The Hindu Business Line : Active funds: Style drift, benchmark pose problems

Readers of this column know that we often discuss the importance of index funds as part of the core equity portfolio framework. Several investors have questioned this approach, stating that diversified funds are better, as they typically beat the market index. Why then do we consider index funds? The article dated March 29, 2009 discussed style mandates and management expense ratio to explain why diversified funds are not optimal for the core portfolio. We continue the argument, citing examples across asset management firms to illustrate the point.

Fund offerings

Constructing a suitable core portfolio using active funds can be quite demanding for investors. Here is why.

One, some funds use broad benchmarks for their diversified funds. HDFC Capital Builder and Franklin India High Growth Companies Fund, for instance, are benchmarked to the S&P CNX 500.

A fund can adopt such broad-based benchmark if it does not carry any style bias. Empirical evidence, however, suggests that all fund managers carry style tilts.

Morningstar, for instance, benchmarks HDFC Capital Builder to the BSE Midcap Index, as it believes that the fund has a mid-cap tilt. A broad fund mandate, however, gives the portfolio manager the right to have large-cap bias at a later date.

What if the fund changes from mid-cap to large-cap tilt after an investor takes exposure to it? Such a style drift would overexpose an investor to large-cap stocks, if her portfolio already has a large-cap fund.

Two, lack of appropriate investable style benchmarks makes it difficult to evaluate a diversified fund’s performance. Birla Sun Life classifies its GenNext Fund as large-cap, mid-cap and small-cap blend style. Yet, it is benchmarked to the S&P CNX Nifty.

ICICI Prudential Dynamic Plan according to its investment objectives “… captures upside opportunities across value and growth, large and mid-cap, index and non-index stocks.” This fund is also benchmarked to the Nifty Index.

If the benchmark does not clearly capture the portfolio manager’s investment process, against what is the fund’s return supposed to be measured?

An appropriate benchmark is important because active funds charge higher management fees for beating the benchmark index.

Three, several diversified funds choose the BSE 100 and BSE 200 as their benchmark index. The Reliance Vision Fund and the Reliance Growth Fund are instances. The BSE 100 and 200 are not style-specific indices. Rather, both contain large-cap and mid-cap stocks across growth and value spectrum. Taking core exposure to such funds would blur the distinction between the core and the satellite portfolios. For, both portfolios would then be actively managed within the same universe of stocks.

Finally, fund houses typically offer active funds that carry similar investment objectives. Kotak 30 and Kotak Select Focus are both large cap funds.

Investors may find it difficult to discern differences among funds with similar strategies and construct meaningful portfolios of such funds.

Conclusion

Index funds do not suffer from the above shortcomings. They do not have style drifts. Nor are their benchmarks ambiguous. But why take exposure only to large-cap index funds?

The reason is that large-cap stocks are well-researched and widely owned. The large-cap active funds, hence, find it difficult to consistently beat the Nifty or the Sensex. That is why the core portfolio often carries a passive exposure to large-caps through index funds. An index fund benchmarked to a broad index such as the S&P CNX 500 is optimal too.

The risk-return characteristics of mid-cap/small-caps are different. Skillful managers can beat the appropriate benchmarks through security selection and market timing skills, as this space is relatively under-researched. Pure mid-cap funds may, hence, be considered for the satellite portfolio, which is constructed to beat the benchmark index.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at enhancek@gmail.com)

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