximise returns? We will address this important issue in our following musings.
Key Takeaways
Equity investments remain the best bet for long-term wealth generation and equity mutual funds provide an ideal platform for the same to a common investor.
The advertised returns of a mutual fund are not the ones that an investor will get.
There are costs, both overt and hidden, which are associated with all the mutual funds that can adversely impact your returns.
To maximise your returns you need to get rid of or minimise these bleeding costs. We will discuss the ways to do this in our subsequent musings.
MUSING 22: PASSIVE INVESTING: IS INDEXING THE WAY TO GO?
We have already seen the perils of active investing—be it in the form of individual stock picking or mutual funds. Let me now introduce you to the concept of ‘passive investing,’ a form of investing where you don’t need to get involved on a regular basis once you have made your basic investing decision. Essentially, your portfolio gets on auto mode giving you time to enjoy your life following other pursuits that you love. The bonus is that you end up getting more returns than you would have got through active investing. I know it sounds too good to be true, so let’s examine it further.
The first fundamental issue that we must understand is that investing in an equity mutual fund, either in lump sum or through SIP is also active investing. Why? You may ask. After all, you have given a lump sum amount or a SIP mandate to the mutual fund company and thereafter what they do with it is their headache. Essentially, from an investor’s point of view, this is passive investing. Please understand that your fund manager of the mutual fund is playing an active game with your money as he is trying to generate ‘alpha’ meaning a return that beats the market index that the fund is benchmarked to. Obviously, all the ills of active investing that we have already discussed are bound to come to fore causing a drag on your returns.
The mutual funds that seek to track a given index (e.g. Sensex or Nifty) by owning all or nearly all of the stocks in that index with no attempt to pick stocks with superior performance (thus the fund buys or sells the stocks contained within the fund only when they move out of the index, which is rare), are called ‘index funds67.’ Since these funds are not trying to chase the market or generate alpha but only give returns as close to the chosen market index as possible they are not under pressure to buy and sell frequently and can follow a ‘buy and hold’ strategy, a winner in all market conditions. Don’t take my word for it, read on as to what financial masters have to say about index funds.
“The idea that a bell rings to signal when investors should get into or out of the market is simply not credible. After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently,” says John Bogle, Founder, Vanguard group and author of ‘Common Sense on Mutual Funds.’
“Fewer than one in ten millionaires are active investors. We have encountered more non-millionaire active traders than millionaires who actively trade. How can this be possible? Because it is very expensive to buy and sell one’s equity holdings each day or week or month68.”
It is apt to give an interesting real life story here. Warren Buffet, one of the greatest stock picker and billionaire investor, had placed a bet with a hedge fund, Protégé Partners on January 1st, 2008, that an S&P 500 index fund, after costs and fee, would outperform a portfolio of hedge funds over ten years. Hedge funds employ multitude of different strategies to earn active return, or alpha, for their investors. It goes without saying that a hedge fund manager would leave no stone unturned to generate market-beating returns. So what is the outcome of this bet? Even before the deadline of 31 Dec 2017 had reached, the hedge fund had conceded defeat meaning it could not defeat the returns given by the market (S&P 500 index.) This real-life example reinforces the fable of the hare and the tortoise.
The legends quoted above are acclaimed for their financial acumen and vision and surely what they tell us ought to be taken seriously and acted upon with alacrity by a common investor. In India, we have equity index funds tracking the Sensex (30 stocks) or Nifty (50 stocks) or a portion of these indices by various techniques and combinations. We will hereafter restrict our exploration to index equity funds.
To begin with, index funds do not chase market returns as they are directly invested in the market. To take an example, a fund that is mimicking Sensex has in its portfolio all the 30 stocks which constitute the Sensex, in the same proportion. Hence, it will provide returns almost similar to what Sensex provides. Just to recapitulate, since inception, Sensex has given CAGR of 16.5 percent, a phenomenal rate of return indeed.
What about active mutual funds? You might ask. India’s oldest mutual fund is UTI Master Share fund which was launched in Oct 1986. Until March 2018, this fund has given CAGR of 18.08 percent. Its expense ratio is 2.32 percent and if we assume other overheads as approximately 1.7 percent (details available in musing on active mutual funds,) then the effective returns come to 14 percent, very good returns indeed but much less than 16.5 percent as given by Sensex which was born in the same year, and without any effort on part of the investor.
One index fund, however, is not the same as the other. Index funds could be:
• Cap-Weighted: Holding stocks in the fund in the same proportion of cap (capitalisation) weightage as in the underlying index. “This means that if the value of a stock doubles or goes down by half, its proportional contribution in the index does as well, so it’s not necessary to buy or sell any to keep things in balance. Thus, as long as the stocks remain in the index, it is not necessary to buy or sell stocks because of change in market value69.” A common investor would be better off sticking to this methodology of indexing.
