January 10, 2018

10 Years After The 2008 Peak

On Jan 8 2008, the BSE Sensex closed at a then all-time high level of 20,873.  This week, as it hit new all-time highs, I have been poring through performance numbers of equity funds over these last 10 years.  In this post, I’d like to share some of my observations and thoughts.

Is this what we expected?
“How much return would you expect the Sensex to give over a 10 year period?”  Back in the day, I would pose this question to advisors and investors, as part of a long-running series of exercises that I conducted.  Throughout 2007-08, the most common answer I got was “at least 15% p.a.”.  It was an understandable response.  The growth in the Sensex from its base date in 1979 to its value at the end of December 2007, stood at just over 20% p.a. (without reinvesting dividends).  Some would consider the estimate of 15% p.a. to be too high.  The most conservative estimates that I heard were of a growth of no less than 10% p.a.  Yet, the fact is that over the last 10 years, the BSE Sensex TRI grew by just 6.6% p.a.  The BSE MidCap TRI did a bit better, growing by 7.9% p.a.  And for whatever you may find it worth, the BSE SmallCap TRI grew by just 5.3% p.a.  All these numbers pale in comparison to the fact that a 10 year deposit with SBI over the same period would have given an assured compounded annualized rate of 8.78%.

So, going forward, could such long-term underperformance by equity indices be a more frequent occurrence, or is this just a blip?  When I discussed these numbers with a prominent industry observer, he responded with a quote that is frequently attributed to Keynes: “Markets can remain irrational far longer than we can remain solvent.”

How much value did actively managed funds really add?
Of the 140 actively managed, domestic, diversified equity funds that survived these 10 years, only 2 schemes gave an annualized return in excess of 15% p.a.  While the median return of this group was 9.2% p.a., 61 schemes (i.e. 44% of all schemes) gave less returns than the SBI deposit would have.  Of these, 28 schemes (20%) gave less returns than the BSE Sensex.  All these numbers exclude entry loads, which were prevalent at the time.

How did the largest schemes perform?
The table below gives the list of the largest equity funds (by AUM) at the end of December 2007 along with their returns over these 10 years.  Some of the names on this list may surprise those who weren’t investors at the time.  I can’t say how many investors were committed to being invested in these schemes for 10 years or more.  For those who were, it is a moot question as to whether their faith in these schemes was justified.  For better context, I have also given the ranking of these schemes based on their return.

AUM Rank
Dec 2007
Return p.a.
2008-2018
Return Rank
2008-2018
Reliance Growth Fund19.9%72
Reliance Diversified Power Sector Fund24.1%181
HDFC Equity Fund311.4%37
ICICI Prudential Infrastructure Fund44.8%173
DSP BlackRock India T.I.G.E.R. Fund55.6%155
Reliance Vision Fund67.8%116
Fidelity Equity Fund*710.2%65
Franklin India Flexi Cap Fund810.2%66
SBI Magnum Taxgain Scheme98.2%105
Reliance Focused Large Cap Fund105.6%156

Returns are for the period 8 Jan 2008 to 8 Jan 2018 and exclude loads.  AUM and Return ranking is among all open-end equity funds that survived these 10 years.  Total no of funds: 202.
* This scheme has seen a change in fund house management from 2008 to 2018.
Data/ Information sources: AMFI, NJ India Invest, Value Research

How many of us could predict the top performers?
The table below gives the list of domestic, diversified equity funds which gave the highest return over these 10 years.  Alongside I have given their ranking among equity schemes based on their current AUM, as well as their AUM ten years ago.  Going by their AUM ranking ten years ago, it would seem that most investors weren’t betting big on most of these schemes.

