The Mutual Fund Show: The Perks And Perils Of Investing In Focused Funds

Amit: I think looking at the numbers I can only say, brace for impact is what people should actually look at. More importantly, are these SIP numbers also including the STP numbers? Because you don’t get STP numbers from AMFI at any point of time. So, if you have Rs 8,800 crore of SIP throughput which is coming in and you have Rs 1,100 crores of net sales in equity including couple of NFOs which are in the market, so definitely you had a Rs 10,000-11,000 crore worth of retention. This is to the fact that you have got a lot of money which came into mid-cap size SIPs for the last two-three years and they have not been doing well. So, the investor experience probably is not good for those guys who started the SIP two-and-a-half years ago. Markets are at lifetime high, but my portfolio is a negative or probably doing less than liquid fund returns—I think that might be prompting for redemption. I don’t think so profit-booking is something which has taken a toll on mutual funds because there was no profit in the portfolio.

Kirtan: I think one thing that I have really realised over time is, because of this ‘Mutual Funds Sahi Hai’ campaign that has been happening, a lot of these new investors have come into the investment pool and taken up mutual fund as one of their investment vehicles. Now unfortunately, most of these guys who have either come through a mediator, or have taken online portals to come and do investments, have really not had the experience of hand-holding. Taking forward the conversation that Amit made, what is happening is, markets are at all-time high but unfortunately most of it is not seen in their portfolio, and plus they are not ‘hand-held’. That is making it very difficult for them to look at the larger picture beyond what can happen if they stay invested for another four-five years. Which is why I think there has been a lot of pull-out. A lot of people that are hand-held in the investment process, however, are sticking by and those guys are not stopping their SIPs.

Kirtan: Anybody who is in the highest tax bracket should look at allocating some part of their portfolio to the ETF and anybody who is in the 10-20 percent bracket probably have other options which are far better than this one.

Kirtan: Let’s say for example, today there are four categories of people who would generally look at investing in something like this. One is a fixed deposit holder, another is probably a debt mutual fund investor, third is an FMP investor in the mutual fund space and fourth is somebody who is investing directly in the bonds.

Now for somebody who is investing in a fixed deposit, the bond ETF would give a very similar predictable opportunity at this point in time, but the larger advantages are two - first is liquidity and second is returns are slightly higher post tax. That is because in an FD, you end up paying your slab rates. Over here, you will get indexation advantage.

At the same time, for somebody who is investing directly in bonds, this becomes a good opportunity for two reasons - the ETF will give them diversification and at the same time (lower) cost, and hence the return is slightly superior.

Somebody who is in the debt mutual fund investment space—there are two categories that I would like to compare with the Bharat ETF in terms of credit risk. So, you have in the mutual fund space something called as the banking PSU and slightly off, but you still have a corporate debt portfolio. Now, if you do some analysis on all of these portfolios, you will understand that post expense, the client is going to make 5.75 to 6.10 percent returns, which is also not predictable, which is the yield shown at this point time. I think this makes a lot of sense because a three-year debt portfolio ETF is today roughly showing the yield of 6.7, and the cost of hardly anything 0.005 percent is one rupee of cost for Rs 2 lakh investment. So, I think this is a far superior option.

There are two reasons why this can act as a better opportunity for FMP investors. First is the cost of the ETF versus FMP and second is liquidity. Theoretically, you would have debt and FMP also traded on the exchange but generally, you don’t have liquidity. So, if you really want to get out of an FMP, even if it is traded on the exchange, you don’t really get an exit option practically.

Kirtan: Yes.

Amit: I think people who hold to maturity kind of scenario, who don’t want to look at their monies for three years or 10 years can definitely look at such kinds of products but we should not harp on cost because there are only three things - good, fast and cheap. And you can only pick two. So, good and fast will not be cheap. Fast and cheap will not be good and good and cheap will not be fast. People generally try to say because it is cheap it must be good, but I don’t think I subscribe to that.

Second, this is the first experiment in debt ETF. So, I would want to wait. I would want to see what the difference between the actual NAV and the market maker is. If that is closer to the realisable value, then probably I’ll be comfortable putting money. This essentially is an institutional product where probably, the institutions will put money who have their three-year and 10-year money to be put out of their PF and everything. A short-term product will definitely be of much more value to a retail investor if he wants to put his money for three years and then he’ll get a better yield out of it. Liquidity, you will get through the exchanges. Only thing is, I would wait for the market maker to come closer to the realisable NAV.

