Mutual Fund

Investing in a T.I.N.Y. (There is No Yield) World

“Every portfolio benefits from bonds: They provide a cushion when the stock market hits a rough patch.” – Suze Orman

Indians are obsessed with fixed deposits. As per the latest data by RBI, 55%+ of financial assets by Indian households are held in form of deposits with banks. In the recent years the rate of deposits have come down drastically, 2years back I was able to make the deposit with the bank @8% returns but now that interest rate has come down to ~5%. The fixed deposit investors are out scouting the other better avenues and Debt Mutual funds are getting explored by many. We can not deny the importance of Debt as an asset class in our portfolios but managing it well is also very important. Today we will try to workout, possible good alternative options to build the debt exposure using Mutual Funds.

Though First thing first, Should you opt for Debt Mutual funds or not. This point need more attention and I tried to cover a lot over the last two years in How to Build the debt fund portfolio.

  • If you are employed individual investor and investing for retirement goal, EPF should be your go to option. You can increase investment by using VPF & Yes, even after the new rules of tax on contribution in excess of 2.5lacs per year will attract tax on gains
  • If you are investing for your 15-20 year horizon, PPF is next universal venue available to every resident to invest up to 1.5lacs. Married couples can have separate PPF accounts to invest up to 3 Lacs each year
  • If you have daughter of age <10yrs, you can also opt for Sukanya Samridhi Yojana. Even though the maturity profile is 21yrs, but at 18yrs you can take some amount out
  • For elder citizens >60yrs, There are couple of more relevant options for them in form of Senior Citizen Saving Scheme (SCSS) & Pradhan Mantri Vyay Vandan Yojna (PMVVY)
  • If you are in lower income tax bracket of <=10% then it is ok to stay with your traditional options of NSCs, Post office Investing. There is no point of adding risk to the portfolio for smaller gains

If non of the above criteria are met or options available, Which means you have short terms goals up to 10-15 years or your income tax rate is higher and for higher savings requirement you need to add exposure to debt in alternate options. Let me clarify that investing in endowment insurance plans with higher premium is not a wise choice. Mutual Funds are good tax efficient options to manage for such goals specially for people with higher tax slabs.

Before we try to zero down on the category of funds, Let’s understand the two main risks associated with Debt funds; Interest Rate Risk & Credit Risk (For more details: Check This). There are 16 main debt fund categories as per SEBI Guidelines, I have tried to map these on broad basis across the two axis with increasing credit risk (Left to Right) and interest rate risk (down to up). The fund which is farther from the origin have the highest risk, in below map credit risk funds have higher risk of default and also have interest rate risk. Gilt funds invest in bonds from Govt of India with assumed no default risk but they rank higher on the interest rate risk, while the Overnight funds have the lowest form of interest rate risk as well as credit risk. The chart is median presentation so you will have funds in each category which have higher credit risk vs others, so one has to manage and monitor their funds exposure regularly.

After the IFLS, DHFL & Franklins episodes of credit risks in 2018-2020 period, The credit risk funds have been discarded by the investors. Lot of Advisors & Distributors have also become risk averse and prefer advising for funds like Liquid funds, Low/ Short duration funds in majority of the cases or for longer time horizons 8-10yrs or more suggest to invest into Gilt funds to avoid credit risk. Let me state that I am against the suggestion of investing in Gilt funds for Investors who do not manage portfolio regularly.

Gilt funds (Grey bars) vs Money Market Funds (Golden bars)

Check the above chart you can change the reference to Money Market funds return vs Gilt funds returns. You will notice that for multiple period the return of gilt funds go for negative or near zero returns as well as to high double digit returns. Though over a period of last 20yrs history the mean return has been 8.1% but have a high volatility (STD Deviation) of 6.5%. More often, I find people jump off the ship in the period of zero/ negative returns. While the returns of Money market funds over last 20yrs have the mean of 7.3% with lower volatility of 1.5%, Returns have stayed in the zone of 5% minimum to 10% maximum. Therefore, If you do not time your purchase of gilt funds then you might be up for a bad experience in investments. There are portion of interest rate cycle, where investing in gilt funds can be rewarding. Lot of investors, look at the recent history of fund returns while buying the fund which is quite a wrong approach. I discussed the steps to analyze the Yield to Maturity (YTM) of the bond funds in Debt Funds 2.0.