Return p.a.
2008-2018
AUM Rank
Dec 2007
AUM Rank
Current
HDFC Mid-Cap Opportunities Fund16.5%364
DSP BlackRock Micro Cap Fund16.0%10826
ICICI Prudential Value Discovery Fund14.7%975
Canara Robeco Emerging Equities Fund14.5%25759
Franklin India Smaller Companies Fund14.2%4923
Sundaram Select Midcap Fund14.0%1929
DSP BlackRock Small and Mid Cap Fund13.8%4435
IDFC Premier Equity Fund*13.6%7730
UTI Mid Cap Fund13.5%11444
L&T Midcap Fund*13.4%23986

Returns are for the period 8 Jan 2008 to 8 Jan 2018 and exclude loads.  AUM ranking is among all open-end equity funds.  Current AUM ranking is based on AUM  at end of Nov 2017 which is the latest date for which data was available across all fund houses.  Total no of funds- Dec 2007: 287; Current: 385. 
* These schemes have seen a change in fund house management from 2008 to 2018.
Data/ Information sources: AMFI, NJ India Invest, Value Research

How important is the long-term performance of a scheme to investors?
This is the question that bothers me the most.  It is widely recognized that a scheme’s long-term, multi-cycle performance is a good indicator of a fund management team’s competence.  However, if the current AUM of equity schemes is anything to go by, it would seem that long-term performance of a scheme doesn’t really matter to many investors.  As evidence, consider this: three of the ten largest actively managed, diversified equity funds today, did not exist 10 years ago.  These three schemes currently have a combined AUM of ~47,000 crore.  In other words, investors have poured significant money into schemes that were not tested in the brutal bear phase of 2008-09.  I find it all the more astonishing given that two of the fund houses behind those schemes had a patchy record with their other schemes during 2008-09 while the third fund house itself did not exist at the time (nor did its sponsor have any known track record of fund management). 

That’s not all.  There is one more statistic that quantifies the lack of consideration for long-term performance.  It is that the actively managed, domestic diversified schemes that actually underperformed the BSE Sensex over the past 10 years currently have a combined AUM of ~19,000 crore.  If you include thematic/ sector funds, that number goes up to ~32,000 crore.

Warren Buffett famously stated that risk comes from not knowing what you are doing.  While past underperformance (or absence of performance) is no guarantee of future underperformance, I hope investors in all these schemes know what they are doing.

December 31, 2017

The Murky Inconsistencies Of Axis Hybrid Fund

From 2011 onwards, Axis MF has launched a series of 3-4 year closed-end, income schemes with marginal equity exposure (like a MIP) under the common name of Axis Hybrid Fund.  At its peak, the AUM under these schemes was ~7600 crore.  The current AUM of the outstanding schemes is estimated to be around 5800 crore.  Despite the considerable AUM of these schemes, there is very little awareness about their portfolios and performance. 

These schemes first came to my attention, a few months ago.  Since then, I have had the opportunity to look at them closely, and have found a lot that is questionable and disturbing.  In this post, I’d like to shed light on some of the issues that I have seen.  For the record, I sent an email to the fund house, raising the points in this post, but received no acknowledgment or response from them.

Active or Passive?
Each scheme under the Axis Hybrid Fund series has been/ is passively managed.  The annual reports confirm this.  The approach has been to manage the debt portion of each scheme like a FMP, and to allocate the equity portion to Nifty Call Options that are held till their expiry.  The problem is that, going by the Scheme Information Documents (SID), it would seem that the equity portion is supposed to be actively managed.  Consider this extract from the SID of the first scheme in the series:

For the equity portion, the focus would be to build a diversified portfolio of strong growth companies, reflecting our most attractive investment ideas, at all points of time.  The portfolios will be built utilizing a bottom-up stock selection process, focusing on appreciation potential of individual stocks from a fundamental perspective.

From the fourth scheme onwards, the text was slightly modified to include a caveat “to the extent the fund invests in equity shares”.  Nevertheless, the SIDs have continued to mislead by unambiguously stating that the schemes “will invest in a diversified portfolio of Equities & Equity Related Instruments (including options premium) across market capitalisation.”

But that isn't all.  Three of the schemes in the series were rolled over on maturity, for another 3-4 years.  Ever since then, they have stopped holding any equities in their portfolios: shares or derivatives.  That’s despite the fact that the indicative asset allocation provides for the schemes to have 5%-30% of their portfolios in equities “under normal circumstances”.  All other schemes continue to hold the Nifty call options.

There is a bigger question, though, that lingers in my mind: in a closed-end fund (especially one with a 3-4 year maturity), does buying and holding an index (or index call options) really constitute an investment strategy?  As it happens, one portfolio manager whom I spoke to, had this to say: “That is hardly a strategy.  That is speculation.”