• Equal-Weighted: Equal weight is a type of weighting that gives the same weight, or importance, to each stock in a portfolio or index fund. Hence the smallest companies are given as much weightage as the largest companies in the portfolio. Equal-weighted index funds tend to have higher stock turnover than market cap-weighted index funds, and as a result, they usually have higher trading costs70. Some studies, however, suggest that of late, equal-weighted funds have done better than cap-weighted ones. The jury is still out.
We can now look at the advantages of index funds over active equity funds:
Since index funds replicate an index and sell or buy stocks only if they move out of the index, they tend to follow ‘rule-based investing,’ always beneficial in the long run as it proscribes the tendency of fund managers or investors to jump in and out of market.
The expense ratios of these funds are low—in India roughly 0.2 percent-1.0 percent as compared to active mutual funds where these tend to be as high as 2.5 percent.
Active fund picking is like searching for a needle in the haystack. With index funds, one buys the entire haystack.
To get the best from the market one should remain invested in good times and in bad. Since index fund remains invested in the market throughout, they have a better chance of catching the market upswings as compared to active funds.
There is no empirical evidence that active fund managers actually beat t
he market over the long-term (in developed Western markets.) In India, the index funds have not tended to do very well. We will revisit this point subsequently too.
Since index funds trade very less, they incur lesser trading costs and short-term capital gains tax as compared to active funds.
Despite all the advantages of index funds, they have not proved very popular in India where they constitute barely 3 percent of total mutual fund AUM. In mature markets like the U.S. the most popular index fund, Vanguard 500, which mimics the S&P 500 index, has AUM of nearly $350 billion. The expense ratio of this fund is only 0.14 percent and since its inception in 1976, it has given a return of 11 percent, comfortably beating its benchmark. Possibly in India, we will take a few more years to reach this level of efficiency which will require the following71:
Better indices constructed especially for index funds. Tracking Sensex (30 stocks) or Nifty (50 stocks) is not tracking the entire Indian market which consists of nearly 5500 listed companies on BSE and 2000 on NSE. A total market index like ‘Vanguard Total Market index’ or a much wider cross-section like S&P 500 (500 largest market cap industries in the U.S. comprising nearly 70 percent of total market) will be more appropriate to mirror the full return of the market.
The expense ratios need to be pruned down to below 0.20 percent to gain real advantage over active funds.
There is one genuine concern with the index fund investing methodology – they will never make you fabulously rich as actively managed funds can, at least in a given year. This is more relevant for small-cap funds as Sensex and Nifty, both made of large-cap stocks, will not be able to match small-cap returns in a year of small-cap boom. But always, in the long run, index funds give you the returns as given by the market and outperform the most actively managed funds.
There may also be occasions when the market may remain flat over long periods of time like “between 01 January 2000 and 31 December 2012, the S&P 500 was flat. No returns. This period includes what is often called the lost decade because most people made no progress but still endured massive volatility72.” In India too we have had our flat returns period like from September 1994 to November 1998 when the market moved only sideways. In such situations too, indexing strategy will not prove effective.
Be that as it may, index funds are a category of mutual funds which need to be watched closely and over the next few years may turn out to be the way to invest in stock market. Of course, the entire equity portfolio need not be in index funds. There is, however, yet another way to invest in market indices following passive investing route, called Exchange Traded Funds or ETF, which we shall cover in the next musing.
MUSING 23: EXCHANGE TRADED FUNDS (ETF)
According to Investopedia, “An ETF is a marketable security that tracks an index, a commodity, bond, or a basket of assets like index funds.” ETF are similar to index mutual funds but the units of these funds are listed on the stock exchanges and traded on the stock market like individual stocks. Like index funds they mimic the Sensex or Nifty or specially constructed indices and hence buying the ETF is akin to owning the entire stock range of the benchmark index. All the advantages of index funds outlined in the previous musing apply to ETF with the flip side being that every time an ETF is bought or sold, a transaction fee accrues, similar to a stock trade.
In mature international markets, ETFs have become a vehicle of choice for institutional and individual investors alike. In the US for example, the first ETF was launched in 1993 and within this short span of 25 years, the ETF market size is around $ 3 trillion, with more than 2000 listed ETF.
“The growth of ETF in the U.S. capital markets is a textbook case study in ‘Disruptive Innovation,’ right alongside well-known historical examples like Amazon, Google, Facebook, Netflix and scores of others successful enterprises,” says Nick Colas of ConvergEx.
In India, the AUM of equity ETF is just about 9 percent of total AUM of equity mutual funds. Thus, India has seen a slow growth of ETF, but of late there has been a push in this direction with the government allowing the Employees Provident Fund Organisation (EPFO) to invest up to 15 percent of their funds in ETF. In addition, the government launched Bharat-22 in 2017, a specially constructed ETF of 22 stocks of public companies belonging to different sectors of the economy, which was lapped up by individual investors.