We can time the bond funds by following the interest rate cycle. Two things are required to time, One is our position in the interest rate cycle and another is the modified duration of the available funds. My assessment of interest rate cycle is that we are almost at the near bottom there is very less chance of the further decrease in the interest rates but might increase by 1% or more over the next 2 years. Also the possibility of increase is more certain (Which could be delayed or accelerated by RBI) because of below three pointers:

  • Restoration of cash reserve ratio (CRR) dispensation of 1% of net demand and time liabilities (NDTL) given last year to be unwound in 2 phases of 50 bps each beginning late March and late May
  • Additional 1% of NDTL dispensation given on statutory liquidity ratio (SLR) for availing funds under the marginal standing facility (MSF) extended by 6 months to end in Sep
  • Held to maturity (HTM) hike of 2.5% for SLR securities acquired between September – March, now extended by 1 year to 31st March 2022. Accordingly, eligible SLR securities are now expanded to include securities acquired over FY 22. Importantly, this relaxation will now start unwinding from the quarter ending June 23

To assess the impact of such interest rate increase, you need to check the modified duration of the fund which is published in the fund fact sheet as well as can be accessed on portals like Value Research Online etc. Let’s take an example of gilt fund (Axis Gilt fund), It has given a fantastic return of 12%+ over the last one year. Though if you will check the details, It has a YTM of 5.9% with modified duration of 7.2yrs. If the interest rate increases by 1% over next 12 months, The bond value will decrease by 7.2% and this will result in negative returns (+5.9% – 7.2*1%). If the interest rate increases by 0.5% then also the returns will be very low (+5.9% – 7.2*0.5%). Therefore, It is essential to have funds with lower modified duration & High YTM with lower risk exposures. As the fund like Money Market will buy the new bonds to replace the maturing bonds with bonds of increasing rates, the overall return of the fund over next 3-5 years will be better vs Gilt funds.

Lastly, If you do not want to time the interest rate cycle then that is completely fine. The funds category I have flagged in the center of the Risk Map are evergreen from my point of view (Corporate Bond funds, Banking & PSU funds and Medium Term Debt Funds). Over the last 20 yr period the mean returns of fund have been 8.4% for Medium term bond fund with 4.5% volatility (Higher return vs lower risk in comparison to Gilts). One can buy a good fund from this category and stay invested for long term. In Summary, If you are investing new money into debt funds then stick to Money market or Low duration bonds funds at present to avoid the impact of interest rate risk.

Let me know in case of any questions or feedback. Till next, Happy Investing!

Mutual Fund

Rise of Indexing: The Tale of Diminishing Alpha!

“By periodically investing in an index fund, the know – nothing investors can actually outperform most investment professionals.”Warren Buffet

Summary:

  • This article is part of series on mutual funds, where we discuss and analyze the queries we receive on various investing approach
  • In Investing there are no absolute answers therefore it is important to keep our approach adaptable and mind open enough to embrace for the new approach
  • We analyze both the quantitative and qualitative aspect to help you take the informed decision by understanding the possible pros & cons of your choice

In 2018, I have flagged that one should have the Core portfolio of funds for long term and suggested the options of Large Cap, Index funds, Multi-cap Funds or Aggressive Hybrid Funds. Though we have constantly getting the request to confirm that most people have been suggesting to opt for an index fund, is that a right approach? I have also noticed over the last few months that Index funds have become the main choice of advisers in India market. Is that because of their recent superior performance or some other reasons? I am not sure but we will try to figure it out in today’s article. The whole premise of suggesting the index funds is based on the pillars of below arguments:

  • The Low cost of Index funds vs active funds makes is difficult for active funds to outperform the index consistently
  • There is no consistent way to identify the best fund for future based on it’s historic data
  • The number of active funds out performing the index funds are <50% in most years
  • You can not predict the market returns of future so the best approach is to take the index fund and be happy & probably few more…

Indian mutual fund industry has grown to US$ 400bn+ in terms of assets under management (AUM), Though the AUM of equity funds is still less than half (<US $ 170bn). The Top 3 equity categories by AUM are the ones suggested for the Core Portfolio; Large Cap, Multi-cap and Aggressive Hybrid Equity. These categories contribute 36% of the equity AUM in the mutual fund industry. For today’s analysis, we have taken Top 5 funds based on AUM in each category to compare with the Top 5 index funds.

We have used Regular funds for analysis so we have the longer history available for analysis. We looked at the data from Jan 1, 2010 to Dec 23, 2020 for almost 11 years. The Index funds used are mostly large cap indexes due to the longer data history availability, we do not have Nifty 100 or Nifty 500 Index funds with longer history available.