Excessive Expense Ratios
Generally speaking, the norm is for passively managed funds to have lower expense ratios than similar, actively managed funds, and for income funds to have lower expense ratios than equity funds.  FMPs usually have the lowest expense ratios among income funds, and that’s mostly true for Axis MF’s FMPs (Axis Fixed Term Plan).  Since 70%-95% of the portfolio of any Axis Hybrid Fund is managed as a FMP, these schemes should logically have expense ratios that are only slightly higher than the FMPs launched by the fund house.  Quite to the contrary, the actual difference between the two is glaring.

Average Expense Ratios: FY 17
Regular Plans Direct Plans
Axis Fixed Term Plan series 0.50% 0.07%
Axis Hybrid Fund series 2.53% 1.34%

Data source: Abridged Annual Report 2016-17

For those who can do the maths, if you assume that, on an average, 80% of the portfolio of each Axis Hybrid Fund scheme was managed as a FMP, and apply the average expense ratio of Axis Fixed Term Plan series to that portion, you will conclude that for the passively managed Nifty call options, the investors in regular plans were charged 10.6% of the equity AUM as expenses.  Think about that for a moment.  Is there any measure by which such a number can be justified?

There’s one other thing that disturbs me.  You may remember those three schemes I mentioned above which were rolled over and which no longer hold any equities.  Those roll-overs happened between Jan-March 2017.  Well, despite being now managed exactly like FMPs, their average expense ratio in the first 6 months of the current financial year was 2.84% (source: unaudited half yearly financials, Sep 2017).

I suspect that the Axis Hybrid Fund series are among the most expensive passively managed mutual fund schemes in the world.

Questionable Performances
All the schemes in the series are benchmarked against the CRISIL MIP Blended Index.  On account of the exposure to derivatives (which increases volatility), it is best to compare performance only across the complete tenure of a scheme.  Even so, the results vary significantly.  While the first three schemes in the series each outperformed the benchmark by an average of 2.1% p.a., the next eight schemes each underperformed the benchmark by an average of 4.2% p.a.  By any standard, that’s an astonishing level of underperformance, even after considering the excessive expensive ratios of the schemes.  Not only that, each of these eight schemes underperformed their own liquid fund (Axis Liquid Fund) by an average of 1.2% p.a.  The table below gives the relative returns of each of the schemes in the series that have matured.

Return p.a.
Scheme Benchmark
Axis Hybrid Fund - Series 1 11.2% 9.4%
Axis Hybrid Fund - Series 2 11.6% 9.4%
Axis Hybrid Fund - Series 312.0% 9.7%
Axis Hybrid Fund - Series 5* 6.2% 11.3%
Axis Hybrid Fund - Series 6* 7.1% 12.0%
Axis Hybrid Fund - Series 7* 7.2% 11.3%
Axis Hybrid Fund - Series 8 7.7% 11.8%
Axis Hybrid Fund - Series 9 7.7% 12.1%
Axis Hybrid Fund - Series 11 6.6% 10.9%
Axis Hybrid Fund - Series 12 6.6% 10.3%
Axis Hybrid Fund - Series 13 6.4% 9.7%

Returns are for regular plans and for the entire tenure of each scheme
* Axis Hybrid Fund - Series 5, 6 & 7 were rolled over and their returns are for their original tenure
Data/ Information sources: Axis MF, CRISIL, NJ India Invest, Value Research

What makes those numbers even more awful is the volatility that accompanied the returns.  I would like to particularly mention Axis Hybrid Fund – Series 5 which, apart from giving the lowest return, had, at one point, a level of volatility that rivalled that of equity funds.  As evidence, consider the chart below which covers the first six months of the scheme.

Axis Hybrid Fund - Series 5 NAV

On the basis of the chart above, one could be mislead into thinking that this was an equity scheme rather than an income scheme.

All of this leads to an obvious question: why would anyone have invested in any of these schemes?

