Does investing in actively managed mutual funds make sense?

Actively managed mutual funds are supposed to beat their benchmark indices. If the index returns 10%, an actively managed mutual fund should return more than 10%. Similarly if the index loses 10%, the fund should lose less than 10%. You pay a small management fee to the mutual fund for managing your money and outperforming a benchmark index. Else why them money for their services; you could well buy an index fund which is passively managed.

For the uninitiated, in an actively managed fund, the fund manager creates a portfolio and buys and sells stocks depending upon his/her judgement, experience, ability and skill. In contrast, in a passive fund, the portfolio mimics a particular index, the stocks and the percentages in the portfolio are the same as those in the benchmarked index.

So do actively managed funds actually beat their respective indices?

Consider the Nifty-50 index that comprises 50 large cap stocks.

Over the last 3 years, the Nifty has risen at 23% compounded (as on 22 August 2008 day end).

Over the same period, only 22 out of 108 diversified equity funds that have existed for more than 3 years have given a return higher than 23%!

86 out of 108 funds have not been able to beat the Nifty index.

That's 80% of all such funds!

So why should the management fee be paid for managing money?

The percentage is similar for returns over 1 year. 82% (152 out of 184) diversified equity funds could not even garner a return of 5.1% given by the Nifty.

There are reasons for such underperformance. But the end result is, that over the last 3 years, 80% actively managed diversified mutual funds have not been able to beat the common index.

A similar trend exists in developed markets as well. For example, in the USA, 80% funds fail to beat their benchmark indices.

Mutual funds often become victims of their own success. When a particular fund outperforms, a lot of fresh money flows into it, chasing past performance. With larger assets under management, maintaining the same level of performance becomes difficult.

When mutual funds as an industry becomes too big, they tend to become a sizeable portion of the markets themselves. It then becomes difficult to beat the market since mutual funds start representing, in a very significant manner, the market itself!

Add to that the management fees and transaction costs. That takes away a little from the returns. At least in India, management fees are small. In the USA, this is not always the case.

The famous investor, John Bogle, an ardent advocate of index funds and does not think actively managed mutual funds can outperform an index over a long period of time.

In India, over the longer run, actively managed mutual funds have indeed beated the Nifty and the Sensex. For example, over the last 5 years, 41 out of 61 funds beat the Nifty returns. But one has to understand that mutual funds have proliferated in the last 3-4 years. There are only a handful of funds that have existed for over 10 years! Mutual funds that have a long history have been much smaller in size earlier. It is easier to beat an index with lesser capital under management. Size often becomes a hinderance for success.

Also, over the last 5 years, till 2005, midcap stocks that go seriously undervalued during the period 2000-2003, gained more than largecap stocks. Moreover, an economic upturn helps the performance of smaller companies more than those of larger companies.

Consequently, most funds outperformed the Nifty during the period 2003-2005.

Three years ago, actively managed mutual funds could easily have been declared superior to index fund investing. But in view of their recent underperformance compared to index investing, the jury on whether investing in actively managed mutual funds is better than passive index funds investing, is still out.

Only time will be the judge!

Is the Indian stock market now cheap?

Has the Indian stock market become cheap after the fall this year?

But first, as I have said in the past, the concept of cheap or expensive depends upon the investor's time horizon and his/her return requirement. What is expensive for one investor can be cheap for another.

Having said that, sometimes we agree to some ballpark measure of cheap and expensive. So is the Indian stock market cheap now as many 'experts' and fund managers opine?

Here are some facts for you to decide yourself:
-As on 20 August 2008 closing, the BSE Sensex level was 14678 with a PE ratio of 18.22, Price:Book Value (PBV) at 3.80 and a dividend yield of 1.26%. All other things being equal, the lower the PE and PBV, the cheaper are stocks. The higher the dividend yield, again the cheaper are stocks.
-The corresponding figures for the Nifty 50 are 18.43, 4.02 and 1.27% respectively.
-The BSE 200 index comprising 200 stocks, had a PE of 18.52, PBV of 3.53 and Dividend Yield of 1.15%.
-Let us look at history to get an idea about this. Here is the data for the same during past lows:

Index: BSE 200
Date------------PE------PBV----Dividend Yield(%)
23 Oct 1998----10.74----1.2------2.68
24 Apr 2003----9.86----1.42-----3.42
17 May 2004---12.17----2.14-----2.6
11 Jun 2006----14.80---3.21-----1.75
20 Aug 2008---18.52---3.53-----1.15 (Current)

Compare this with the current valuations mentioned above.

