FUND FULCRUM

June 2021

The Association of Mutual Funds of India (AMFI) released its monthly data for May 2021, which gave some interesting insights about the Mutual Fund industry’s performance amidst the ongoing COVID-19 pandemic. Liquid funds have particularly been gaining traction, with the masses waking up to the significance of emergency funds during these times, along with the massive redemptions from these funds in the face of increased hospitalizations, medical emergencies, and more. The industry, at large, however, registered a robust growth. The value of assets under management (AUM) in terms of retail investors grew by around 39.28 percent on a Y-O-Y basis, from Rs 12.25 lakh crore in April 2020 to Rs 17.06 lakh crore in April 2021, according to AMFI data. While the number of liquid fund schemes remained unchanged at 39 for both April 2021 and May 2021, there was a marginal drop in the number of folios, which suggests a cumulative outflow of funds. What was noteworthy, however, was the steep fall in the total amount amassed by liquid funds between April 2021 and May 2021. Around Rs 1,98,000 crore was pumped into liquid funds in May 2021, as compared to almost Rs 2,50,000 crore in April 2021. The net outflows were also higher in May 2021, standing at Rs 45,000 crore as compared to an inflow of Rs 41,000 crore in April 2021. 

 

Axis MF, ICICI Prudential MF and Nippon India MF have added highest number of folios in the last one year, according to AMFI data. Axis MF and ICICI Prudential MF have both added over 20 lakh new folios in FY 2021 while Nippon India MF saw an addition of close to 11 lakh folios. Mirae Asset MF and Canara Robeco MF ranked fourth and fifth in terms of addition of new folios with 8.26 lakh and 5.68 lakh folios, respectively. In percentage terms, PPFAS MF and PGIM India MF have witnessed highest growth in folios with 255% and 199%, respectively among all fund houses. Meanwhile, 11 fund houses witnessed decline in folio count. Franklin Templeton MF, HDFC MF, L&T MF and Aditya Birla MF were among the fund houses that saw the highest decline in the number of folios last financial year. Overall, the industry has added 79.95 lakh new folios in FY 2021 as against 68 lakh folios in FY 2020. Scheme categories like international funds, balanced advantage fund and bond ETFs have gained traction in the past one year leading to addition of new folios. Passive fund was another category that brought in new folios to the industry. Growth in folio count can be attributed to the ease of investment through digital channels

Equity funds have witnessed the highest net inflows in the last 14 months. The MF industry has seen net inflows of Rs. 10,083 crore in May 2021. This is the third straight month of net inflows after 8-month outflow streak in equity funds, according to the latest data released by AMFI. However, the MF industry has recorded net outflows of Rs. 38,600 crore due to outflows in liquid and overnight funds. The debt category has recorded net outflows of Rs. 45,500 crore in May 2021. Overall, the industry average AUM has remained unaffected by the net outflows in debt funds as it touched a new all-time-high of Rs. 33 lakh crore. Retail SIP accounts, SIP AUM and SIP contribution which signifies retail activity in the mutual fund industry has seen continued upward trend for the second month this fiscal, leading to overall industry AUM moving to record high of Rs. 33.05 lakh crore and 10 crore folios. Overall, equity schemes have witnessed net inflows of Rs. 10,083 crore in May 2021. The figure is almost thrice the April 2021 net inflows of Rs. 3,437 crore. Barring ELSS, all equity schemes have recorded net inflows. Multi-cap funds garnered highest net inflows in May 2021 at Rs. 1,954 crore. The fund category, which has been on the sideline since the introduction of flexi-cap funds, was able to post such a high number due to NFO success of ABSL's multi-cap fund. The NFO alone contributed Rs. 1,922 crore to the category. Mid-cap funds and focused funds were next in line with net inflows of Rs. 1,368 crore and Rs. 1,169 crore, respectively. Closed-ended equity-oriented schemes have seen net outflows of Rs. 848 crore largely due to maturity of a couple of schemes. Inflows in debt schemes were back in the red after Rs 1 lakh crore net addition in April 2021. The category witnessed net outflow of Rs. 44,512 crore in May 2021. Liquid funds and overnight funds have recorded the biggest outflows. Net outflows in liquid funds and overnight funds were Rs. 45,447 crore and Rs. 11,000 crore, respectively. Low duration and money market funds have seen net inflows of Rs. 7,823 crore and Rs. 4,334 crore, respectively. Inflows in hybrid schemes has declined to Rs. 6,217 crore from Rs. 8,641 crore in April 2021. Inflows were led by arbitrage funds with net addition of Rs. 4,521 crore followed by dynamic asset allocation funds that witnessed net inflows of Rs.1,363 crore. Balanced hybrid funds have seen net outflow of Rs 435 crore. Industry AAUM has gone up by Rs. 56,965 crore to Rs. 32.99 lakh crore. Total folios count has crossed the 10-crore mark. Gross monthly inflows through SIP have risen to Rs. 8,819 crore, a 2.6% rise from April (Rs. 8,596 crore). Number of SIP accounts has increased to 3.9 crore. SIP AUM at the end of the month was Rs 4.67 lakh crore, which is Rs 32,624 crore higher than the AUM on the last day of April 2021. The MF industry has added 3.85 lakh new investors in May 2021 taking the total count of unique investors to 2.34 crore in May 2021 as against 2.30 crore in April 2021. The industry’s total folio count has risen to 10.04 crore in May 2021 from 9.86 crore in April 2021, an increase of 18.67 lakh new folios. Gross redemptions have risen to Rs.6.31 lakh crore in May 2021 from Rs.5.72 lakh crore in April 2021. Overall, the MF industry has seen net inflows in equity funds. Debt funds have recorded net outflows of Rs.44,512 crore on back of redemption from liquid funds and overnight funds.