It would seem that these schemes were mostly ‘sold’ rather than ‘bought’, if you get what I mean.  Going by the latest disclosures, 99.7% of the AUM came through distributors.  Probably most tellingly, over 92% came through associate distributors of Axis MF (presumably, Axis Bank).  I can only imagine what kind of conversations they had with their clients.

December 25, 2017

In The World Of ‘Yo-Yo Funds’

On the fringes of the more volatile mutual fund schemes, there lie a set of schemes that I am tempted to describe as ‘yo-yo funds’.  Why?  Because of the way that their NAVs swing up and down, like a yo-yo.  All too often, their NAVs rise sharply one day, and then fall sharply the next day, or vice versa.  Thus far, all such schemes that I have seen are closed-end equity/ hybrid schemes, and a  key common link to their NAV fluctuations is their exposure to long-term derivatives contracts.  In this post, I propose to shine a bit of light on these schemes.  In doing so, there are three things that I hope to accomplish.

The first is to create awareness about the existence of ‘yo-yo funds’.  In conversations that I have had with advisors and investors, most of the people that I spoke to, could not believe that the NAV of any mutual fund scheme could fluctuate in such a way.  The second is to caution those considering investing in closed-end equity and hybrid schemes that are likely to have exposure to long-term derivatives contracts.   Such NAV fluctuations are something that they could well encounter, and they should be willing to accept that.  The third is to reinforce the point on volatility which was the heart of my last post.  I believe that fund houses need to be more sensitive to the impact that volatility can have on investors, even in closed-end schemes.

To keep things simple, I’ll focus on two such schemes. I’ll present some numbers on their NAV fluctuations, as also the visual evidence of charts.  Both are 3-4 year closed-end equity schemes, but with different benchmarks, and managed by different fund houses.  Both schemes were launched in July 2017.  To be clear, my choice of these schemes is not related to what I feel about their fund houses.  These are good examples that can help in reflecting upon the problematic existence of ‘yo-yo funds’.

HDFC Equity Opportunities Fund-II-1100D June 2017

Benchmark: Nifty 50
Launch Date: 12 July 2017
Maturity Date: 20 July 2020

The chart below shows the NAV movements of the scheme since its inception.  It also gives a sense of the frequent swings that made me regard this as a ‘yo-yo fund’.  It may be instructive to compare those swings with the movement in the value of the benchmark at those times.

HDFC EOF II 1100D June 2017 NAV

The table below summarizes the extent of daily fluctuations in the NAV of the scheme, relative to its benchmark index. 

Fund Benchmark
Max rise on a single day 4.2% 1.2%
Max fall on a single day -4.3% -1.6%
Standard Deviation (daily returns) 36.5% 11.8%
% of days on which swing in excess of +/- 3% 23% Nil
% of days on which swing in excess of +/- 4% 5%
Nil

Data period: 17 July 2017 to 15 Dec 2017
Data/ information sources: HDFC MF, NJ India Invest, NSE, Value Research


ABSL Resurgent India Fund – Series 4

Benchmark: S&P BSE 200
Launch Date: 7 July 2017
Maturity Date: 6 June 2021

As with the previous scheme, the chart below shows the NAV movements of this scheme since its inception.  You may notice that the NAV swings in the case of this scheme (relative to the previous scheme) are much more pronounced.  This is also borne out by the data in the table below the chart.

ABSL Resurgent India Fund - Series 4 NAV

Fund Benchmark
Max rise on a single day 5.7% 1.3%
Max fall on a single day -6.0% -1.9%
Standard Deviation (daily returns) 44.5% 12.6%
% of days on which swing in excess of +/- 3% 23% Nil
% of days on which swing in excess of +/- 4% 16%
Nil

Data period: 17 July 2017 to 15 Dec 2017
Data/ Information sources: ABSL MF, Asia Index, Value Research

Both these schemes hold Nifty put options, evidently for the purpose of hedging.  There are some who argue that such hedging is necessary to protect investors in the schemes, and that the volatility should be seen in that context.  There are others who suggest that the volatility is mostly on account of the lack of depth in the derivatives market, and that it is unfair to blame fund houses for that.  To me, though, these arguments overlook/ bypass a more fundamental question: what is the compulsion to launch closed-end equity schemes, particularly those with maturities of 3-4 years?

