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Should you invest in passive funds now?

Two investors debate whether one should invest in passive funds after the bloodbath in mid and small caps

Should you invest in passive funds now?

Jai: Great to see you, Veeru! Where have you been all week?

Veeru: I was busy taking stock of my portfolio. My portfolio value has been falling for the last couple of months in my NSDL CAS statement, so I got worried and was wondering what to do.

Jai: Taking stock is fine, but don't start changing around your funds in a hurry.

Veeru: Actually, I am quite tempted to sell some of my active funds and buy index funds. See, in the five years until 2017, all the large- and mid-cap funds I had were bolting like Usain Bolt and leaving Nifty 50 far behind. But everything changed in 2018. Currently, I see the Nifty 50 is easily beating my active funds. My cousins in the US are advising me that I should shift all my money to exchange-traded funds (ETFs), as they did. After all, India catches up a few years later with whatever happens in the US today.

Jai: Yes, active funds have struggled in 2018. I was looking at the Value Research data. In the last one year, 93 per cent of the open-end large-cap funds underperformed the Nifty 50 Total Return Index. On three-year performance data, too, 80 per cent of the funds are lagging behind the index.

Mid-cap funds are in the same situation. About 40 per cent of the active mid-cap funds didn't match the Nifty Midcap 100 Total Return Index for one year and 80 per cent didn't on a three-year basis. But I would say it is too early to conclude anything, Veeru.

Veeru: You are contradicting yourself. You have yourself said that active fund managers are not able to beat the index. Then why stick to them?

Jai: Before making any wholesale change in your portfolio, it is always better to wait and see if the trend you've noticed is a temporary phase or a permanent one. Right now, I'd say this active fund underperformance is a temporary thing.

Veeru: How can you say that? Aren't three years long enough for you?

Jai: See, this is not really a three-year trend. Mid-cap stocks have fallen so much in the last six months. The mid-cap and small-cap indices are down 15 and 21 per cent. This has hurt active funds, which usually own mid or small caps. Their recent fall has been so sharp that it has pulled down the trailing three-year return also. Until the end of 2017, a majority of active funds were still outperforming the indices.

Veeru: But there have been some permanent changes in the mutual fund industry, too. After SEBI's new classification rules, large-cap fund managers must now invest 80 per cent of their assets only in the top 100 stocks and mid-cap fund managers must invest 65 per cent in the next 150. SEBI has also asked funds to use total-return indices as their benchmarks. Earlier, funds used to show a lot of alpha (outperformance) by owning more mid and small caps and padding up returns with dividends.

Jai: Right. SEBI's changes do make it harder for active funds to show alpha through shortcuts. But there were one-off factors at work in the recent mid cap/small-cap fall - mutual fund selling to comply with the new rules, crackdown by the stock exchanges, FII selling, auditors quitting, etc. So I would say the last six months have been an unusual phase in the market. What we need to see is if active funds pull up their socks once things settle down.

Veeru: But why wait? Why not just shift now?

Jai: Because shifting in a hurry could mean lost opportunity. There have been many phases in the past, as in 2008, when active funds lagged behind the index. But they then came back to deliver much higher returns than the index when the market bounced back. In fact, in India, active funds have always been delivered big alpha in bull markets or even sideways markets but struggled in bear markets.

As an investor, your primary aim is to make big money in the long run, right? If you look at the 10-year returns even today, active large-cap funds have earned an 11 per cent CAGR against the Nifty 50 TRI's 10.1 per cent. Active mid-cap funds have given 16.3 per cent against 13.2 per cent on the Nifty Midcap 100 Index.

Veeru: I am willing to wait in the case of mid-cap funds. But I see a case for preferring index funds for large-cap stocks. Large-cap funds have managed only 1 percentage point more than Nifty 50 in the last 10 years. Active funds charge much higher expense ratios of 2-3.2 per cent a year, while some Nifty 50 ETFs are available at 0.10-0.50 per cent. With ETFs, I don't have to worry about choosing the right fund. Plus, fund managers in India keep quitting. So how do I know the track record of an active fund will continue?

Jai: Remember that in India, NAVs are presented after deducting the expense ratio. So, the outperformance you see from active funds is after accounting for their higher costs. But the points you made about choosing the right funds and the fund managers changing are excellent ones. So, yes, if the alpha for large-cap funds shrinks any further, it would be worth having passive funds in your portfolio.

Veeru: That's what I am saying. I will simply buy a Nifty 50 fund and be happy. After all, the EPFO is doing this.

Jai: Hey, it's different for institutional investors. Index funds and ETFs in India are nowhere as efficient or attractive as those in the US. Some have expense ratios as high as 1.5 per cent. Some have fairly high tracking errors against their benchmarks. And sometimes because there isn't much trading in the secondary market, you end up buying at a premium and selling at a discount to the NAV. You need to keep all this in mind while choosing ETFs.

Veeru: I also see that while there are many index funds and ETFs tracking large-cap stocks and indices like the Nifty 50 and Sensex, there are hardly any to play mid caps.

Jai: Yes, that's true. In the US markets, they even have ETFs tracking the broader market, through indices like S&P 500 and Russell 2000. Active managers find very hard to beat those! But here, we do not have ETFs going beyond the top 100 stocks due to liquidity issues. Most ETFs track the Nifty 50, Sensex or, at best, Nifty 100.

Veeru: But of late, I am seeing some exotic ETFs tracking the Nifty Quality 30, Nifty Value 20, Nifty Equal Weight, Nifty Low Volatility and such indices. Maybe they can do the job?

Jai: That's difficult to say. To really know whether to own Nifty Quality 30 or Value 20, you will need to choose between the quality, growth and value styles of investing. Each style outperforms at different times in a market cycle. I would say this choice is harder to make than buying active funds!
Veeru: Actually, I wish there were better indices in India.

Jai: Totally agree. Today, most of the indices we have are meant for traders and business-channel watchers, and not long-term investors. How do the index providers pick stocks to include in the Nifty or Sensex? They look at free-float market cap, liquidity, impact cost, etc., etc. Fundamentals like EPS growth, return on equity, debt-equity have nothing to do with being in the index. Effectively, only the stocks that are most fancied and actively traded can get a place in the index. As a long-term investor, you would be keen to buy the opposite type of companies - those with good growth, ROE, etc., but which are not well-known in the market. Only then can you make big money in the long run.

Veeru: Yes, but I'm sure this will soon change. I've been reading about how the investor interest in US markets has forced index providers to come up with many innovative indices based on fundamental factors. It's called factor investing. I am quite sure it will happen in India, especially if active funds struggle like they've done in the last six months.

Jai: That's likely. But personally, I think the Indian markets have too many qualitative factors to assess that can't be built into screeners or filters - unscrupulous promoters and creative accounting, operator activity, crony capitalism, the fact that the price you see on screen may not be the real price for the stock for a big seller. You need a real-life fund manager, and an experienced one at that, who can pick good stocks from all this junk.

Veeru: Yes, but then, even active managers do not always succeed in separating the wheat from the chaff.

Jai: I agree. Let's hope we get an ultra low-cost broad market ETF. That will be a good bet, I think.