Mutual funds sahi hai — the advertising blitzkrieg aimed at wooing retail investors seems to be working. Consider this: equity folios crossed the 80-million mark by the end of 2018. In fact, while AMFI launched the awareness campaign in 2017, individual asset management companies collectively spent over Rs.3.50 billion on advertising last year. Their optimism is understandable — the 43-player industry’s assets under management (AUM), which crossed Rs.10 trillion for the first time in 2014, took less than three years to double beyond Rs.20 trillion by August 2017! That investors are taking seriously to MFs can be gauged by the tripling of net inflows into equity funds from Rs.532 billion to Rs.1,578 billion between 2014 and 2018 (See: Inflows swell). It is this copious flow that helped the market buffer FII sales of Rs.732 billion in 2018 as domestic investors bought stocks worth Rs.1,097 billion. However, the volatility in the market and regulatory changes by Sebi did have a bearing on the MF industry with only 12 of the 154 large-cap funds managing to beat the benchmark last year (See: The long and short of it).
More than the volatility, the biggest change that hit the industry last year was the reclassification of mutual funds that was aimed at reining in the endless duplicity of schemes from desperate fund houses looking to gain a lead in the AUM race. New funds offerings (NFOs) were just adding to the schemes, offering little value to investors.
Under the new classification, there are now 10 categories of equity funds that investors can choose from. Every AMC can only offer one scheme under each of the category allowed by Sebi.
Before the reclassification was announced, AMCs were offering investors more than 800 open-ended schemes. Also, each fund house had its own interpretation of what constituted a large-cap. While some invested in the top 100 stocks, others would look at the top 200 stocks as their universe. The ambiguity was more pronounced when it came to investing in mid-caps.
Only a handful of funds made a conscious effort to ensure that their weighted average market capitalisation was closest to the benchmark indices. A majority of funds had a free hand across market cap while choosing their investments. Now, as per Sebi’s mandate, a large-cap fund must invest at least 80% of its corpus in large cap stocks and the universe that they can invest in is limited to the top 100 stocks by market capitalisation.
The changes are not exactly to the liking of the industry. Nilesh Shah, managing director, Kotak Mahindra Asset Management, says, “Large-caps were unconstrained. You could invest in mid or small-cap when you want. Many a times you picked up Bajaj Finance as a small-cap and you could hold it till it became a large-cap. You can’t do that now.”
Even before the classification, outperforming the benchmark has been a concern for the large-cap fund managers. In the past three years, 62% of the large-cap funds underperformed the benchmark index, the Nifty 100 Total Return Index. On a 10-year basis, the performance looks even bleaker, with 68% of the funds lagging the index.
What makes things more difficult for fund managers, especially the underperforming ones, is that Sebi has mandated funds to use the total-return indices (TRI) as the benchmark. TRI takes into account not just the price return of the stocks but also the dividend paid out on the stocks. Earlier the funds were using the price index which didn’t include dividend receipts as the benchmark. Typically the dividend yield of the Nifty 100 is around 1.5% and the price index understates the return to that extent. For fund managers, that number is significant to outperform on an annualised basis.
The general sense in the industry is that outperformance will continue to be a bugbear for large-caps. Dhirendra Kumar, founder and CEO, Value Research, warns that large-caps funds will lose their relevance if they continue to underperfom and index funds will increasingly become relevant for investors wanting to invest in large-caps. “While there is uncertainty about the market and the return that large-cap funds generate, the only thing certain is fund expenses, and that is always lower with an index fund,” feels Kumar.
Consider this; while the total expense ratio (TER) for an actively managed fund can vary from 1.75 to 2.5% depending on the corpus, the TER for index funds is capped at 1%. Already, AUM of index and exchange-traded funds has increased more than 16x from Rs.190 billion to Rs.3,389 billion, between 2014 and 2018 indicating that investors are clearly warming up to passive investing in India. But fund managers say unlike in the US where passive funds make up for almost 50% of the market, index funds and ETFs still have a long way to go. The tracking errors against the benchmark are still high and there isn’t much trading of ETFs in the secondary market, so you end up buying at a premium and selling at a discount to the NAV. So, for now, fund managers aren’t losing any sleep over index funds. Anoop Bhaskar, head of equity, IDFC Mutual Fund, says, “For all the talk about passive investing taking over, even if we outperform seven out of 10 years, the outperformance will make up for the underperformance.” Concurring with Bhaskar is S Krishna Kumar, CIO-Equity, Sundaram Mutual Fund, who says that it’s not RIP for large-cap funds. “I am not a fan of passive investing especially in an emerging economy such as India where there are still a huge number of under-researched stocks. As long as there is growth in the economy, you will have more and more entrepreneurs listing their emerging businesses. So, there will be enough opportunities for active fund managers and bottom-up stock pickers to outperform.”