December 11, 2017

The Scourge Of Volatility

Last week, one of my frequent collaborators brought to my attention the case of an investor who had been sold a closed-end equity scheme by his relationship manager at a private sector bank.  On the face of it, the episode had all the key elements that I associate with the rash of mis-selling pursued by young, ignorant, callous, smooth-talking bankers, fuelled by excessive incentives from sales-hungry fund houses.  Among other things, the investor was given the impression that this scheme was the real deal, and that the client could exit anytime he liked (“all you have to do is sell it on a stock exchange”).  For their efforts, the bank charged the client 1.50% of the amount invested (this was over and above what they gained on account of getting the client into the regular plan). 

I am not aware of the risk profiling that was done by the bank, but soon afterwards, the client started getting jittery.  He was tracking the NAV movements of the scheme, and what he saw, perturbed him.  At one level, he was flustered by the fact that despite the current surge in stock prices, one month on, the scheme had not shown any positive returns.  More than that, though, it was the seemingly unending daily spikes in the NAV that left him aghast.  If that sounds hard to believe, consider this: on 6 of the 7 business days in this month so far, this domestic, diversified equity scheme rose or fell more than any other equity scheme (including sector specific schemes and international funds). For the investor, things came to a head last week when the scheme’s NAV fell by an astounding 4.3% on a single day: a day when the scheme’s benchmark index, the BSE 200, fell by just 0.8%, while the BSE Sensex fell by a mere 0.6%.

So how on earth did this scheme manage to be so volatile?  What was it holding that caused such a fall?

The November-end portfolio was officially uploaded just this weekend, so till then we could only speculate about what the portfolio might be.  My guess was that this scheme was holding concentrated positions in dubious mid-cap/ small-cap stocks.  I was wrong.  It turned out to be a well diversified portfolio, with no concentrated positions.  Moreover, the top stock holdings were all respectable names.  Even more baffling was the fact that only about two-thirds of the portfolio was in stocks.  As much as 35% of the portfolio was in money market instruments.  With such a portfolio, that kind of a fall was impossible to fathom.

But then my collaborator pointed out a tiny element of the portfolio that I had overlooked.  The scheme had some exposure to Nifty December 2020 Put Options.  It was this part of the portfolio that was a key contributor to the fluctuation.  For those who understand how prices of derivative contracts fluctuate, this should not be a surprise.  But for those who don’t, consider this: on the day of that huge fall in the scheme’s NAV, the prices of the two sets of contracts held by this scheme tumbled by 67% and 71% respectively.  It seemed ironical, given that this exposure was ostensibly meant to hedge the portfolio against a fall in equity prices.

If you think that this is an isolated case, I’d like to suggest otherwise.  This may be an extreme case, but when I did a quick check on the data available at Value Research, I found closed-end equity schemes to be, on an average, 17% more volatile than open end schemes.  Additionally, within the limitations of what I could analyze, I could link this to the exposure that many of these schemes took to long term derivatives contracts.  If you consider the added impact of this on an investor’s ability to get a fair price in the event that he/ she decides to exit before maturity, you may get a sense of how much of a scourge volatility can be to investors in closed-end schemes.  Take the aforementioned investor, for instance.  The day after the NAV fell by 4.3%, he tried to exit the scheme, but couldn’t find a buyer.  Even if there had been a buyer, would he have got a fair price?  As it is, trading a closed-end fund on an exchange is loaded in favour of the buyer: it can be expected to happen at a discount to the NAV.  If the scheme happens to be as volatile as this scheme was, I’d say that it would significantly increase the level of discount that a buyer would expect. 

When I shared my thoughts with some industry insiders, the argument that I was offered was that most investors in closed-end schemes do not seek to exit before maturity, and hence volatility would not matter to them.  I find it hard to agree with that.  In the imperfect but real world that we live in, I believe that many, if not most investors feel humanly compelled to periodically track the performance of the schemes that they have invested into, regardless of whether these are closed-ended or open-ended.  And if they see excessive volatility, they are likely to feel uncertain about the future, and to consider exiting.

