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A spate of (non) innovation

Most new mutual funds are launched to serve the business needs of the fund company. Investors should stick to the tried and tested.

A spate of (non) innovation

To all outward appearances, Indian mutual fund investors seem to be living through a golden age of innovation by mutual fund companies in the last few years. Innovative and new types of mutual funds are being launched regularly, all to ensure that the investing needs of the public are met not by simple, boring old funds that we have all been familiar with forever but shiny new types which will work much better for everyone.

Is that right? Or is there something more to the story? To those who are a little too familiar with the long history of what the financial services industry means by innovation, it all looks a bit suspicious. However, more on the motives behind the latest wave of innovation later, let's look at what it actually holds for investors.

One such innovation is smart beta funds. These are essentially passive funds that are not really passive. They sound like some heavy scientific research has gone into them so a lot of investors are curious. Passive funds in general have been the focus of a big hype wave for some time and the wave is getting stronger. If you read the financial media as well as generally keep an eye on investments-related parts of social media, you get the impression that a passive fund revolution is well on its way. Most AMCs have a larger and larger bouquet of passive funds, and there has been a rush to launch new passive funds. Some AMCs have started focussing almost entirely on such funds, and one new AMC has been launched which has promised to be 100% passive.

However, the central logic of passive funds, imported from western markets, is something that is not too exciting for equity investors. The message that a passive fund carries is that 'No matter how hard you try, you won't be able to do better than the market on a sustainable basis, so don't even try. Instead, be satisfied with market returns that are equal to an index.' Equity investors tend to be an optimist and aggressive lot, so naturally this holds little appeal. As a category, passive funds have grown strongly but that's mostly because of the EPFO's steady inflows - retail interest has been low.

One solution that seems to have been chosen by mutual fund companies is passive-but-a-little-bit-active funds, of which these smart beta funds are a prime example. These are funds that are based on an index, but with a little twist added. They take the base composition of well-known index like the Sensex or the Nifty but then add a modification to it. It could assign equal weights to all stocks instead of by market cap. Or it could limit itself to a third of the stocks that have the best P/E and recompose it periodically. Or perhaps the lowest volatility. All these identify some factor that should, logically, drive better performance than the original unmodified index and then modify that factor.

Any of these sound good but the question is whether they are a predictor of better performance than the base index. That is a question that the fund supposedly answers by testing the fund's idea on historical data.

The real problem is that such funds are not passive funds but actually active funds. Someone made up the idea and fine-tuned it - only the day to day trades are automatic. Do they fit the original logic of passive funds? Clearly not. To answer my original question, the root of such funds lie not in investors' needs but in the business needs of the fund company. It's always to sell new funds based on a supposedly new idea rather than to build up a set of regular investors in older, established funds.
Not just that, under SEBI's new fund categorisation system, more than one fund cannot be launched in the core categories so the fringe, specialised categories are now seeing this kind of 'innovation'.

Investors' real needs are better served by choosing simple mainstream, well-established funds with a good track record and then investing steadily in it.