Small World Big Trouble
While mid-cap funds fared fairly better over the past couple of years until December 2017, it lost much of its outperformance in 2018 when the Mid-cap Index tumbled over 12%. In the past one year, while mid-cap funds outperformed the benchmark Nifty Mid-cap 150 Total Return Index, in absolute terms, they were down over 11%, on average. In contrast, large-cap funds were down 1.85% but yet underperformed the benchmark Nifty 100 Total Return Index, which was up over 2.5%.
Notwithstanding the performance over the past one year, the AUM for mid-caps has grown impressively over the past five years. It increased more than 3x to Rs.2,747 billion in 2018 (See: Sticking with mid-caps). Despite a volatile year, the AUM for mid-caps increased by 16% in 2018. In the past, stock market rallies would attract massive one-time investment by retail investors and at exorbitant valuation. When the market would correct, retail investors would quit the market disillusioned with huge losses. While it may be premature, to draw a conclusion based on one year’s data, this time around investors are warming up to the idea of long-term investing through systematic investment plans (SIP). Cumulative monthly SIP flows reached Rs.685 billion during April-December 2018 from Rs.314 billion during April-December 2016.
Fund managers feel that the new boundaries of the mid-cap universe can be a challenge. While the top 100 companies by market capitalisation have been reserved for large-cap funds, the next 150 companies have formed the investment set for mid-cap funds. “You have to leave it to the discretion of the fund manager. Otherwise all the funds will look the same, if you are constrained to invest from a pack of 150 stocks. There won’t be a difference and that’s a challenge,” says Sunil Singhania, founder, Abakkus Asset Manager. He also believes that the constant portfolio changes due to market capitalisation will hamper fund performance. “You have to keep shifting portfolios as the stock moves from being a small-cap to a mid-cap to a large-cap. It will become difficult to outperform indices,” he says.
Small-cap funds now have the most flexibility and the largest universe of stocks to choose from. They can now invest in companies that are ranked 251 and lower, in terms of market capitalisation. Going by the latest classification of small-cap stocks, the largest company has a market cap of around Rs.85 billion and falls under the top 1,000 companies; If you take the top 1,000 companies in the BSE, their market cap ranges between Rs.5 billion and Rs.85 billion, which means the stock picking ability of the fund manager will be the single-biggest driver of generating alpha.
Fund managers say the problem is not just the shrinking of choices in large and mid-cap stocks. It is also the way the classification is done, of revising the classification based on market cap every six months. According to them, the updation needs to happen every month, because in six months, a lot of things could change in the market. Fund managers say that in a volatile market, a large-cap could become a small-cap and vice versa. But in a situation where the fundamentals of a stock is deteriorating so quickly, it is high unlikely that the classification is going to hold them back from selling. Classification or not, a stock with deteriorating fundamentals has no place in any fund portfolio. Conversely, if you have a small-cap that moves rather quickly to becoming a mid-cap, if the investment mandate is to stick to small-caps then the fund manager needs to ideally book profit and find another that meets his investment criteria. Anyway, Sebi only mandates that 65% of the corpus needs to be invested in mid and small-cap stocks for the respective fund categories. For fund houses which were already following a disciplined approach of sticking to the investment mandate, the transition was easy like in the case of Sundaram Mutual Fund. “Even before the classification in our mid-cap fund, about 70% of the corpus was invested in mid-caps and in our small-cap fund, about 90% was invested in small-cap stocks. If you were a fund house that was already following the investment mandate, there would have been no issues,” says Krishna Kumar.
Staying The Course
Kumar of Value Research believes the classification will benefit investors in the long term. “Investors stand to gain as they can compare funds more accurately. Earlier, there were too many divergences in fund portfolios making it very challenging to compare fund performance,” he says.
The classification led to the formation of a new category called the large and mid-cap fund. While it is not vastly different from the earlier multi-cap funds, it has allowed funds to realign their existing schemes to fit into Sebi’s classification of categories. In the large and mid-cap fund, there must be an allocation of at least 35% in large-caps and mid-caps, whereas in a multi-cap, the fund manager has the discretion to have a large-cap orientation or a mid-cap orientation depending on his or her view of the market.