But more than my own view, let me give the final word to Peter Stanyer, an authority on the subject of wealth management and more.  In his marvellous book, Guide To Investment Strategy, in the context of investing with a target date, he makes the point that it is reasonable for an investor’s confidence “to be shaken by disappointing developments along the way, even if those developments are not surprising to a quantitative analyst.”  He further goes on to say that “the perceived risk of a bad outcome will be increased by disappointments before the target date is reached, undermining confidence in the investment strategy.”  Now that‘s food for thought.

Special thanks to Robin Jehangir for his valuable inputs to this post.

November 26, 2017

A Nightmare Of Flawed Processes

At the start of this year, I wrote a post: Will You Get Your Money Back, On Time?  In that, I spotlighted the case of an investor who was unable to execute a redemption transaction on the website of a prominent fund house.  His experience was all the more harrowing because, despite his best efforts, he couldn’t reach the customer service team at the fund house.  As an investor, there were two aspects of that episode that I found particularly scary. The first was that the entire incident was the result of poorly designed processes on the part of the fund house.  By my count, there were at least five questionable actions that were triggered through no fault of the investor.  The second was the attitude of the people at the fund house who took no responsibility for what happened.  That made me wonder if they would even bother to examine the flaws of their processes, let alone take any corrective action.

That was not an isolated case: it was just one that warranted a detailed post.  Fact is, I have seen evidence of such flawed processes, across multiple fund houses.  In this post, I would like to present another case, that transpired last week, and which should be of relevance to all investors.  Here, too, the events described could have happened to almost anyone.

This case relates to a Mumbai-based DIY investor who attempted to redeem his investments in a certain ultra short term fund managed by another prominent fund house.  This is a fund house that prides itself on the quality of its processes, and its customer service team.  The investor planned to execute the transaction via the fund house’s website on Monday last week.  But a day before that, on Sunday, when he went on the website to check the exact value of his investments, he was shocked by what he saw.

The summary showed the Account Summaryvalue of his investments as 35.92 lakhs, which was in line with what he estimated.  However, when he opened the account statement, he was stunned to see that the number of units available for Account Statementredemption were zero.  As he wondered why that was the case, he spotted an entry made just a few days earlier, with a cryptic description: “pledging”.  It seemed as if all his units had been pledged, something he was absolutely sure, that he had not requested.

Being a Sunday, he had no way of contacting the fund house.  So frantically, he called up people who might have an answer, but it got him nowhere.  He spent a restless day, and night, and first thing on Monday, called up the fund house.  He didn’t get an immediate explanation but someone assured him that they would get back.  They did, but with a baffling reply.  Apparently, in the course of the last switch that he had made (from an equity fund into this scheme), the fund house had deducted a lesser exit load than what was applicable.  When they realized their mistake, they marked a lien against his units with the intention of recovering that amount.

Right away, that threw up several questions, none of which the customer service person could answer.  Why hadn’t they simply written to the investor, or called him up?  If for any reason, they had to mark a lien, why did they do it on the entire units, given that the amount to be recovered was merely 4,000 or so?  Why couldn’t they explain it better on the account statement, instead of using an ominous word such as “pledging”?  Why were they hassling him in this manner when it was the fund house which was at fault?  What sort of processes did the fund house have in place if it couldn’t calculate the exit loads correctly?   Wasn’t the investor entitled to compensation from the fund house for the mental anguish caused by its actions?

From what I could gather, the investor conveyed his intention to immediately withdraw his entire investments.  The customer service person told him that he could do so, and that the amount would be deducted from the redemption proceeds.  Unfortunately, even after that assurance, things didn’t go smoothly.  As per the fund house’s service standards, the redeemed amount should have been automatically credited to the investor’s bank account, early morning on Tuesday.  That didn’t happen.  Once again, he was forced to call up the fund house and enquire what was going on.  Eventually, a few hours later, the amount was credited to his account. 

Many years ago, someone asked me what was the worst thing that could happen to a mutual fund investor.  To that person’s surprise, my answer then, as it would be today, was that in my opinion, there could be nothing worse for an investor than to not be able to rightfully access his/her money at will.  Just like the investor mentioned here, and the one in my earlier post, I have lived such a nightmare once: I hope that I don’t have to, ever again.  I hope that you don’t have to, either.