Another important point, they are doing a pure AAA portfolio. What happens if there is a downgrade? You still have a credit risk in the portfolio. Your NAV will take a toll, same as a normal short-term bond fund or credit risk fund. How many retail investors will understand this?

Amit: Two large NBFCs were AAA last year. That is my argument to it.

Amit: I think putting concentrated bets where your conviction lies is the actual mix and success of focus funds. Typically, funds are at 30-35 stocks going up to 45 stocks with the top funds at 65 percent of their portfolio in the top 10 out of the 34-35 stocks what they hold. So, people had this acronym of HRITHIK last year. HRITHIK was HDFC Bank, Reliance Industries, Infosys, TCS, HDFC, ITC and Kotak Mahindra Bank. So, I think more concentrated the rally the more focused funds will do. So, diversification will preserve wealth, focused funds will enhance wealth. Although, if you look at the more developed markets, focused funds have not been outperforming large cap funds. In India, since you don’t have a perfect market and news doesn’t travel simultaneously to everyone, I think over a long period of time, focused funds will still outperform large caps.

Amit: Yes.

Kirtan: Just to give you a background on what I think on this line is, most of these portfolios that we looked at—let’s say, the funds which have given the highest returns of the last three years—all of these funds have 20-25 stocks in their portfolio. That is extremely highly concentrated. So, if you look at the top holding that most of these funds had that we looked at or anywhere in the range of 9-9.5 percent in one stock, like he said, the top 10 holding concentration is 65 to 70 percent. And even so top three sector holdings are in the same range of 65 to 70 percent. Now, we are saying that the portfolio at large is allocated to 10 stocks and three sectors at 70 percent of the portfolio, which is going to be very difficult unless the fund manager gets the call right. So, looking at a situation where if the fund manager is not able to get the sector call or the stock call right, probably this will not really work in the client’s favour.

We did some analysis over the last five years. So, we looked at the top 10 months in which Nifty lost the most of the last five years, and we could very clearly identify a trend that the top five focused funds that performed the most over the last three years, they all lost more than what the Nifty lost. Doing the same analysis on a multi-cap and large-cap, multi-cap was very much in line with what the Nifty gave and the large caps did better than what Nifty did, which very categorically makes me believe that focused funds are for somebody who is sophisticated and understands the investment risk. If I run the same analysis which we did over a 5-7-year horizon, focused funds have done better than the multi-cap and large cap in that space. So, for us anybody who is looking at anything less than five years in terms of investment and does not really understand the risk between a multi-cap fund and a predominantly focused fund should not really look at this space. For anybody who is looking at five years and above and understands the risk-return potential, it can be a good bet as one part of the portfolio.

Amit: My view is that, we should not look at fast returns on focused funds because the categorisation of all these funds has changed. So, you don’t have empirical data to show how these funds have done because the construct of the portfolio was very different. So, you have to look at I would say, not a right argument, but I would say if somebody wants to do a concentrated PMS at a lower entry value, then you should look at focused funds otherwise you have large and multi cap portfolios which you can do. In terms of names, I think the league table keeps on changing. It will not be right to say which fund and for what reason. Over long periods of time, you take a dart and put on any fund. All funds are at 14 percent 15 percent CAGR anyway.

Kirtan: Going by what MPC came out with, there are three major highlights that I would want to focus on. First, they made a point that PMI has bettered in November. They said that they will increase inflation trajectory from 3.5 to 3.7 to 4.7 to 5.1 and also though they have reduced the GDP number this time around but they also make a mention that probably the next year, first half, they are looking at GDP growing at 6-6.5. Now, if you look at these three things that they mentioned, it was probably understood that the rate card wasn’t called for. In such a situation there two things that I understand to look at from a debt portfolio perspective. Now, I believe that a portfolio with 18-24 months average maturity and a little bit of credit risk will really do well over the next three years.

