Mutual Fund

ICICI Prudential Nasdaq 100 Index Fund: What you should know!

Recently, ICICI Prudential has come up with the NFO for their new Index fund mimicking the US based Nasdaq composite Index. The media has been buzzing and the number of articles about why you should invest in the fund are available in abundance. This is probably the 3rd or 4th fund which enables the Indian investor to take exposure to Nasdaq Index [Other options are via Motilal Oswal & Kotak AMCs]. To save time of mine as well as yours, I’m not going to talk about what this fund is all about & it’s benefits. You can refer to the literature produced by the AMC in their presentation[Link]. We will try to discuss few specific points, that should enable you to decide, if you should add this fund in your portfolio or not. The fund is quite attractive from the perspective of potential ownership of the Big Tech names and next gen Innovative companies. Though as usual, I can not predict the future but I can look for the longer historical track record to make some reasonable expectations. We will try to look through the lenses of Risk & Return and it’s benefit to overall portfolio.

Caveats: Before we jump into the detailed numbers/ charts, Let’s understand that data I used is from the google finance for Nifty 50 Index, Nasdaq 100 index and Currency values. As the market operations differ in both countries, I tried to take the base as Nifty 50 & everything is calculated in the INR terms. The dividends are not included as it’s not the TRI data.

Let’s talk about returns first, I would use the rolling returns data and not the point to point returns as most of the articles and presentations are sharing. I am also going to look thorough the returns for a longer time horizon, Since Jan 2000 to Today a good 20+ years of history. One thing that flags from that analysis is that the last decade has been dominated by Nasdaq vs Nifty 50, though 2000-2010 has Nifty as a winner. Both these returns are in INR terms and do not include impact of Dividends. Overall If we take the Geometric mean of all the 1year rolling returns, Nifty takes the lead with 11% vs 8.6% of Nasdaq. Therefore, If the recent outperformance of Nasdaq is luring you to this fund beware of the lure. Please note that this is based on historic data so we do not know if this would hold true for Future or not.

In terms of risk, The returns of Nifty as well as Nasdaq has been quite volatile. Nifty returns have ranged between +99.4% to -55.5% vs the Nasdaq returns range of +95.5% to -64.3%. In terms of Max drawdown during the analyze period, Nifty had the worst drawdown of -59.4% vs -75.5% for the Nasdaq. Yes, That’s correct the Nasdaq had lost 3/4th of It’s value during the Tech bubble burst in 2000-01 period. In terms of Standard deviation, Nasdaq is slightly better off with 21.9% vs 25.6% of Nifty. Based on these data points, Nasdaq is less volatile but has higher drawdowns & swings to negative.

This does not make a great case for investment in Nasdaq 100 index as the mean returns are lower and risk parameters are comparable if not worse. Though we should not stop here on our decision, As I flagged in my article on Modern Portfolio Theory even if the standalone assets are risky the combination might have the diversification benefits. For e.g. I made the case to have gold in your portfolio for diversification benefit. In 2020, when markets had large drawdowns the rally in gold has cushioned my portfolio a lot and gave me confidence to deploy more money in equities at that opportune time.

Risk (Std Dev) on x-axis & Returns (Mean of RR) on y-axis

I am in awe of the above chart as it’s shape matches with the efficient frontier we have learnt during academic years. replicating something similar with real data & example is a great experience 🙂.

In the above chart, I have plotted 11 portfolio combinations, P1 is 100% Nifty to P11 is 100% Nasdaq. As you move across the Portfolios, you would notice that we would keep on reducing the volatility with increasing mix to Nasdaq and sacrifice some returns in process. This characteristic appears due to lower correlation (approx. 0.5) between these indexes rolling returns over the analyzed period. P4 (70% Nifty : 30% Nasdaq) has a similar volatility to Nasdaq index but adds +180bps on the returns, This means the investors should have higher exposure to Nifty to get a better risk adjusted returns. In real life, the correlations are not constant but dynamic and the realized benefit might be lower than expected as per the above chart.

Based on the above data points, I would say that Nasdaq is a risky proposition as an individual investment with higher drawdowns & lower mean returns for Indian retail investors like me & you . It definitely provides the diversification benefits but that would need an exposure of 20%+, If you plan to invest couple of % points or say 5-10% then you can give it a skip. We might be better off with taking global diversification using other options like S&P 500 or Developed world Index funds, though I have not analyzed so not recommending that yet.

Don’t jump on all the NFOs hitting the market, Follow the broad thoughtful portfolio which needs less changes to be a successful investor over a long term. Happy Investing!

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Mutual Fund

AT1 & Tier II Bond Risks hiding in plain sight!

“The best approach here, if at all possible, is to use supervisory and regulatory methods to restrain undue risk-taking and to make sure the system is resilient in case an asset-price bubble bursts in the future.” Ben Bernanke

I am a strong believer that the Indian financial regulatory environment is managed quite well. The way Indian banks are regulated and monitored, it has resulted in the history such that no consumer of a bank has faced the loss of capital over last 2 decades. Even though the bank failures/ mergers have happened, still it has been a largely salvageable situation. In recent times, banks like Yes bank or Lakshmi Vilas bank has gone through the restructuring and it has exposed one of the risk associated with the Additional Tier 1 (AT1) bonds. Recognizing the same risk, SEBI has come out with a proactive regulation to limit this risk exposure for Mutual Fund investors. This in my view, is a very welcome move as a regulator to protect the retail investors capital.