 

Piquant Parade

 

Mutual fund distributors will soon be able to register SIPs faster as National Automated Clearing House (NACH) is set to become functional 24x7 from August 2021. The NACH system, which is used to register SIPs with banks, currently operates only on those days when banks are open. “NACH is currently available only on the days when banks are functional. In the interest of customer convenience, and to take advantage of the availability of RTGS on all days of the year, it is proposed to make available NACH on all days of the week throughout the year, effective August 1, 2021," according to RBI. The new rules will bring down the turnaround time to register SIPs through NACH. The process currently takes 7-10 working days depending on the investor's bank. Once this gets implemented, the processing time should come down by 30%, with the reduced registration time leading to a higher conversion rate.

 

The latest AMFI data shows that 98% of the total complaints received in the MF industry were resolved quickly. Of the 13,926 total complaints, 13,690 were resolved within 30 days. Meanwhile, only 114 complaints were pending at the industry level at the beginning of the current financial year. An analysis of the data shows that majority of the investor complaints were regarding redemption proceeds, non-debit of SIPs, data updation, discrepancy in account statement and correction in investor details. Among fund houses, HDFC MF has witnessed the highest complaints in FY 2021 (3,159) although the number of complaints has reduced from FY 2020 (5,293). Next in line was ICICI Prudential MF with 2,145 complaints followed by L&T MF with 1,553, Axis MF with 1,530 and SBI MF with 1,069 complaints. Many complaints were on account of SIP transactions.

Regulatory Rigmarole

SEBI has enhanced the overseas investment limit per fund house to $1 billion from the existing $600 million. The overseas investment limit for the industry has been kept unchanged at $7 billion. This implies that though each mutual fund can now invest more in overseas markets, they still have to make sure that the combined industry investment does not exceed $7 billion. The regulator also increased the investment limit in overseas ETFs to $300 million per mutual fund from $200 million earlier. The overall industry limit remains at $7 billion. This is the second such increase in overseas investment limit within a year. In November 2020, SEBI had hiked the limit per fund house to $600 million from $300 million. Interestingly, the industry limit was kept unchanged even then.

SEBI put in place fresh guidelines for participation of mutual fund schemes in interest rate swap, a derivative product. In market parlance, an interest swap is a derivative product used for hedging interest rate risk by mutual funds. It is used between companies to swap their future interest rate payments from fixed to floating or vice-versa. Mutual funds can enter into plain vanilla Interest Rate Swaps (IRS) for hedging purposes. The value of the notional principal in such cases must not exceed the value of respective existing assets being hedged by the scheme. In case participation in IRS is through over the counter transactions, the counterparty has to be an entity recognized as a market maker by RBI and exposure to a single counterparty in such transactions should not exceed 10 per cent of the net assets of the scheme. However, if mutual funds are transacting in IRS through an electronic trading platform offered by the Clearing Corporation of India Ltd (CCIL), the single counterparty limit of 10 per cent will not be applicable.

