Index funds: Making inroads
Vetri Subramaniam of UTI Mutual Fund shares his pragmatic views on the future of active managers in India
Mar 5, 2019
What can Indian investors learn from John Bogle, the pioneer in index investing and founder of Vanguard, who passed away recently?
There's no one who has done more for small investors than he has. He created a simple yet revolutionary product - the index fund. He took a torchlight and shined it on the one aspect of the fund industry that no one was focusing on - costs. That is a valuable legacy. What many don't talk about is that he was also a very thoughtful investor, as much as Buffett or anyone else. He had very strong views on mean reversion in the markets and paid a lot of attention to market cycles. He underlined that simple solutions are always better than complex ones.
Compared to developed markets, the passive-fund industry in India is quite small, with index funds and ETFs managing less than 5 per cent of total assets. Why is this? Is it because Indian investors are ignorant of their benefits?
Not really. The growth of the mutual fund industry in India has started only in the last 15 years or so. The experience everywhere in the world has been that the growth in mutual funds has kicked off only through active funds, with passive funds coming in much later.
If you look at the history of US funds, John Bogle mentions in his interviews that when he started off his index funds, they were a flop. They didn't receive very large inflows for their first 15 or 16 years. I think you cannot compare the proportion of passive assets in India today straight away to those in the US because the two markets are in very different stages of evolution.
In India, people are only now becoming aware of the benefits of equities and mutual funds and are beginning to look at financial planning. In the US market, until the dot-com era, passive investing was barely a blip on the radar. Index funds really started to take off there only after the dot-com crisis, when retirement money began to be allocated in a big way to passive funds. It is a matter of looking at comparable timelines.
So, are we a decade or more away from passive funds catching on in the Indian market?
The Indian market is still far away from the degree of institutionalisation or mutual fund penetration that the US has. But do we know where the tipping point (for indexing) is? We really can't tell.
Today, the data is already suggesting that the challenges for active investing in India have begun. I am not talking of one-year data here, which can be an aberration. Data tells us that hardly any large-cap fund has managed to beat the index in the last three years if you use a common benchmark. Mid-cap funds are expected to do better, but the number of mid-cap funds outperforming over three years is pretty low, too. There are data issues here of course, with some funds changing categories after the new SEBI rules and benchmarks moving to total returns instead of price returns. But the ELSS category is a good indicator because it has not been much affected by SEBI's reclassification. But even ELSS funds, in the last three years, have struggled to outperform a common benchmark like the BSE 200, too. Yes, once you move to five years or eight years, many more active funds manage to beat the benchmark.
We need to appreciate that though equities create wealth in the long run, alpha is a zero-sum game. For someone to show alpha, somebody else needs to suffer negative alpha. It is impossible for everyone in the market to outperform the aggregate market return! Fees also make an impact on alpha. As a market gets more institutionalised, like in the US, more and more sophisticated investors compete against each other, making it harder for active managers to outperform.
Today, 50 percent of the Indian market (outstanding stock) is held by promoters. If you leave them out of the equation, foreign portfolio investors own 23-24 per cent and domestic institutions own 14-15 per cent, with only the remaining with retail investors. As the level of skill of the participants climbs higher, the difficulty in extracting alpha increases.
Isn't the limited suite of passive funds in India also a reason? We mostly have Nifty 50 and Sensex funds but no fund tracking broader indices like the S&P 500.
Yes, I do think the passive industry will India will develop better if we are able to go beyond 50-stock indices and ETFs. For that, better liquidity across the market is critical. In the US, the single biggest index used by passive funds is the S&P 500. I don't know how practical it is to operate a 500-stock ETF or index fund in India. To really manage a 500-stock passive fund in India, we will need a deeper market with better liquidity. There should be sufficient float in these companies and there should be no circuit or price limits that suddenly freeze trading in a stock and make it difficult for me to execute a trade. At the same time, we will need to have more companies listing on the markets and widening the choices. These are structural issues and will take time to be sorted out. There's both a demand-side and a supply-side problem to running an S&P 500 fund in India.
At UTI, we offer passive funds based on the Nifty 50 and the Nifty Next 50. So, we are now covering the top 100 companies. If we can get from Nifty 50 to BSE or Nifty 200, that would be welcome, as it would give investors a broader representation of what's happening in the economy. I think the 50 biggest companies are a really narrow universe to represent the vibrancy and churn in the Indian economy.
What's the road ahead for Indian active managers if alpha generation becomes more difficult?
For active managers, there are three takeaways. One we need to set up strong processes so that there is a method in the way we construct portfolios, there is discipline in stock selection and there is consistency in how we apply that over time. You will always need good people, but the process is important.
Despite this, there will be certain periods in the market when a particular investment style or strategy may not work. But we should be able to stay the course with our chosen strategy. This needs to be communicated to investors. If you look back at the funds where we have generated big alpha over the last 10 years, there will be periods when they didn't outperform the benchmarks. So active managers need to work with a process, recognise that there could be periods of underperformance and communicate the same to investors.
My sense is that as the industry evolves there will be three buckets. There will be the passive fund providers, who will offer to get investors to their destination at the least cost. Active mutual funds will be in the middle, offering alpha and better risk-adjusted returns at a fee which is likely to settle lower than current levels (based on global experience).
At the other extreme, there will be the 'pay for alpha' managers who will operate AIFs or portfolio-management schemes that restrict their asset size to maximise alpha. They will use differentiated strategies such as concentrated portfolios or derivatives, which may work best on a limited scale. But they will demand both a fixed fee and a profit share in return for restricting their asset size.
At UTI, most of the funds peg their portfolio weights to benchmarks. Does a benchmark-agnostic fund deliver better wealth creation in the long run?
I'd like to clarify that of the stable of funds that we run, while our process is uniform, there are two funds that are completely bottom-up and can be called index-agnostic. One is UTI Equity Fund and the other is UTI Midcap Fund. Our other funds are benchmark-aware, as I would like to put it.
I don't think any mutual fund can completely disregard the index, because there is a need for risk management. Basically, the promise we are holding out to people when we ask them to invest in equity funds is that the Indian economy has good potential and equities do well in the long term. We use BSE Sensex or BSE 100 data to showcase that equities have done well. This is a product where people can come in at any point in time and leave at any point in time, too. That requires risk constraints in place.
Running a mutual fund for retail investors is a very different ballgame from running a closed-end, limited partnership kind of vehicle for sophisticated high net-worth investors. Such a fund is not for a small guy who is effectively telling a mutual fund, 'Here are my hard-earned savings. I am looking to get to a certain goal in 10 or 15 years. Give me a return that is better than the asset class and is better risk-adjusted'.
Benchmarking to an index is absolutely critical for establishing risk constraints for a mutual fund. So, I don't think any mutual fund can say that it will completely disregard the benchmark.
Why hasn't UTI ventured beyond Nifty 50 and Sensex into the strategy indices such as quality, value and so on?
We did evaluate few other passive products and have launched the Nifty Next 50 ETF. We'll take a call on doing more factor-based products eventually.
Our view is that with ETFs playing on value, quality and so on, you need an educated buyer on the other side. It is very important for investors who buy those products to receive the right kind of advice on when to buy or sell these funds, and how much allocation they need to have to them. So, investing in factor-based funds is not quite the same as investing in a Nifty 50 fund or BSE 100 fund.
The beauty of the simple index fund is that you don't have to worry about timing and you simply have to stay the course.