SEBI in it’s circular dated Mar 10, 2021 has addressed this issue. Currently, There is no limit on exposure to such bonds by AMCs in their funds. SEBI has prescribed that Any AMC should not own more than 10% of such instruments issued by a single issuer. Also, Individual Mutual Fund scheme shall not invest more than 10% of its NAV of the debt portfolio of the scheme in such instruments and shall not have more than 5% of its NAV of the debt portfolio of the scheme in such instruments issued by a single issuer. These are significant limits as in current situation there are 22 funds that have over 10% exposure to AT1 and perpetual bonds as on February 2021. (Source: Morningstar India) As per the regulation, the current exposure would be grandfathered and AMCs can make fresh investments in the perpetual bonds only once their exposure comes within the prescribed limits.

Though the clause of grandfathering would not be much useful for debt funds which have restriction on their Macaulay duration like Low/ short or Medium duration bond funds as per Oct 2017 circular by SEBI. As the AMCs have to value the perpetual funds with maturity of 100 years, the Macaulay duration is set to be changed drastically. Even though the clarification given on Mar 22, 2021 has updated the maturity applied to increase in phased manner, still the impact might be significant.

For e.g. the Low duration funds should have Macaulay duration of less than 1 yr. HDFC Low duration fund has exposure of 11.74% to perpetual bonds. One such bond is STATE BK OF INDIA 8.75% S-II perpetual bond. The bond has the issuer call option for Sep 2021, which means if issuer calls to redeem this bond it will mature is 5 months from today so it’s maturity is <1yr. Though if we have to calculate the Macaulay duration of this bond as per new regulation the maturity as 10years & expected YTM of 8.7% for AA+ category bonds, it comes out to be 7.06years. Therefore, 12% exposure in 7Yrs Macaulay duration would make the portfolio Macaulay duration of 12% * 7 = 0.84 and this means the fund should have the remaining 88% of the portfolio with maturity of <0.2years. This is quite difficult to achieve and the fund have to make lot of changes to adhere to the new regulation of valuation of perpetual bonds along with maintaining the Macaulay duration of <1yr.

As I have mentioned earlier (Investing in TINY world) that at present it does not make sense for having duration exposure in your portfolio. The current regulatory change would increase your exposure to interest rate risk. You should review your funds in your holding and probably opt for one of the actions as per me. Exit should be done in optimal manner to have lower tax/ exit load impact.

  • If the portfolio holds <5% of assets in form of perpetual bonds, you should not worry and consider the fluctuations in it’s NAV as part of market risk you have signed for
  • If the exposure is 5-15%, and your debt fund is of Low/ Short/ Ultra Short duration or 15%-20% in your Banking PSU/ Medium duration fund then there is problem as the fund has to value funds with assumed maturity of 10 years in short run. This will increase the interest rate risk as well as Macaulay duration of the fund so the fund houses might have to reduce the exposure. This would have an impact on NAV and if you have a really large exposure, you should contemplate reducing your holdings (Speak to your advisor/ distributor)
  • If your fund has >20% exposure & your have significant investment in such fund than consider to get out of such fund

It is important as an investor to understand such products in details. Attached link shares the details of such perpetual bonds, which clearly states its risk (refer the term sheet from page 78). These bonds are Non-convertible, Perpetual, Taxable, Subordinated, Unsecured. each term in it’s definition poses a risk. If you thought that the interest rate on bonds is higher and probably covers for the risk, I would recommend to read page 86 for Coupon Discretion & Page 88 for Loss Absorbency. The coupon is discretionary as well and if issuer needs to cancel the coupon, it can with no recourse available to bond holders. Hope this helps you understand the positive intent of SEBI to limit exposure to such bonds.

Lastly, Don’t just think that the regulation is going to impact just the debt funds. It will also impact your Hybrid aggressive funds as well. Even though there is no Macaulay duration limit applicable to such funds, They would have to comply with the 10% upper limit of exposure in the debt portfolio. In simple terms, I would interpret this as follows: “If the Hybrid Aggressive fund has 25% exposure to debt than no more than 2.5% of the portfolio should be in perpetual bonds.” If my interpretation is correct, this might be a bigger trigger of upheavals in aggressive fund category as all of the Top 3 funds (SBI Eq Hybrid/ HDFC Hybrid Eq & ICICI Pru Eq & Debt) by AUM have >3% exposure to perpetual bond funds. ICICI Prudential Eq & Hybrid has the higher exposure among the three funds 9.53% of the fund AUM as of Feb 2021. Similar would be the story in Balanced advantage funds or conservative hybrid funds.

In Summary, Please do no invest and forget your investments. Keep monitoring for the impact of such regulatory changes and make the necessary amends in your portfolio. If you find it difficult to monitor your portfolio at your end, speak to your advisor or distributor to understand such impacts or stick to simple products for investments which avoid such risks. It is your money and your responsibility to monitor the same. Happy Investing!

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