Special thanks to Robin Jehangir for bringing this case to my attention.

October 26, 2017

In Praise Of SEBI’s Scheme Rationalization Directive

In the three weeks since SEBI released its circular on categorization and rationalization of mutual fund schemes, there have been at least two dozen opinion pieces written on it, across newspapers, blogs, and online portals.  With a number like that, it is usually pointless to try and add anything new to the conversation.  But after going through what has been written, and speaking with advisors and investors, I feel that SEBI’s circular hasn’t been appreciated as much as it should have.  I think it is one of the most important directives from the regulator in recent times, and deserves a standing ovation.  If nothing else, I’d like to add my voice to that of those who have applauded it.

Here are some of the ways in which I expect it to benefit investors:

You’ll know what you’re buying: A number of fund houses have made it difficult for investors to comprehend the true nature of the schemes that they buy into.  In some cases, the scheme names are misleading while in others, the investment objectives are way too ambiguous.  While the issues with the names may still persist, SEBI’s elaborate description of most categories leaves little wriggle room for fund houses to creatively expand a scheme’s investment objective.  So once this directive comes into effect, if you buy an equity scheme categorized as ‘large cap’, you’ll know exactly what to expect.

You’ll have clearer choices: Currently, choosing between scheme categories can be tricky.  There are at least two issues that investors face.  The first is that there is a lack of uniformity in the way that scheme categories are defined by various entities.  For example, one prominent online portal divides domestic, diversified, non-ELSS equity funds into five categories whereas another splits these into just three categories.  Hopefully, SEBI’s intervention into the classification process will result in all these entities adopting a uniform approach. 

The second problem is that among the prevailing classifications, some categories are so loosely defined that certain schemes could fit into any of two or three different categories.  As a result, there are differences in the way that these schemes are categorized by different entities.  While SEBI’s classification does not completely eliminate overlap, the important difference is that there will now be little ground for an entity to categorize a scheme any differently from the way a fund house does.

As a foot note, I’d like to say that I disagree with those who contend that the SEBI circular keeps far too many categories, particularly among debt funds.  I believe that the number of categories is a less consequential issue than it is being made out to be.  As for debt funds, their structural complexity as well as the widely segmented audience that they cater to, necessitates far many more categories than equity funds.  I think that the categories put forth by SEBI meet that requirement quite well.

Underperformance will be difficult to mask: At present, some fund houses have multiple schemes with similar objectives but with subtly different strategies/ portfolios.  This enables them to hedge their bets on which strategy/ portfolio will do better.  But more than that, this helps in effecting a psychological deception upon prospective investors.  Put differently, if you are a prospective investor who is comparing fund performances in a category in which there are, say, two somewhat similar schemes from the same fund house, you are more likely to notice the better performing scheme (and miss seeing the underperforming scheme).  Thanks to SEBI’s stipulation that a fund house can have only one scheme in most categories, fund houses will now have to necessarily go with their highest-conviction strategies. Hopefully, then, a clearer picture of the true performance of a fund manager should emerge.

Style drift will be curbed: Style drift is far more widespread than most people realize, and is thus a bigger risk than most people realize. Going by the latest SPIVA India scorecard, as many as 53% of the funds that were classified by Morningstar as large-cap 3 years ago (and which continue to exist today), no longer have a large-cap orientation.  In fact, in just the last 1 year, 25% of equity funds that were classified as large-cap, have ceased to have a large-cap orientation.  In case you’re wondering, it isn’t just large-cap funds, or even equity funds.  11% of equity funds that were classified as mid/small-cap a year ago, are no longer classified as such, while 32% of debt funds across Morningstar’s ‘Intermediate Bond’ and ‘Short-Term Bond’ categories no longer fit those categories.  SEBI’s circular is short on the details of how it will monitor style drift.  But the painstaking detail in which it has defined most categories, gives one the confidence that that, in itself, should be useful in curbing style drift, without constraining a fund manager’s flexibility.