 

SEBI has introduced a new system that would define the maximum risk that a debt fund manager can take. With this, the market regulator has introduced 9-level matrix titled potential risk class (PRC) which is based on interest rate risk (measured in terms of Macaulay Duration) and credit risk (measured by credit risk value) of the scheme. While Macaulay Duration is the time taken to recover the real cost of a bond measured in terms of years by calculating the present value of future cash flows (interest and principal), credit risk value is the credit rating of a debt instrument. To make things simple, SEBI has introduced weighted average method to measure average interest rate risk of a scheme based on its Macaulay Duration. The regulator has introduced three classes which will be placed on the rows of matrix.

·         Class 1 where Macaulay Duration is less than or equal to 1 year (Can buy individual debt instruments with maturity of up to 3 years)

·         Class 2 represents Macaulay Duration of less or equal to 3 (Can buy individual debt instruments with maturity of up to 7 years)

·         Class 3 can have any Macaulay Duration and can hold papers across maturities

Similarly, SEBI has classified another three classes based on weighted average credit ratings of debt instruments. This will be located on the columns of the matrix.

·         Class A will have credit rating value of more than and equal to 12. G-sec, state development loans, Repo on government securities, cash and AAA rated papers fall under this

·         Class B reflects credit rating value of more than or equal to 10. Funds falling under this will have to hold debt papers having rating of AA+ and AA

·         Class C can hold lower rated papers

Overall, schemes falling under Class I and Class A will be least risky and the scheme falling under Class III and Class C will have highest risk. This additional disclosure along with risk-o-meter will come into effect from December 1, 2021.

 

SEBI has clarified that asset allocation norms on open-ended debt schemes will be applicable on 90% of the total assets. For instance, corporate bond funds will have to invest 80% of total assets in highest rated bonds issued by corporates, according to the SEBI scheme of re-categorization. With all such schemes having to keep 10% of the total assets in liquid assets, corporate bond funds will now have to invest at 72% (80% of the remaining 90% assets) of the total assets in highest rated bonds issued by corporates. Last year, SEBI had asked fund houses to invest at least 10% of the total assets of all open ended debt schemes except overnight, liquid and gilt funds in liquid assets like cash, government securities, T-bills and repo on G-sec. This will come into effect from December 1, 2021.

 

RIAs will have to apply for membership of BSE Administration and Supervision (BASL) on or before August 31 2021, according to SEBI. SEBI clarified that the membership of BASL is compulsory for all RIAs to keep the RIA license active. On June 14, the market regulator appointed BASL, a subsidiary of BSE, to oversee activities of RIAs and check if they comply with the regulatory norms. The appointment came into force on June 1, 2021 and is valid for three years. Individual RIAs will have to pay a fee of Rs. 2,000 to get the membership while corporates and LLP will have to shell out Rs.1 lakh as annual membership. BASL has kept renewal fees at Rs. 1,800 for individuals / partnership firms and Rs. 99,000 for corporates and LLP. RIAs can also take three-year membership. The fee is over and above SEBI registration and renewal fees to obtain RIA license.

 

India’s mutual fund industry might be sitting right at the beginning of a massive growth cycle. The penetration of mutual funds in India remains low when compared to global peers, leaving abundant ground for various asset managers to cover. India’s AMCs should deliver healthy 15% AUM/profit growth in the long term, given a large untapped base of savers and high operating leverage – a view reinforced by the performance seen in other countries at a similar point in the industry cycle.

 NFONEST

June 2021

Three NFOs of various hues are open at present and find a place in the June 2021 GEMGAZE.   

BOI AXA Bluechip Fund

Opens: June 8, 2021

Closes: June 22, 2021

BOI AXA Mutual Fund has launched its new fund offer, BOI AXA Bluechip Fund, an open ended mutual fund scheme. The primary investment objective of the scheme is to provide capital appreciation and/or dividend distribution by investing predominantly in large cap stocks. The scheme’s performance will be benchmarked against Nifty 50 Total Return Index. It will be managed by Mr. Dhruv Bhatia.