Now, why do I make that comment? If you look at a debt portfolio today, let’s say the spread between the term repo and a two-year AAA is 160-170 basis points. But if you do the same thing of a term spread on a repo and two-year AA, the spread is 250 to 300 basis points. Now, if you extend that a little beyond that and do a three-year, five-year analysis of a term spread of repo and a three-year repo and a five-year, the spread is hardly 10 basis points or 15 basis points higher than what an 18-month or a two-year is offering. For which, I would like to believe it does not make sense to take the duration risk for a 10 basis points or a 15 basis points higher return whereas a 18-24 is at a sweet spot. Also, at the same time, why do I feel that while we select a portfolio, a little bit of credit may really help. That’s because if you look at last year, the spread between liquid and credit portfolio in the debt mutual fund space was again in the range of 170- 180 basis points.

Today, that same spread of liquid at 5.75 percent is roughly 450- 500 basis points. That’s the kind of spread at which a liquid and credit fund today is at and a lot of this credit related risk is to my mind, factored in, understood and people taking credit risk probably now understand that there are chances that things might go wrong and things are not similar to what it was a year back when people did not think debt can have risk. So, to my mind, any fund with an 18 to 24 month of average maturity, slight credit risk and using the rolling down strategy can be the right investment to make for the coming 2-3 years.

Kirtan: While I say risk, I’m not actually focusing towards getting somebody to invest in a credit risk fund. All I am saying is, while we select the short-term fund, 18 to 24 months, it should not be a problem if the portfolio has some bit of AA.

Amit: Somebody spoke to me last week and he said that fiscal deficit and CAD (current account deficit) are like your English and Maths marks in your 10th grade. If you get that right, everything else falls in place. If the government is trying to do that and a slippage from 3.3 to 3.6 on fiscal is ok, I don’t think we should be worried about that. Where is the opportunity in debt? Your repo is at 5.15 percent your 10-year is at 6.50 percent. You have got a 135-basis spread there; both are sovereign. I think that is what duration calls for. So, you can have that has one third of your portfolio.

If you look at MCLR—the bank lending rate—that’s today at 8 percent and if you look at the three-year bond, it’s at 6.60 percent. There is a 140 basis point spread there. I think that calls for some credit risk also. So, if you have a credit risk rolled down and a duration play and if you forget all of that within one fund, one-third, one-third, one-third, I think that will make something which is very nice for the investor. Another point—return of capital and return on capital—these are two different things. So, when people put money in credit risk, they expect a lot of return on capital. I think first is what return of capital and as banks do, we should also do a SLR analysis of debt funds, wherein ‘S’ is for safety, ‘L’ is for liquidity and ‘R’ is for returns. So, if you are a very conservative investor, don’t get into any of this. Put it into ultra short and sleep or a low-duration product but you have something wherein you aim for 7.5 percent plus post tax return, then I think a one third duration one third credit and one third roll down, I think this combination will work in your favour.

Amit: A short-term fund with credit exposure is what you should look at.

Kirtan: Same here, ultra-short term, low duration or short term with some credit exposure.

Amit: Typically, NFOs don’t add any great value to a client’s portfolio because you take three months to deploy and if the markets go up, then you are not participating in the rally. I’ll bet if you are investing in an NFO and if you feel that the markets will go down, they have three months to invest. Typically, going into a thematic fund or a sectoral fund isn’t what I think any of the advisors will consider, and here we are talking of something which is completely dependent on the government and you’re banking on one refinery being sold and if that is a success, then you are saying that everything else will be whitewashed.

I think a 5 percent tactical call for most of the guys who are in the high risk category, if they want to do, they can probably go ahead and put money into it. But typically, if you stay focused, if you stay large cap, if you stay multi-cap I think they will capture these tactical themes as and when they come rather than putting my money in a pure sectoral or a thematic fund. Not just this, but any.

Kirtan: Completely concur. There are thousands of funds to choose from and there is very little logic made available to invest in an NFO, because you have absolutely zero understanding of what has happened and what can happen. At the same time, this again goes back to the same argument that I made for focused funds, there’s going to be extremely high concentration on a particular sector. Thematic is something which isn’t meant for everybody and probably a multi-cap or even a focused or a large-cap basket should do much better in terms of risk-return than taking up an NFO which is thematic.

Amit: Sector rotation is well-captured by a large cap fund or a multi-cap fund and if the sector is in vogue, I think fund managers are smart enough to load their portfolios with this. So, one should avoid – not only for this mutual fund but any of the mutual funds, if you have a sector fund, I think one should avoid – and stick to your core large cap, multi-cap focus kind of a portfolio.