Valuations seem twice as expensive as they were in April 2003. Ok, you might say that the frontline stocks are not cheap. How about the midcaps and small caps?
The NSE Midcap index quotes at a PE of 13.09. The PBV is 2.32 and a dividend yield at 1.64%. A PE of 13.09 does not seem expensive...looks cheap in fact!
Except that midcap companies are exactly that. They do better than large caps in good times and poorer during bad times.
To know what cheap really means, have a look at the same values for the same index in April 2003: PE = 6.28, PBV = 0.93, Dividend Yield = 4.67%!

So while the midcaps might have been very cheap in 2003, current valuations, though not expensive, are not as cheap and can get cheaper. Again, today midcaps are twice as expensive as they were in Apr 2003!

-The market capitalization (value of all stocks traded) of Indian stocks to GDP ratio (Market Cap:GDP ratio) currently stands at close to 1.1
-Market Cap:GDP ratio stood at 0.25 in April 2003, at 0.42 in May 2004, at 0.32 in March 1979
-The higher this ratio, the more richly stocks are valued.

Mutual fund managers and experts will have us believe anything. They give an example showing how the BSE sensex went up 18% compounded since 1979. So they advise people to buy stocks and mutual funds (so that they can get their Rs. 1 crore bonuses). They however forget that the starting point in 1979 was low (market cap:GDP = 0.32).
Had the market cap to GDP been 1.1 (current levels), Sensex in 1979 would have been at 340 and the compounded returns till date would have been 14% and not 18%! Still good, but much lesser than 18%.


Consider a few more facts:
-The period from 2003 onwards was characterised by low inflation and low interest rates. Inflation now is above 12%. High inflation is not good for stocks.
-The yield on a 10 Year Government of India security ranged between 5.8% to 7%. Currently it is close to 9.5%. Generally, PE values and interest rates are inversely related.
-High interest rates are not good for stocks. High interest rates reduce corporate earnings, slow down growth, make fixed income securities more attractive and hence reduce the attractiveness of stocks.
-The world is slowing down and so is the Indian economy
-Foreign money is the primary driver of Indian stock markets. From 2003 to 2007, the rupee appreciated from R.48/USD to Rs.39/USD, an appreciation of 23%. This added to the gains of foreign investors. This year alone, the rupee has depreciated more than 10%, adding to losses of foreign investors.
-India has a large trade deficit. With high oil prices, the deficit has widened and is unlikely to be filled up by a net capital inflows. A net negative balance puts downward pressure on our currency, making it depreciate and hence a poor choice for foreign investors. Also, unlike China, a large chunk of our foreign reserves are not owned by us but is kept on behalf of foreigners.
-India has a large fiscal deficit (including the off balance sheet items like oil bonds). A high fiscal deficit tends to push up government borrowing and hence push up interest rates, not good for companies and stocks. With a world credit crisis and foreign money unlikely to be available as easily as earlier, it could well 'crowd out' some private investment and cause further slowing down in the economy.
-With the bursting of a long 25 year credit bubble in the developed world, things for the investing arena have changed. Credit is unlikely to be anywhere as free or cheap in the coming years. Tremendous changes are occuring in the developed countries, particularly USA, which is altering the investing landscape. It is not wise to extrapolate past trends blindly into the future.
-Stocks had a wonderful environment to perform over the last few years. High growth, low interest rates, low inflation, cheap credit, excess capacities, all contributed to a the superior performance of stocks. Good times do not last forever (neither do bad times) and conditions now are the reverse of earlier ones.


There is a Chinese saying that goes something like this: "There is a time to cast your net and there is a time to dry your net."

The time for fishing got over when storms appreared earlier this year. The time to go fishing again has, in my opinion, not yet arrived. It is time to dry you nets, wait for the storm to blow over and for the fish to come back closer to your shores.

Have Crude Oil prices peaked out?

Crude oil, which seems to be the bug bear of most world economies and stock markets, has corrected from its high of around US $148 to about US $118.

Many believed that such high crude oil prices were unsustainable and crude was in a bubble. So their faith in their views seems to have been vindicated.