Axis Quant Fund

Opens: June 11, 2021

Closes: June 25, 2021

Axis Mutual Fund has launched an open-ended equity scheme, Axis Quant Fund. It is an open ended equity scheme mandated to follow a quantitative model. The investment objective of the scheme is to generate long-term capital appreciation by investing primarily in equity and equity related instruments selected based on a quantitative model. The scheme is mandated to invest 80% to 100% of its total assets in equity and equity related instruments of selected companies based on a quantitative model, upto 20% of its assets in other equity and equity related instruments. It can also hold upto 20% of its assets in debt and money market instruments and upto 10% in units issued by REITs & InvITs. The investment process of Axis Quant Fund will be based on a fundamental factor based approach with the aim of generating superior risk adjusted returns compared to the benchmark. The factors employed are the ones that have a strong academic basis and / or are considered central by fundamental investors in their process. The universe would be screened using quantitative measures like data availability, liquidity etc. and then subsequently several factors would be used to evaluate the stocks’ attractiveness from a risk and return perspective. Axis Quant Fund’s performance will be benchmarked against S&P BSE 200 TRI (Total Return Index). The fund will be managed by Mr Deepak Agarwal and Mr Hitesh Das (for foreign securities).

HDFC Banking and Financial Services Fund

Opens: June 11, 2021

Closes: June 30, 2021

HDFC Mutual Fund launches HDFC Banking and Financial Services Fund. The investment objective of the fund is to provide long-term capital appreciation by investing predominantly in equity and equity-related instruments of companies engaged in banking and financial services. The scheme will benchmark its performance to the NIFTY Financial Services TRI. The fund is managed by Mr. Anand Laddha (equity and derivative research and sales) and Mr. Sankalp Baid (overseas investments).

Axis Nifty 50 Index Fund, NJ Flexi Cap Fund, ICICI Prudential Metal and Energy FOF, Axis AAA Bond Plus SDL ETF – 2026 Maturity Fund of Fund, NJ Dynamic Asset Allocation Fund, Axis 2050 Gilt Fund of Fund, Axis Asset Allocator Fund, Aditya Birla Sun Life NASDAQ 100 FOF, Nippon India CPSE Bond Plus SDL G Sec Index Fund, Nippon India Nifty Auto ETF. Nippon India CPSE Bond Plus SDL Index Fund and DSP Nifty 50 Equal weight ETF are expected to be launched in the coming months.

 

GEMGAZE

June 2021

The consistent performance of all five funds in the May 2020 GEMGAZE is reflected in all the funds holding on to their esteemed position of GEM in the June 2021 GEMGAZE.

Nippon India ETF Nifty BeES Gem

Incorporated in December 2001, Nippon India ETF Nifty BeES (formerly known as Goldman Sacs Nifty ETF Fund and then Reliance ETF Nifty BeES) has an AUM of Rs 3670 crore. The one-year return of the fund is 61.29% as against the category average return of 58.79%. The fund has earned return since launch of 15.91%. The top five stocks constitute 41.32% of the assets of the fund. The top three sectors finance, technology and energy constitute 68.18% of the assets of the fund. The expense ratio of the fund is 0.05% and the turnover ratio is 55%. The fund is benchmarked against the Nifty 50 Total Return Index. The fund is efficiently managed by Mr. Vishal Jain since November 2018.

ICICI Prudential Nifty Index Fund Gem

The Rs 1697 crore ICICI Prudential Nifty Index Fund incorporated in February 2002, has earned a one-year return of 60.29% slightly more than the category average return of 58.79%. The fund has earned return since launch of 15.22%. Top five holdings constitute 41.45% of the portfolio. 68.28% of the assets are invested in finance, technology and energy, the top three sectors. While the portfolio turnover ratio is 47%, the expense ratio is 0.45%. The fund is benchmarked against the Nifty 50 Total Return Index. The fund is managed by Mr. Kayzad Eghlim since August 2009 and Nitish Patel since January 2021.

Franklin India Index Fund Gem

Franklin India Index Fund, incorporated in August 2000, has an AUM of Rs 414 crore. Its one-year return is 59.66%, slightly more than the category average return of 58.77%. The fund has earned return since launch of 12.86%. Top five holdings constitute 41.59% of the portfolio. 68.078% of the assets are invested in finance, technology and energy, the top three sectors. The expense ratio of the fund is 0.67%. The fund is benchmarked against the Nifty 50 Total Return Index. The fund is managed by Mr. Varun Sharma since November 2015.

