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Want To Beat The Index? Then Read This!


Posted on 27-Sep-2019 Comments  0

Beating the Index

It is much harder to beat the index and index funds is the answer 

For a long time, India was the haven for active investing. There were a large number of promising mid cap and small cap stocks. Large caps were underpriced and fund managers had enough options to pick and choose stocks to beat the market. Investors often used to wonder how fund managers could consistently outperform equity indices in India when global fund managers were struggling. That trend appears to be coming to India too; as per Morningstar.

Tougher to beat the index

If you were take any equity fund and look at long period returns and then break it up into 5 year time frames, the results will be surprising. You will find that in the five years since 2014, funds have literally struggled to beat the index. Consider some statistics of the Indian equity large cap funds for the calendar year 2018. The difficulty in outperformance was most pronounced in the large cap category. For example, over a 1 year time frame, 92% of the funds failed to beat the indices as per a study by SPIVA. If you extend that investment time frame from 1 year to 3 years, 90% of the funds still failed to beat the index. That is a little more disconcerting. If you consider a slightly longer time frame of 5 years and 10 years, you will still find that over 60% of the fund managers are still finding it hard to beat the index. To that extent, mutual fund investing is more like tossing a coin. What does that mean?

Assets are converging

The big shift that happened in the last few years is that markets are becoming more of a beta market and less of an alpha market. Synchronized monetary policy followed by central banks across the world has led to assets across classes and also assets within classes converging a lot more. As a result, most of the market risks and the market opportunities are reflected adequately by the index itself. It is going to be very hard for fund managers to consistently beat the index, even in India. A bigger dilemma it will be for investors. When 90% of the fund managers have failed to outperform the indices in the last 3 years, what is the probability that the investor can select a fund manager who can outperform. It is actually as low as 10%. That is where passive allocation becomes a lot more relevant. 

Look for passive opportunities 

If you have been wondering as to why index funds are such a big attraction in Western countries, this is why. It is practically very hard to beat the index on a consistent basis. But it is a lot more difficult for investors to identify such funds that can beat the indices on a consistent basis. A simpler answer would be opting for index funds or index ETFs. Over a 3 year period, you know for sure that you stand a 90% chance of doing better than active funds. That passive trend is finally coming!

Standstill Pacts

SEBI is right in coming down heavily on MF standstill agreements

Speaking at a conference organized by a leading industry association, the SEBI had come down heavily on standstill agreements signed between mutual funds and borrowers. The SEBI chief rightly underlined that there was no provision in the SEBI MF regulations for such standstill agreements and asked mutual funds to make appropriate disclosures and provisions. Here is why this really matters.

Being more accountable

The SEBI chief was obviously talking with reference to the deal between the Essel Group and a clutch of mutual funds. These MFs, through their FMP schemes, had bought into bonds issued by Essel group companies. As an added surety, the promoter had also offered his personal shares as pledge. That is where the problems arose. This was more of loan against shares and SEBI felt that MFs were behaving like banks without the accountability of banks. The situation got exacerbated when the promoters of the Essel group could not honor the standstill agreement as on September 30th and asked for another extension of the standstill agreement till March 31st. While some funds have agreed to it, other funds have chosen to sell out; and rightly so. It is here that the SEBI chairman has expressed his unhappiness with the opacity of the standstill process. The SEBI chief rightly underlined that such agreements were outside the purview of SEBI.

Case against standstills

The SEBI chief has made two very important arguments against standstill agreements. Firstly, Tyagi has argued that standstill agreements are an unregulated way of postponing the issue. NAVs are supposed to reflect the market value of the portfolio as close as possible. However, when such standstill agreements are signed they do not reflect the fair value of the portfolio and to that extent they amount to value distortion. Secondly, SEBI feels that side-pocketing is a legitimate solution where the good portfolio is continued and the toxic portfolio is side-pocketed. This allows MFs to participate in ICAs but most MFs have not been too happy with the idea of side-pocketing.

Postponement is default

It is in this light that SEBI has modified this aspect of MF regulations. Under the new scenario, it is clear that any such standstill agreement will be treated as the equivalent of loan ever-greening. That means; the MF will have to make an immediate provision for default and adjust the NAVs accordingly. As SEBI rightly put it, such ever-greening tends to project the wrong picture of credit risk funds and make them look safe. The fact that promoters have asked for extension of standstill means that it was a wrong decision in the first place. After all, MFs owe their primary responsibility to unit holders and not to borrowers!

Vulture Funds

Why RBI must be careful about vulture funds buying Indian NPAs

In the last few weeks, there has been a lot of interest shown by international funds to participate in distressed assets of banks. Despite all the provisions and the NCLT process, Indian banks have close to Rs.11,00,000 crore ($150 bn) of NPAs in their books. Not all these are bad and some may be substantially recoverable. These are just NPAs that adhere to the RBI norms for making provisions. It is here that the markets appear to be quite excited about these new animals called distressed funds.

Enter vulture funds

Globally, these distressed funds are also called vulture funds; although the name may not look alluring. Like the vulture that feeds on the dead, the vulture funds also buy distressed assets at a huge discount and then look to hive off this portfolio at a neat profit. Different vulture funds have different models like equity participation model or leveraged models etc. The bottom-line is that these vulture funds look to provide an immediate exit from the NPA mess and allows the bank and the shareholders to appropriately monetize these locked up assets. Vulture funds would again pick and choose assets because they may not be keen on assets that are too sticky. These vulture funds have a role in the sense that they help the banks to put a value to their assets and also to quickly monetize the same. However, in the Indian context, it is essential to be a lot more cautious about vulture funds.

Asset stripping is a risk

India needs to tone down its enthusiasm about such vulture funds. There are two big risks with such vulture funds, as has been seen in the context of the West, where such models have been applied in the past. Firstly, vulture funds tend to be choosy about the assets they will select. So, banks will not be able to hive off their NPAs as a basket but allow these vulture funds to pick and choose. Obviously, these funds will pick the more promising NPAs leaving just shells behind. Secondly, some vulture funds will show interest if they are able to carve these NPAs into a separate entity and get further funding. This will also mean loss of control for government.

Creates market volatility

But the bigger risk is that these vulture funds or distressed funds substantially add to the volatility in the markets. Here is why! Firstly, when these vulture funds do the due diligence on bank NPAs, they have the opportunity to take contrary positions in the F&O market. This can distort the price and add to unnecessary volatility in the markets. The second risk arises from the fact that most of these funds tend to be heavily leveraged. So time has a huge cost for such funds. That means; they will strip good assets and make an exit rapidly so that waiting costs do not add up. This creates huge volatility. Hence, we need to be a little more tempered in our enthusiasm!

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