Monday, January 6, 2020

Can passive funds lead to wealth erosion?

In the first part of this note, we dealt with the nuances that passive funds introduce to the investment market and why they are preferred by institutional investors. We also discussed why incentives for individual investors differ from those of institutions and the contention that lower costs ensure better performance is a fallacious one.

In this part of the note, we discuss the factors which contribute to relative performance and the role that ETFs can play in the portfolios of different categories of individual investors.

The relative performance of an actively managed fund vis-à-vis the index depends largely on the constitution on the index itself and the performance of choices made by the fund manager. For example, as of December 8, 2019 the weight of Reliance Industries and HDFC Bank in the BSE Sensex is 12.42% and 12.00% respectively. In contrast, no actively managed fund can invest more than 10% of its portfolio in any single stock. Therefore, all actively managed funds are under-weight these two stocks because of the composition of the index itself.

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This note was published on on January 4, 2020

Why passive funds appeal more to institutions than individuals

The active versus passive debate has been raging for a while. Purists on both sides claim that their way is better and provide data which back their claims. One startling aspect of the debate is that most purists believe their side of the spectrum suits all investors equally. However, investor behaviour depicts a clear divide between institutions and individuals.

It is an undeniable fact that Exchange Traded Funds (ETFs) have been growing at a much faster pace than actively managed funds and consequently, commanding a larger share of equity assets managed by the MF industry. From a 0.5 percent share of industry assets on October 2014 to more than 6 percent in October 2019, it has been the fastest growing segment in the industry. In the past 2 years, it has accounted for more than 20 percent of industry growth. However, this growth has come largely on the back of institutional investments rather than those from individual investors, who have continued to invest in actively managed funds. And it is this dichotomy that needs further exploration.

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This note was first published on on January 03, 2020

The Bharat Bond ETF is not without risks

The Bharat Bond ETFs are here and those in the investment ecosystem in India can’t stop talking about them. Asset managers, advisers and the media have all expressed their opinion, which is largely positive and salutary.

The Bharat Bond ETF is, after all, a brand-new investment product; an option that investors didn’t have yet. It’s certainly different; but, does that make it necessarily better? Let’s take a deeper look.

How it compares with other options

The Bharat Bond ETF offers a unique combination of relative return certainty (if held to maturity), beneficial tax treatment (if held for more than three years) and liquidity (if one needs to exit before maturity – as the ETFs will be listed on the exchanges).

Returns from a bond instruments such as debt mutual funds, when held for at least three years, get taxed at a rate of 20 percent, with indexation benefits as well.

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This note was published on on December 16, 2019

Trade war: For countries like China, the free lunch is now history

In his 1997 article in the Journal of Economic Literature, famously stated that “The economist's case for free trade is essentially a unilateral case: a country serves its own interests by pursuing free trade regardless of what other countries may do.” This statement has become a kind of rallying cry for those opposed to the trade war initiated by the current US administration; proof that the trade war will hurt American interests in the long term.
And though Mr. Krugman, a winner of the chooses to stand by this statement, the trade environment in which this statement was originally made was an innocent one. It was an age when most participants complied with the rules of fair play that were established through practice rather than regulation. An environment which preceded China’s entry into the trade arena and its weaponization of trade.
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This note was published on on December 25, 2019

Increasing the efficacy of monetary policy

Another data point has been released with the rate climbing once again. And as expected, commentators are invoking the “stagflation” ghost. Meanwhile, the Reserve Bank of India (RBI) continues to chase completely dissonant goals, intervening to weaken the rupee even as they maintain a high level of real interest rates.
Monetary policy, especially when operating through the interest rate mechanism, cannot address emerging from consumption items in which demand is either price inelastic and/or interest rate inelastic. Consumption of these items is also called non-discretionary consumption because these items typically include only necessities. Any change in prices of these can cause brief deviations from their trend demand patterns, but not a change in the trend itself. As would be obvious, changes in interest rates do not have much of an impact on the consumption of these items. As such, it is unusual for to respond to changes in the price of these items because, well, it can’t do much about it. Higher interest rates do not have an impact on the demand for food and retail consumption of electricity.
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This note was published in the Business Standard on December 22, 2019.