HDFC Index Fund – Sensex Plan Gem

HDFC Index Fund - Sensex Plan is a nineteen-year old fund with an AUM of Rs 2210 crore. Its one-year return is 57.76%, a tad less than the category average of 58.79%. The fund has earned return since launch of 15.23%. Top five holdings constitute 48.24% of the portfolio. 74.93% of the assets are invested in finance, technology and energy the top three sectors. The expense ratio of the fund as well as the turnover ratio is low at 0.4% and 31.02% respectively. The fund is benchmarked against the S&P BSE Sensex TRI. The fund has been managed by Mr. Krishan Kumar Daga since October 2015 and Mr. Arun Agarwal since August 2020.

UTI Nifty Index Fund Gem

Incorporated in March 2000, UTI Nifty Index Fund has an AUM of Rs 4022 crore. The one-year return of the fund is 61.10% a little more than the category average of 58.79%. The fund has earned return since launch of 11.67%. Top five holdings constitute 41.38 of the portfolio. 68.27% of the assets are invested in finance, technology and energy, the top three sectors. The portfolio turnover ratio is a moderate 30% and the expense ratio is very low at 0.29%. The fund is benchmarked against the Nifty 50 Total Return Index. The fund is managed by Mr. Sharwan Kumar Goyal since July 2018.

 

FUND FLAVOUR

June 2021

Passive investing …

An Index fund tracks a broader market index such as Sensex or Nifty and its portfolio will comprise the same stocks as in the Sensex or Nifty in the same proportions. The Securities and Exchange Board of India, SEBI defines index mutual fund as, ‘open ended mutual fund scheme which replicates 95% of assets of its benchmark’. Index funds are also known as passive funds since they track a particular index and do not require a high level of management of the fund. The fund manager, who is managing the fund investments looks after the stocks which have to be bought or sold according to the composition of the underlying benchmark. In India, NSE’s NIFTY 50 and BSE Sensex are popular benchmarks for index mutual funds. A NIFTY index fund will have the same 50 stocks, in the same weightage as in NIFTY 50 Index. A Sensex index fund will invest in 30 stocks, in the same proportion as in Sensex. As far as the return is concerned, the fund and the index deliver almost the same return. The difference between the two leads to the origination of tracking error which the fund manager tries to minimize.

 

…of various hues

The wide array of index funds available in the market are enumerated below:

1.      Broad Market: A big market would naturally want to capture a wide range of the market. Large market index funds usually have the smallest expenditure ratios. The asset sales in broad index funds are generally small and tax-efficient as well. This is suited for those investors who wish to achieve a huge variety of shares or bonds.

2.      International Index Funds: The Global Index funds offer international exposure. An investor could opt for funds that monitor indices that are no longer linked to any particular geographic region in the emerging or frontier markets.

3.      Market Capitalization: The investors who are involved in the long term investment horizon would benefit from an increased exposure towards a wide range of small and medium enterprises by investing in index funds via market capitalization.

4.      Bond Based Index Funds: Bond Based Index funds could help in maintaining a balanced combination of short, intermediate and long term bond maturities which result in steady revenues.

5.      Earnings Based: Index funds also have the capability of working on the basis of the profits or revenues gained by a company. The growth indices are generated with businesses with the expectation of generating profits faster than others in the market. The value indices consist of stocks that are trading at a lesser cost as compared to the company’s earnings.

ETFs vs Index Funds

An Exchange Traded Fund or an ETF tracks an index, like an index fund. But the ETF units are listed as well as traded on the stock market and cannot be bought easily from an Asset Management Company (AMC) or even sold to a fund house. A Demat and a trading account are needed to buy a unit of ETF in the stock exchange. The index fund, on the other hand, could be purchased or even redeemed just like any other mutual fund. There are some indices that are not traced by Index Funds but are tracked by ETFs. Indices like Nifty Value 20, Nifty Low Vol 30 are tracked by ETFs which are not tracked by Index funds.