You’ll be able to make fair comparisons:  Making fair and accurate performance comparisons between schemes is integral to good investing.  Unfortunately, on account of the issues mentioned earlier (ambiguous investment objectives, style drift etc.), investors are rarely able to do so.  Once SEBI’s classification comes into effect, this should become a thing of the past, and you should be able to make genuine apples-to-apples comparisons of fund performance.  Doubtless, it will take time for the benefits to materialize but from the point of view of investors, this could well be the biggest benefit from SEBI’s directive.

October 04, 2017

Total Return Index Benchmarking

Around six weeks ago, DSP BlackRock MF stated its intention to “compare its funds’ performance” to the total return of their respective benchmark indices.  A few days later, Edelweiss MF made a similar announcement.  While these were noteworthy decisions, I couldn’t quite understand the need for these fund houses to formally proclaim their intentions to the world at large.  To be honest, a part of me felt that these announcements had a holier-than-thou ring about them.  More than that, though, it was the wide media coverage of these announcements that stood out for me.  Sure, it was helpful in spreading awareness about the difference between a Total Return Index (TRI) and a Price Return Index (PRI).  But beyond that, it seemed to me that most of the coverage was hype and lacked clear perspective.  In this post, I’d like to chip in with some scattered thoughts.

TRI benchmarking has little to do with appropriateness
By any reasonable standard, the appropriateness of a scheme’s benchmark index is determined by the similarity of the constituents of the benchmark with the universe of securities that the scheme will invest into.  So, for a scheme that invests in large cap stocks, the Nifty 50 or the BSE Sensex could both be appropriate benchmarks.  It is a fund house’s individual decision as to which index to choose as the formal benchmark.  As for choosing a TRI over a PRI, that has little to do with appropriateness in that sense: it is more like raising the height of a hurdle to jump over. If a fund house chooses a TRI over a PRI, then at best it can be assumed to be signalling its intent to raise the bar for its performance.  Bear in mind, though, that a fund house can raise the bar for its performance in any number of ways, and without making such announcements. 

Where will performance be reported?
Even if a fund house chooses TRI benchmarking, its performance reporting will be restricted to documents that are released by it (e.g. fact sheets, SID, KIM etc.).  So, to investors who prefer to compare scheme performances across multiple fund houses, such reporting will be of little use. 

Investors can choose their own benchmark
No matter what benchmark index a fund house chooses, in analyzing the performance of a scheme, an investor is always free to use whatever benchmark index he or she thinks appropriate.  For example, in all instances of index data used by me on both my blogs, I have used total return numbers only.  It is not as if that is necessarily better than using price return numbers: it is merely an expression of my personal belief.  And I have done so, regardless of what practice the industry or individual fund houses have followed.

The notion of “alpha” varies
There are some who argue that a TRI is a better choice for accurately determining “alpha”.  In my opinion, a lot depends upon how one defines “alpha”.  For those who regard “alpha” as a mathematical formula, it is understandable for them to prefer a TRI over a PRI.  But in my experience, for most people who look for “alpha”, it is just a broad appraisement of the value added by a fund manager.  Sure enough, some of these people assess “alpha” against a TRI but there are many to whom the TRI/ PRI choice may be inconsequential.  There are also those who believe in assessing “alpha” against an appropriate index fund (rather than an index) while there are yet others who, in their own wisdom, assess “alpha” against the returns from a bank deposit.

TRI benchmarking is not new in India
In conversations with investors and advisors, I gathered that quite a few of them were under the impression that these announcements were pioneering/ ground-breaking in the context of the Indian fund industry.  In fact, there was at least one report, in The Economic Times, which credited DSPBR MF as “the first fund house to start with this practice”.  The truth is that Quantum MF has been following TRI benchmarking for years, for both its equity schemes, as well for its Nifty ETF.  Other fund houses following this practice selectively include IDBI MF and Kotak MF (thanks to one scheme taken over from the erstwhile Pinebridge MF).  And then there are some fund houses that have taken a somewhat convoluted approach, if I may call it that.  To take an example, SBI MF compares the returns of its Nifty Index Fund with the Nifty 50 PRI, but measures its tracking error against the Nifty 50 TRI.  As far as I am aware, none of these fund houses trumpeted their decisions and perhaps, for that reason, these haven’t attracted the media coverage that the more recent announcements have.

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