Rough road ahead

Index funds have it

Diversified equity schemes of mutual funds have gained great popularity in the last few years. But, are they really so good?

Investing in a mutual fund scheme would make sense if the mutual fund gave the investors more returns after accounting for all expenses, as compared to the market. Evidence from the local mutual fund industry over the last five years has not really been encouraging.

Over periods ranging from 6 months to 5 years, a good number of schemes have failed to beat the returns of the BSE Sensex. This was particularly true over the 2 and 3 year periods.

But, this shouldn’t really come as a surprise. The world over, most mutual fund schemes fail to beat the returns of the leading index in the country they operate.

In the all-time classic, A Random Walk Down Wall Street, Burton G Balkiel explains that over the entire 30-year period from 1973 to 2003, “two-third of the schemes (in the US) proved inferior to the market as a whole.”

In the Indian context, the evidence largely seems to suggest that more than half of the diversified equity schemes have generated greater returns than the Sensex in the 6-month, 1-year and 5-year categories, but not by a huge margin.

However, that’s before considering the entry load, which in case of an index scheme is limited to 1% of the amount invested vis-à-vis 2.25% in case of a diversified equity scheme. A lower load helps in a greater amount of money being invested in index schemes vis-à-vis diversified schemes.

Also, it needs to be asked, would investors have been able to identify in advance the diversified equity schemes that beat the benchmark? Typically, investors look at the scheme’s performance over 1-3 years to decide whether to invest in the scheme. But, past performance does not mean future performance as well. So, that’s also a risk.

As Balkiel wrote, “As long as there are averages, some managers will out-perform. But, good performance in one period does not predict good performance in the next”.

“No one can consistently predict either the direction of the stock market or the relative attractiveness of individual stocks and thus no one can consistently obtain better overall returns than the market.

And while there are undoubtedly profitable trading opportunities that occasionally appear, these are quickly wiped out once they become known.

No one person or institution has yet to produce a long-term consistent record of finding money-making, risk-adjusted individual stock-trading opportunities, particularly if they pay taxes and incur transaction costs.”

There are others who agree with this logic and feel investing in index funds is the best way out.

As Gus Sauter, the chief investment officer of Vanguard, points out in Eric J Weiner’s book, What Goes Up: The Uncensored History of Modern Wall Street, “That isn’t to say that some managers might do better than the market, but on an average they won’t.

So, with that in mind, investors should try to get market performance and keep costs to a minimum. The idea was you could significantly reduce the risk of an actively managed fund by simply investing in an index fund.”

Given this, it makes more sense for investors to stick to index funds, which essentially collect money from investors and invest in stocks that make up a stock market index, in the same proportion as their proportion in the index. In short, they aim to replicate the index.

As for returns, index funds have done reasonably well, given their mandate and also the tracking error, which is an accepted phenomenon in case of index funds.

Rough road ahead

Most of the automobile stocks have risen faster than the broader markets since August 23, 2007. Four stocks — Maruti Suzuki, M&M, Ashok Leyland and TVS Motors — have risen by an average 25% each, outperforming the BSE Sensex (up 19.31%), while two others — Tata Motors and Hero Honda — have risen in line with the Sensex, Bajaj Auto (up 13%) is the only one to have underperformed.

The BSE Auto index is up 17.63%.And why are auto stocks moving up? Earlier this year, they were battered down (by as much as 25%) from their peaks, scaled between January and early-February 2007, leading to a drop in the average PE of the sector to below 14, as compared to 17-18 for the Sensex. Thus, the market saw some value in auto stocks at lower levels.

The chief reason for the fall is no secret, viz. rise in interest rates, which impacted (slowdown) the demand for vehicles.

The recent upmove in share prices has been particularly sharp after the US Fed cut interest rates. This seems to have strengthened the market’s belief that domestic interest rates, which seem to have peaked, will also be cut sooner than later. With some banks having selectively cut rates (marginally), the sentiment has improved.

The current rally has been driven more by sentiment. But, since markets tend to move along expectations, they also tend to fall when such expectations are belied.

Hence, if domestic interest rates remain high (and impact demand), which seems likely if economists are to be believed, the euphoria may not last long.

A ray of hope, albeit in the short-term, is the approaching festive season and also that it is the end of first half of the year, wherein sales usually increase as vehicle buyers are able to claim depreciation that helps reduce tax liability.

Meanwhile, with overall vehicle sales (until August) flat-to-down for most players (except for Maruti) and considering the firm input costs, the performance of auto companies is unlikely to be any good. Analysts have estimated profits to fall by as much as 30% for major auto companies (except Maruti) for the current quarter.

However, says Amar Ambani, analyst at India Infoline, “the Q2 results are already discounted in the stock price.” He adds that with some lenders having announced a cut in lending rates, festive season around and new launches expected in the two-wheeler space, sentiment has improved.

To sum up, most of the news seems to be factored in. Hence, auto stocks are unlikely to move up in a hurry, at least till the first sign of recovery in sales is visible.

At current levels, the average PE for the sector works out to around 15, which in a way indicates that the downside may also be limited. For those with a contrarian view, one may buy very selectively on dips with a long-term perspective.