Rationale for index funds…

You may be intrigued given that index funds just track a benchmark and not seek to outperform. Outperformance is always better than just benchmark returns. Markets are a zero-sum game, meaning for every person making money, somebody has to lose money. This means that all active managers collectively cannot beat the market. The reason is cost, and they are the biggest drag on the performance. An active mutual fund seeks to outperform any index, which means it needs the resources to do so. This involves hiring a group of expert analysts, getting the best Chief Investment Officer(s), the best research, the best tools and other things. All this does not come cheap, and there are costs involved. On comparing the expense ratios of active large-cap mutual funds and index mutual funds, the category average expense ratio of active mutual large-cap mutual funds (direct plans) is 1.28% whereas it merely ranges from 0.2 to 0.5% in the case of index funds.

Index Funds – one up on active funds…

1.      Lower costs : Since index funds are passively managed, the total expense ratio (TER) is very less as compared to the actively managed ones. While an actively managed fund may charge anything between 1-2% as TER, an index fund would typically charge between 0.20% to 0.50%. At face value, the cost difference may seem small but in the long run, the difference can be as large as 15% of your net returns.

2.      Mitigation of risk: By investing in index funds, the investors take exposure in the index which helps them in mitigating the unsystematic risk for the investors. Unsystematic risk means a risk which is associated with a particular stock or industry.

3.      Diversification: Index funds allow diversified exposure as all the leading companies form part of the index. Auto diversification allows investors to reduce the risk of staying invested in a particular stock or sector like auto, pharma etc.

4.      Management: The fund manager of an actively managed fund is constantly under pressure to beat the benchmark. So, he invests in various companies to increase profit. This is a double-edged sword. One wrong investment decision can lead to huge losses. This does not happen in an index mutual fund. In an index fund, the fund manager has no scope to change the allocations. Hence an index mutual fund eliminates management errors.  

5.      Taxation on Index Funds: A capital gain arises on the redemption of units of the index fund. The gains can either be short-term or long-term depending on the holding period of the units. If the units are sold within a period of 1 year from the date of the allotment, this would give rise to short-term capital gain and is taxed @ 15%. Furthermore, the long-term capital gains are taxed @10%, above Rs, 1,00,000 without the benefit of indexation. For example, if there is a long-term capital gain of Rs. 2 lacs and the investor withdraws this amount after a year of investment, the tax will be levied on Rs. 1 lac and the amount payable will be Rs. 10,000.

6.      Efficient Market Hypothesis: An Index fund which is a representative of the market shall outperform all active funds in the long run. According to the efficient market hypothesis, markets cannot be outperformed by any fund manager or investor. Competitors get to know about the price anomalies at a certain point of time and the stocks are kept at a price according to their fundamental value.

 

On the flip side…

1.      Outperformance ruled out: It is tough for a fund manager to outperform the stock market every time but many investors and actively managed funds are actually able to outperform the market. The Index funds do not outperform since they have the tendency to track the market performance not of exceeding it.

2.      No control on stock selection: while an active fund manager can refrain from investing in poor quality stocks, an index fund manager might have to invest in such stocks if they form part of the underlying index. Hence, protection will be restricted to a great extent. Moreover, the index fund manager cannot avail of certain unexpected opportunities to add up on good quality yet beaten down socks in the sector. Therefore, they have to settle down for suboptimal returns.

3.      Only mature companies: The index companies are mostly mature companies who have their best growing years in the past. Investors in index funds hence, cannot benefit from the high growth potential of the emerging small companies.

 Criteria to contemplate…

1.       Investment Horizon: Index funds are suitable for investors who have a long-term investment horizon. The fund return might fluctuate in the short-term but it usually evens out in the long run. It is important to stick to the fund over the decided horizon so as to reap the full benefit from the fund.

2.       Financial Goals: If the investors make sure to stick to the investment horizon, index funds are able to offer better returns, which in turn will help the investors to achieve their financial goals. This can include retirement, wealth creation etc.

3.       Risk Tolerance: Index funds are not prone to or less prone to the volatility related to equity and risks because they map an index. Index funds lose their value when there is a market downturn. It is advised to invest in a mix of actively managed index funds.

4.       Taxation and Expense ratio: Index funds usually have better taxation and a lower expense ratio when compared to other funds. If there are two funds tracking, say Nifty, both will generate a similar return. The fund which will have a lower expense ratio will provide a higher return on investment.