But fund managers argue that while the schemes are being realigned, the past performance may not actually be a true indicator of the fund’s potential because the investment strategy followed was different. Take for instance, Mirae Asset Emerging Bluechip, which was earlier a mid-cap fund that invested about 35% in large-cap stocks. Post the reclassification, it invests about 55% in large-caps. But given its higher mid-cap orientation before the reclassification, its three and five-year performance is way ahead of its peers — it notched a three-year return of about 18% against the category average of 13% and a five-year return of around 26% as against a category average of 16%. Fund managers say the new classification puts some funds in a position of advantage because of the orientation in their previous avatar. “When funds come into new categories thanks to the change in classification, say from being a mid-cap to large and mid-cap fund, it has a great track record to showcase but it may not be a reflection of the current strategy,” says Bhaskar.
The Indian stock market has typically gone through five and six-year cycles, where one or a couple of sectors have created most of the wealth. For instance, it was technology stocks that were the clear favourites during 1995-2000. Post the tech meltdown, from 2001 to 2007, until the global financial crisis, capital goods and infra ruled the roost. Post 2008, defensives took centre stage with pharma and FMCG making a comeback.
Over the past couple of years, fund managers have been betting on PSU banks, metals and infra stocks. Benign commodity prices are already having a positive impact on metal stocks, since fund managers believe infrastructure will benefit from capex recovery as the domestic environment improves. While PSU banks may have been a little late to the party, things are starting to look up for them with falling rate of asset quality deterioration. Fund managers expect their earnings growth to improve significantly as provisions come down and NCLT recoveries make some progress.
“We believe 2018 was a temporary phase and active managers will have opportunities to outperform the benchmark indices,” points out S Naren, CIO-Equity, ICICI Prudential AMC. According to him, true alpha is generated when market corrects from record valuations. “In 2007, when the boom phase peaked out, the benchmark names were overvalued. However, over the next five to six years, all of these names corrected, making it easier to generate alpha. So, it’s a cycle,” he says.
But before fund managers are able to do that, they have to go an accumulation phase where there will be lacklustre return. “Typically, in an accumulation phase, near term return may not be impressive. But those who stay invested through this phase tend to make good return when the next bull market comes by. The last accumulation phase was 2011-2013. In that phase, the return was flat, but investors who invested then made sizeable return in 2017,” says Naren.
Regardless of the volatility, Naren continues to bet on infrastructure based on its valuation. “Within the infra space, we are selectively positive on power, especially the generation space, since there hasn’t been any investment over the last decade. We also like telecom, construction and corporate banks since the NPA cycle is behind us.” Neelesh Surana, CIO-Equity, Mirae AMC, believes that as the market cooled off in 2018, today there are more choices since stocks have seen price or time correction or both. “We will see reversion to the mean in both GDP and earnings growth. Corporate banks will see a turnaround with NCLT getting more entrenched. Earnings growth has been bleak for the past couple of years, with GST and demonetisation having an impact on the overall growth. But there is definite value in sectors such as power, oil marketing companies and even consumer auto,” he says.
However, negative global growth and political uncertainty could increase market volatility in the short-term, say fund managers. That said, a more resilient domestic growth, low oil prices and higher earnings growth point to 2019 being a better year. Kotak’s Shah believes that the Indian mutual fund industry has a long way to go and dismisses the argument that inflows are fuelling valuation. “In the US, the mutual funds’ AUM is about 100% of GDP and no one talks about inflows fuelling valuation.” India’s GDP doubles every seven years, typically. “In the past 10 years, nominal GDP has increased 3.3x and the industry has grown 6x in size,” he says. Surana believes that, given the lack of investment options in the market today, the Indian mutual fund industry will continue to grow. “In other economies, the mutual fund industry is about 50-60% of GDP. In India, it is less than 10% of GDP,” he says. Investments in equity funds are even lower at 4% of GDP. Equities, as a percentage of savings, have increased to 4.6%, the highest it has been over the past decade. While the sluggish market of 2013-2014 saw its share in savings dip to 2.2% in 2014, the market has since gathered momentum and the share of equities has improved.
The lack of alternative investments options, the liquidity that they offer and their potential to generate alpha will see investors continuing to place their bets on mutual funds but the nature of the beast may undergo a change.“The composition of funds will change, instead of large-cap, a multi-cap and mid-cap will do better. Instead of mid-cap, small-cap will do better. If large-cap was earlier the flagship product now it will be a multi-cap,” predicts Shah.