One possible reason for slow growth of ETF in India could be the need to have a demat account for trading in the stock market. Despite a population of around 130 crores, the number of demat accounts in India are barely 3 crores, which naturally translates to lower stock or ETF transactions.
There is a good assortment of ETF available in the Indian market like gold ETF (already discussed under the musing on gold investment,) Banking ETF and IT Sector ETF. One can even get an exposure into foreign markets through the ETF route by investing in Motilal Oswal’s ‘MOSt Shares NASDAQ 100’ which invests in the US market or ‘Reliance ETF Hang Seng BeEs’ which invests in the Hong Kong market and a host of other ETFs as well. The need and requirement to take international exposure will be covered in a subsequent musing. Here we will limit our discussion to only equity ETF.
The reason one would pay extra fee to the active mutual funds is to consistently get market-beating returns or alpha. But are active mutual funds able to do it? According to one study by HDFC securities, large-cap mutual funds generated alpha of 4 percent in the period 2000-2007 which is now down to only 1 percent (2008-2017.)73 Just take a moment to mull over this fact —a large-cap mutual fund is charging you anything up to 4-5 percent to give you a return which is only 1 percent higher than the market. One can get the same return by paying only 0.2-0.5 percent fee by investing in an index fund or ETF. Obviously, the mutual fund distributors are not big fans of ETF/Index funds as there are no incentives in the form of commissions for them.
Like all good things, however, ETF too have a few drawbacks which must be understood by an investor before taking a call74.
Any investment must have easy liquidity, meaning if one has to sell it for some need or to get out of that investment, there should be buyers readily available. Some thinly traded ETFs may suffer from this problem. Hence, one must observe the trading volume and prices of that ETF for about a month. There should not be a large difference between the bid and ask prices of the ETF. The bid price is the highest price an investor is willing to pay for the stock or the ETF and the ask price is the lowest price at which the shareholder will sell his stock or the ETF.
The preferred method of investing in mutual funds is through Systematic Investment Plan (SIP) route (covered in detail in another musing.) However, while applying the same strategy in ETF, it will prove costlier due to the brokerage fee that will have to be paid for each transaction.
When one invests in a mutual fund, one gets the services of a fund manager who makes the investment decisions for the investor (required even in index funds.) However, in ETF, the investor himself needs to make the buying or selling decisions.
There are ETF which track some specially constructed indices like ‘Smart beta index ETF’ which takes into account factors such as size, value and volatility of the underlying stocks. “It utilises both passive and active methods of investing... passive because it follows an index, but active because it considers alternative factors75.” This methodology is an antithesis of indexing, hence best avoided.
None of the above-mentioned drawbacks, however, are so severe that one desists investing via the ETF route. An intelligent investor, which by now you are becoming, should have a part of his investment in passive investing—index fund or ETF. However, if investing in ETF, treat them like index mutual funds and don’t trade, buy and hold will be a winner here too. Secondly, go for pure index ETF tracking Sensex or Nifty and not for their esoteric cousins like commodity, gold or ETF tracking specially constructed indices.
SELECTING EQUITY MUTUAL FUNDS – I
MUSING 24: THE STARS FALL DOWN
“Buying funds based purely on thei
r past performance is one of the stupidest things an investor can do,” says Jason Zweig, Money magazine columnist and author.
Having established the fact that equity exposure is a must for long-term wealth creation and the best way to do the same is via the mutual funds, we now come to the all-important question: How to select a good mutual fund? We have ready help in the form of ‘star ratings’ which are given by various publications or websites. I will recommend two of them for reference: Value Research and Morning Star. All the relevant information pertaining to equity and debt mutual funds including total expense ratio, portfolio composition and returns over the last 10-15 years or since launch is provided. They also have a star rating system from 5 to 1 star which could be slightly misleading. I mean a three-star fund may not be necessarily worse than a five-star fund. Confused? So was I till I did some research into this aspect.
In a Wall Street Journal Article of 2010 titled, ‘Investors caught with stars in their eyes,’ a study of five-star mutual funds was done beginning 1999 and their subsequent performance over the next ten years. “Out of the 248 five-stars, mutual funds studied just four could keep their ratings after 10 years76.” It works out to a fabulous 0.16 percent. Though the study is slightly dated and pertains to the US, I will aver that there is no reason to believe that its findings are not applicable to India—the percentages may vary. The reason is pretty obvious—the star system works on the fund’s performance in the past and tries to predict their future course. This exercise is as fraught with pitfalls as driving a car looking in the rearview mirror. In any case, all mutual fund prospectus come with the statutory warning “past performance is no guarantee of future returns.”