5.       Return Factor: Index funds passively track the performance of the underlying benchmark. They do not proceed with the goal of beating the benchmark. These funds just have the motive to replicate the performance of the index. The returns generated might not meet the index return due to tracking errors. An investor should shortlist funds which have minimum tracking error before making an investment in an index fund.

 

Index Funds vs. Active Funds

Over the last 1-3-5 years, the average return of the index fund category has been over 60 per cent, 12.5 per cent, and 13.25 per cent respectively. Nifty 50 return over the same period has been 70 per cent, 13.5 per cent and 13.65 per cent respectively. In contrast, active funds (large-cap) have delivered returns between 10 per cent to 17 per cent over the last 3 years and also over the 5-year period. While active funds have the potential to beat market returns, there is always a possibility of some active fund underperforming the market over a certain period of time. According to a recent report from S&P Indices Versus Active Funds (SPIVA) India Scorecard, over the one-year period ending in December 2020, the S&P BSE 100 was up 16.84%, with 80.65% of funds underperforming the benchmark. Over the second half of 2020, 100% of the funds underperformed the S&P BSE 100. Over longer horizons, the majority of actively managed large-cap equity funds in India underperformed the large-cap benchmark, with 68.42% of large-cap funds underperforming over the 10-year period ending in December 2020.

 

A study by mutual fund research firm Morningstar showed that several key categories of mutual funds on an average failed to beat their benchmarks in the year of lockdown. The study looked at performance from 25th March 2020 to 22nd March 2021. 25th March 2020 was the start of India’s nationwide lockdown. In another variant, it looked at returns from 19th Feb 2020 which was the start of the 2020 COVID correction to 22nd March 2021. In the second variant as well, mutual funds across several categories failed to beat their benchmarks. Only 3.45% of large cap funds beat the benchmark in the lockdown year (25th March 2020 to 22nd March 2021) according to the report. The proportion was higher for mid-caps (24%) and small caps (8.70%). In case of multi-caps, just 11.76% of funds beat their benchmarks. The numbers are slightly better if the period from 19th February is considered, with 6.90% of large cap funds, 32% of mid cap funds and 18.18% of mutual funds beating their benchmarks.

 

The failure to beat came despite strong performances by various mutual fund categories in the lockdown year. According to the report, large cap funds on an average delivered 77.76%, mid cap funds gave 96.53% and small cap funds delivered 117.59%. However, all these returns fell well short of indices. For instance, large cap funds on an average underperformed by 14.11%, mid-caps by 10.89% and small caps by 16.39% implying that investors lost out on a large chunk of returns. The S&P BSE 100 delivered 91.87%, the S&P BSE Midcap gave 107.42% and S&P BSE Small Cap gave 133.98% over the same period, according to the report (for Total Returns Indices or TRI). While active fund managers have found it difficult to beat the benchmark over a one-year period, their performance over the medium term (three years and five years) has shown better success rates relative to the benchmark. The polarization of markets witnessed in 2018 and 2019 have now diminished and the sharp bounce back witnessed since March 2020 has been broad based. There are a number of reasons. First, some stocks like Reliance Industries led the rally last summer but mutual funds were barred by regulations from having more than 10% of their assets in a single stock. Second, actively managed funds have underperformed in bull markets historically. Third, the market concentration of the earlier years gave away in the latter part of 2020 to a wider set of stocks rallying. Active managers who run a growth style did relatively underperform.

 

Based on the numbers at any given point, the chances of picking a consistently performing active fund is worse than 50:50. In the case of large-caps, it is consistently worse. And it is going to get worse as the Indian capital markets deepen. Let us take the case of large-caps, and there are 40 AMCs and 40 large-cap funds. Broadly speaking everybody has access to the same information and everybody can only invest in the top 100 stocks, outperforming the benchmark is not easy, not to mention the cost disadvantage they have vs index funds. And there is also the issue of funds just hugging benchmarks which is quite common – this is also referred to as closet indexing. Most funds do not deviate significantly from the benchmarks, and after expenses, they are guaranteed to underperform the index.

 

The final musings…

Index funds are passive mutual funds and aim to achieve wealth creation for investors by replicating the performance of an index. Index funds may be less risky as compared to active funds due to this reason. Such funds help balance out the portfolio across the risk parameter. Even though index funds map a particular index, one should not blindly invest in one of the best index funds. Do your due diligence in research and find out if these funds suit your portfolio and how much you should invest in them.