Tag: mutual funds

Mutual fund portfolio overlap and Active Share

There is a problem of plenty when it comes to mutual funds – direct growth schemes alone number into the high 200s. Investors have responded to this bewildering array of choices by going in for the ‘unlimited buffet’ option. They end up making small investments into a large number of funds. By doing so, they end up owning the whole market – paying active management fee for a passive investment. There are two things investors should keep in mind before adding a new fund to their investment:

  1. What is the new fund’s portfolio overlap with the existing investments?
  2. How different is the new fund’s portfolio from a large-cap and mid-cap index?

The first answer will tell you whether to add the new fund to your portfolio. The second will tell you if you should just replace the fund with an index ETF.

For example, say you own HDFC Mid Cap Opportunities and you are wondering if you should also buy the Birla Sun Life Midcap fund. Here’s how the fund portfolios overlap:

The funds have about 18 stocks in common and a fairly large number of stocks that are not in any of the indices. Given the differing styles, perhaps it makes sense to add the new fund to the portfolio.

The second, also called “Active Share,” shows how different the portfolio is from an index. For example, DSP Blackrock Technology.com Fund has a 26% overlap with NIFTY 100 and a 5% overlap with NIFTY MID100 FREE. Whereas, the HDFC Large cap Fund has a 95% overlap with the NIFTY 100 index. It probably makes sense to replace the latter with an index fund.

For more details about the analysis and its results, please peruse the notebook on github.

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Replacing Mutual Funds with ETFs

Last month, we took a stab at measuring a fund’s alpha over a basket of ETFs (link.) The rationale was that the index often chosen by the mutual fund is not easily accessible to the investor. We saw how mutual fund alpha varies over time. We then asked the question: What if we just invested in the basket instead of buying the fund?

We did a study of the top 10 equity mutual funds by AUM back in March-2011 and found that 4 out of 10 funds under-performed their ETF baskets and 2 out of 10 funds could be replaced by an ETF basket without compromising too much on returns. That is, only 4 out of 10 fund out-performed the ETF basket setup for them.

The code, inputs and results are on github.

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Fund Alpha Over ETF Baskets

A fund’s alpha – returns over a benchmark – is often quoted and widely misunderstood. The root of the misunderstanding comes from investors assuming that alpha is a constant – which it is not – and the funds using benchmarks that the investors cannot actually invest in. Even if an investor decides to go “passive,” there is still an active choice that needs to be made regarding the basket of ETFs he needs to invest in. Let’s answer the first question: What exactly is the active manager’s value add?

Alpha over a basket of ETFs

We select three ETFs, NIFTYBEES, JUNIORBEES and M100, since they are popular and span a fairly decent spectrum of traded stocks in the market. Then, we do a rolling (window of 200) linear regression of returns over 200 days of a few midcap funds (selected at random.) The intercept is the alpha of the fund vs. the ETFs. Here’s how the alpha varies over a period of time:

Two out of the three funds have negative alpha over the ETF basket right now. However, that doesn’t mean that they will stay there.

As an investor, you can use the betas obtained by the regression over the ETFs to “replicate” the fund at a point in time. For example, if you set the start date as the date at which each of the funds had peak alpha and just held onto the basket, here’s how the relative performances look:

In all cases the basket fixed at the peak performs at par or better than the fund. However, you never really know what the “peak” is when you are living through it. What if you fix the basket right at the beginning?

In two out of three cases, we see funds beat ETF baskets.

Summary

  • We use linear regression to measure a fund’s alpha over a basket of ETFs.
  • Alpha varies over time. Out/under performance is sensitive to begin and end dates.
  • If a fund’s peak alpha can be pegged, then a basket of ETFs with those betas will outperform the fund.
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The MNC Fund Gravy Train, Part II

We had discussed how MNCs listed in India have outperformed pretty much every benchmark (here, here.) However, there are are a few dark-spots in an otherwise solid long-term investment thesis that are worth discussing.

The benchmark

The NIFTY MNC benchmark index had two drawbacks:

  1. It is based on free-float market cap and the float keeps shrinking because of buy-backs.
  2. It does not include dividends which are a huge component of returns in this asset class.

For example, Unilever bought back more than $5 billion of HUL’s float [stockquote]HINDUNILVR[/stockquote] in 2013; OFSS [stockquote]OFSS[/stockquote] payed out Rs. 485 per share as dividend on September 2014. The stock was trading around Rs. 3960 at that time – a yield of ~12.25% that is not captured by the index.

If you compare just the NIFTY MNC index to other NIFTY indices, it doesn’t look so good:

MNC.returns

Annual returns:
mnc returns

As you can see, all though the MIDCAP index is volatile, it offers returns an order of magnitude greater than the MNC index.

However, this is the index that we are talking about.

MNC Funds vs. Midcap Funds

For a true apples-to-apples comparison between MNCs and Midcaps, we should look at the funds that reference them. This takes care of the dividend reinvestment and vanishing float problems of MNCs. But creates another problem of having to adjust for alpha, but we will ignore that for now.

Let’s compare the BSL MNC fund vs. BSL Midcap Fund:

MNC.vs.MIDCAP.fund.returns

On a cumulative basis, the MNC fund as beaten their Midcap fund… with shallower drawdowns to boot:

MNC.vs.MIDCAP.fund.drawdown.p2p

Given the past performance of the MNC asset class, we had recommended BSL’s and UTI’s MNC funds to investors. However, we had not considered a googly being bowled by the parent companies.

Key Risk

The biggest risk with MNCs is not quantitative but qualitative. Their parent companies do not want the hassle of going through listed India subsidiaries. It is easier to invest in new projects and expatriate profits if they did so through a wholly owned subsidiary rather than a listed one. Key examples:

  1. Suzuki directly set up a factory in Gujarat and Maruti will “buy” cars from the new plant (IiAS.) [stockquote]MARUTI[/stockquote]
  2. Cummins “rationalized” their manufacturing facilities (IiAS.) [stockquote]CUMMINSIND[/stockquote]
  3. In FY15, 32 MNCs paid out an aggregate Rs. 63 bn, which was almost 21% of their pre-royalty pre-tax profits (IiAS.)

It looks like minority shareholders are getting shafted by the parent. The listed companies are being ‘hollowed out’ and turned into mere marketing outfits that command a significantly lower valuation in the markets.

If you are an investor in MNCs as a distinct asset class, it is time to work these risks into your future return expectations.

The R source code for this analysis and charts can be found on GitHub.

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Update 1: Mid N Small vs. Value Discovery

Back in January last year, we had taken a brief look at Invesco’s India Mid N Small Cap Fund and ICICI Prudential Value Discovery Fund and concluded that even through Religare is marginally better than ICICI, there was nothing there to swing the decision one way or the other. Here’s an update:

Between 2015-01-01 and 2016-08-11, Invesco India MID N SMALL CAP Fund has returned a cumulative 12.59% with an IRR of 7.64% vs. ICICI Prudential Value Discovery Fund’s cumulative return of 12.99% and an IRR of 7.88%. (http://svz.bz/2bf7jzy)

In terms of performance, they are still on top of each other. However, Value Discovery has had shallower draw-downs, making it an easier fund to hold.

Invesco India MID N SMALL CAP Fund and ICICI Prudential Value Discovery Fund drawdown

Invesco’s fund is way smaller than ICICI’s. For those who prefer a smaller fund, Invesco’s would be a way to go. However, overall, the status quo remains.

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