So has crude oil made an eventual top and has its price peaked out?

First some quick fundamentals that are known to everyone:

On the demand side:
-North America and Europe account for about half of the total oil consumption in the world.
-Asia and Middle east account for about 30% of the total oil consumption.
-But Asia and Middle East contribute 60% to the increase in demand for oil while North America and Europe contribute 20%. Clearly, additional demand is coming from Asia and Middle East.
-China consumes about 7.7 million barrels of oil per day, and growing at 7%
-India consumes about 2.75 million barrels of oil per day, and growing at 5%
-Together, the 2 countries consume 10.5 million barrels per day and growing at 6.5% per annum.
-Oil consumption is seeking higher levels, mainly on account of developing countries.

On the supply side:
-World production is declining. Almost all oil fields are in decline. USA, Saudi, Iran, UK, Russia, Mexico, Indonesia, are facing production constraints. Countries like Nigeria are facing security issues. It is estimated that the total production is now going down at the rate of about 3 million barrels/day.
-There has not been a single large oil field that has been discovered in over 30 years.
-World oil production in 2007 was 84.6 million barrels per day, less by 30000 produced in 2005. -Crude oil production is lower than oil consumption.
-Excess 0il demand is being met by reduction in stockpiles.
-And a small amount comes from ethanol.
-Oil produced by current technology is on the wane. Someone will have to find a new oilfield pretty quickly to keep pace with demand.

So demand is high and rising. Supply is falling quite rapidly.

Of course, everyone is aware of this. And prices have already gone sky high moving up from about US $100 at the begining of the year.

Also, shouldn't higher prices drive down demand?

Yes, they would. Some demand destruction will take place on account of higher prices.
But only in countries where oil is freely priced.
In countries like India, where prices are administered, retail prices do not reflect the scarcity value of oil. Hence demand is unlikely to come down.
Across Asia, prices are controlled.
Hence demand from this region will keep rising.

As an example, the US consumes about 20 million barrels of oil per day. A 5% decline in oil consumption is equivalent to less than 2 years' increase in oil demand from China and India alone!

What about alternative sources of energy? Will we not have substitution?

Yes, we will. But it will take time.
It takes time for habits to change.
We change our habits when pain is intense.
And right now, the pain is not intense.
And nothing major seems to be on the horizon currently.

So over the long run, demand is seen outstripping supply significantly.
We do not have an alternative in the pipeline.

But is all of this already discounted in the price? Have we seen the peak for oil prices?

I don't think so.

First, commodity bubbles do not end like this.
There is a lot of buying before the end.
Most people get convinced that high prices are here to stay. Currently there are many skeptics who might think that we are in a bubble.
A lot of investment starts pouring into the sector.
Investors are gung ho about the prospects of the asset under consideration.
Prices stay high for a long period before starting their move down.
There is intense pain for those badly affected by high prices.

We have not seen such signs yet. Prices have come off their highs pretty quickly.

A look at the charts suggests that oil has a long way to go. Sure, in the short term, prices can come down significantly. Which, if they do, will lull everyone into a sense of comfort. And things will keep moving nicely for a while.
But over the long run, prices are very likely to rise.
To what levels is impossible to say.
My sense is that they will be much higher than recent highs.

The world faced a similar oil shock in the decade of the 1970s.
Oil went up from about US $1.5/barrel to US $42/barrel, a rise of 28 times.
And India and China (with their now 2.3+ billion population) were very marginal consumers unlike today where they consume one eight of total consumption.

Oil is in a secular bull market.
It peaked out at UD $42 in 1981.
A secular bear market ensued for oil from 1981 to its low in 1999 at US $11.
Thereafter it started another secular bull phase.

It has gone up 13 times till its peak in its current phase.
Can it go up 19 times to US $200? Sure it can over time.
Can it go higher still? Sure it can.
When a bubble forms, no prices seems too high.
Till the bubble bursts.

So my sense is that we have not yet seen the ultimate highs for crude oil.
Unless someone finds a large oil field quickly, something not achieved for over 30 years.
Unless someone finds out a profitable method of extracting shale oil.
Unless someone finds a quick alternative to oil as energy.
At some stage we could see oil back to US $50.
But that, in my opinion, would be after we have seen it at much higher levels.

So is oil a buy on dips? Or perhaps oil stocks?