‘We don't think ETFs are great products'

Whether it is launching India's first direct-to-investor mutual fund, with no distributors, or taking a road trip across seven cities to meet investors, or picking ‘boring' stocks that turned out to be saviours during the 2008 market correction, Ajit Dayal , Chairman, Quantum Asset Management Company likes to take the road less travelled. In his usual forthright manner, he spoke to Business Line on a range of issues from the mid-cap underperformance to why ETFs are not great investment vehicles.

Excerpts from the interview:

With market movement increasingly defined by FII flows, should it be the key factor that investors should watch out for?

We tell investors that there are two things happening in India. One is the under-lying value of businesses, which is a function of what happens in the Indian economy. It is not a function of what happens in other economies such as the US, Europe or Japan.

Two, the price at which you can buy those shares, which is the function of external events such as the US fed rates and the risk and fear factors of investing in the emerging markets.

So there are two dynamics, one tectonic plate is giving you appreciation because of GDP growth, which really is a summation of better industrial activity in some sense. I don't see this changing.

But we have no idea on what is going to happen with FII flows. Tomorrow if the US increases interest rates to 6-7 per cent for a 10-year treasury, FIIs will take their money from all the emerging markets and put them in their bank deposits. If they did that, stock markets in India and all emerging markets can collapse.

In what sectors do you currently see value?

We are totally agnostic of sectors. We only see value on a bottom-up basis. It looks like we are overweight on consumer discretionary, underweight on oil and energy and have nothing in healthcare. That is purely on account of valuation. It is not that we do not like healthcare. The stock has to be at the right value.

Is there a case for investing in mid-caps now, with valuations looking more compelling?

From the time we launched our fund in 2006, our track record indicates that we have done better than the BSE-30 index as well as the BSE Midcap index. If the Sensex gained 11-12 per cent compounded annually during this period, the BSE Midcap index gained only 5.5 per cent. This is despite taking higher risks in mid-cap stocks given that there are still untried companies to a large extent. So 6 per cent less returns for being in mid-caps is a huge price to pay.

That said, valuation is a function of many things. One is the quality of the management and the survivability of the business. At the current juncture mid-caps deserve to be cheap. We haven't found a way to beat the Midcap index or, for that matter, our own Quantum Long Term Equity fund through holding a mid-cap portfolio.

But mid-caps did see some bounce-back for a while?

We did see a spike in small- and mid-cap stocks between September 2010 and November 2010; but then, again, they are function of money flows. You see that the index and large-caps are expensive, so you buy the cheap stocks. So money flow goes to the mid- and small-cap stocks, leading to a spurt in prices, as was the case in September 2007, and then again in November 2010.

But as the money goes back or the money unwinds, mid-caps are back to square one. So mid-caps from that time lost 24 per cent, whereas the main index lost 12.3 per cent. FII flows influence the price of mid-cap stocks more than the BSE-30 stocks.

If beating the index is becoming difficult, would ETFs make for a better choice?

We don't think ETFs are great products. And what is the rationale behind ETFs? It's easy investing and you mirror the index. The other rationale is that only one out of three actively managed funds actually beat their benchmark index.

By definition, if your underlying index is BSE-30 or BSE-100 or whatever, if the index-keepers are changing the index constituents, you would have to mirror the index. However, the cost incurred by you as the index-tracker is high if there are too many changes in the constituents.

Take the case of BSE-200, where 32 stocks went out and also entered in 2000. If you are an index tracker you too have to take the 32 stocks in and out, besides rebalancing the rest of the index constituents to reflect the new weights. So you have to sell these stocks, pay brokerage, pay securities transaction tax on these new stocks as well on the those that need to be rebalanced. So you are perhaps doing more than 100 transactions because the weights change.

When Satyam was removed in January 2009 and replaced with Sun Pharma they did not replace the latter with the same weight as that of Satyam. It came in at a different weight; therefore, the weights of the other 29 stocks had to change. After 15 years of starting an ETF, I can bet that the tracking error will only widen because those costs will keep on compounding.

What is the case with international ETFs?

In developed markets the index constituents don't change as often as our indices. In US, if the Dow were to change its index constituents, it will be after many debates and discussions. Here, even the S&P CNX Nifty, which is a more modern index undergoes an average of about 10 per cent changes in a year.

The normal weights of the basket changes because of stock market price action and you have got to mirror that, whether it is our index or any global index everyday. But there is the extra rebalancing that has to be done as a result of taking out stocks frequently in the case of our indices.

What is your view on investing through IPOs?

Who wins the IPO mandate? The investment banker who offers a higher valuation. So, it is in the interest of the company and not the investors. I think IPOs are fundamentally built and priced against the investor. Unless you are aware of that, you may always lose money on IPOs, in general.

Much of the IPO market is actually a venture capital market. Each time the market gets hot, IPOs queue up. We, as a fund house have not subscribed to a single IPO, as valuation does not work in favour of our client's money.

Would commodities make for good investments now?

Gold may be a good commodity to hold. In fact, it is a better currency. An ounce of gold would have bought you $31 on August 15, 1981, the date President Nixon de-linked the US dollar from gold. Today, an ounce of gold is worth $1440. So the US dollar has lost 98 per cent of its value in the last 40 years. That's a huge loss for the world's strongest currency.

And no currency in the world has done better than gold. No paper currency has existed for more than 100 years in the history of mankind. Therefore, if you are looking at a hedge against inflation or a store of value, it has to be gold. Even when gold was at $300 in the year 2000, the dollar had lost nine-tenth of its value against the gold.

Gold won't move every year as it is not a productive asset. You cannot hold gold for dividends but it will give you protection against the capital value of what you want to buy. That's why you buy gold.

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