Returns: In my personal experience one thing I have realized is that the quality of advice is always measured by the returns in the end by investors. No matter how much awareness, industry has brought towards other parameters returns still probably remain the most influential parameter. Let’s analyze our funds on this parameters. If we have invested 10,000 in any of the mentioned funds below is the comparison of final value investment in the Large cap funds & Index funds:

Based on the above chart, you can see that the investment in any of the active fund would have outperformed the investment in index fund. All the values are already post expenses so yes absolute gains. All three categories of large cap, Multi cap and aggressive hybrid funds have outperformed the index funds. (The similar conclusion was published in March 2020 in HDFC Hybrid Equity.) Though before you conclude that active funds always outperform, you should note my protest against using the words “Always” or “Consistent” as there is no constant in Investing world.

The landscape of Mutual fund industry is continuously evolving with new regulations, the limits have been placed for each category of funds investible universe, which makes it difficult to outperform the indexes. It is important to understand the trend of returns, for which I looked at the one year rolling returns of the active funds and compared them with the rolling returns of index funds. Below chart shows the trend that active funds have outperformed the index by large margins in the period 2013-2015 but in other years their returns were closer to index funds with +/- 5% of index returns. “In conclusion, we can not say that active funds outperform or underperform the index funds consistently.

Risk: Any investment decision should not be purely based on returns but the returns in reference to the risk fund has taken. Also, how the fund has fared in bull & bear scenarios. We need a fund, which gives us better returns in bull scenario, saves us in bear scenario and matches the index in normal course of period. Looking at the below table, you will notice that the Standard deviation of index funds has been lowest. In terms of maximum return on a one year rolling basis, Multi cap funds top the chart and in adverse scenario Aggressive Hybrid funds have the lowest -ve returns. In case of maximum draw down also, Hybrid Aggressive funds take the crown. Conclusion based on the below historical data is “Active funds have higher volatility/ risk though the higher risk is translated into the better mean returns.

Alpha: If you have your basic knowledge of investments in place and you want to trounce me for calling the Alpha as difference in returns of active funds vs index funds, Let me remediate the problem. We have discussed earlier the Capital Asset Pricing Model and for sake of simplicity assume that beta is the only factor. If we adjust the returns of the funds for beta & calculate Alpha, the results do not change drastically. We still have the periods of outperformance by active funds and periods of underperformance, though the both sides becomes equally likely and symmetrical. This is where most of the index proponent will thump the table & conclude “If we adjust for the additional risk taken by active funds, their outperformance is simply by luck similar to a coin toss.

Based on the analysis so far and looking at the quantitative factors, There is no absolute advantage of active funds over passive funds. Though the suggestions by advisors or other investors for a particular category of funds is more emotional in nature. The researchers found that, following a competition, athletes who won bronze appeared to be significantly happier on average and that silver medalists: “They compare themselves to the gold medalist and thereby think of what they didn’t achieve; the bronze medalists also focus on what didn’t happen: They didn’t come in fourth and fail to get a medal”. (Link) Since most of the people investing or advising active funds put lot of effort in selecting a good fund, they inherently expect their fund to be the best performing fund and are open for disappointment if another fund generates better return.

Let me summarize my recommendation based on the above analysis:

  • There is no sure shot way to find the best return generating fund, which consistently outperforms the Index on risk adjusted basis. (Yes, Accept this)
  • There is no point of jumping between the active funds for better returns, You might get lucky but chances of lagging the mean performance will increase for the people jumping between the funds
  • Advisors of Index fund can never be blamed as their suggested funds will mirror the index returns so no questions or large underperformance. (Advisor never wrong is a great advisor)
  • If you want to simplify your portfolio decisions, Indexing is a simple approach as you can save all the time you spend on searching the best funds and use that time to grown in your career or spend the time with family/ friends or take care of your health. Always remember, “The time in the day is finite, be mindful of how you spend it
  • A better way to get additional risk adjusted returns is by managing the Asset Allocation and re-balancing the portfolio regularly
  • If you can control your monkey mind and not lose your sleep by comparing the performance of your fund vs other funds then It is completely fine to buy a decent active fund and stick with it for long term to reap the benefits. In the end, higher volatility is a temporary risk which reduces with investment horizon

I, Personally, have been an investor in active funds and primarily into the aggressive hybrid funds. The main reason of mine is three fold; I love the whole process of analyzing the funds/ creating the portfolios, Over the long term the higher mean returns will stick but the volatility would reduce and lastly, I only lose sleep if my portfolio is accruing absolute large losses which are relatively protected by Aggressive Hybrid funds. Now going forward the alpha of active funds might diminish but as I often say, “When the facts will change, I will change my approach.” Till then, Active Investing is good for me.

In personal finance, your investing approach should personal than just following the rational best approach. Do write to us or comment about your preference of active vs passive funds and it’s reason. Happy Investing & Happy New Year!

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