Investing in passive funds? Keep it simple and don’t overthink: Pratik Oswal

Pratik Oswal, Head – ETFs and Index Funds, Motilal AMC, says when it comes to passive funds, keep it very simple. There are a lot of options out there – , ETFs, index funds. Between ETFs and index funds, keep it very simple, do whatever you think is convenient, do not overthink it. When it comes to passive funds, keep the basics in the portfolio, do not go too crazy with sectoral funds.

Oswal further says: “When it comes to passive funds, a lot of the action happens in largecaps, specifically Nifty 50 and Sensex. If you look at the overall flows in the market, 80% to 90% of the flows happen only in Nifty and Sensex and this is purely because of the pension funds.”

Let us just talk about a market overview from you, I just want to know how is the josh?
Pratik Oswal: Josh is very strong to be honest. I think it has been surprisingly strong for a very long time now and it still goes strong.

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It does not seem like it’s ending also.
Pratik Oswal: I do not think it is ending. We had a bit of a setback in February or March, but markets have recovered since then. And what is good about the josh in the market is that it is not only josh, the underlying companies are also doing very well. As we know, markets over the long term trend towards the profitability of the underlying companies. So, what we have seen is that even though there has been a lot of action in the market, people have made a lot of money, companies themselves have also done very well. Since companies have done well, valuations are still not crazy right now. So, for people who are looking to enter the market or looking to invest, this is a great time.

So, valuations are not crazy across market caps, specifically midcaps and smallcaps?
Pratik Oswal: Largecaps are actually below long-term valuations and mid and smallcaps are slightly higher than long-term averages, but I would not say they are in a dangerous category where you should be avoiding or switching your portfolio from small and midcaps to largecaps. So that is very important.

Not even reshuffling and rebalancing?
Pratik Oswal: If you are looking at an allocation towards small and midcaps, if you are saying my allocation is 40% and that 40% has gone to 50%, then yes, it is very important to rebalance it back to 40%, but I do feel that in terms of finding value, there is a little bit more value in largecaps at the moment than mid and smallcaps.

Having said that, I also think the risk levels of small and midcaps have changed over the years. You cannot attribute the same level of risk in smallcaps that you did 5 or 10 years ago. Five years ago, an average smallcap company in India had a market cap of about Rs 4,500-5,000 crore. Today an average smallcap company in India is Rs 25,000-30,000 crore. So, it has increased almost four to five times. These companies have very stable balance sheets, stable profit and loss and are very good in terms of business operations and good governance. I do feel that small and midcaps offer a lot more stability than they did say 5 or 10 years ago and which is why I think they are a lot more investable today than they were before.

Would you also recommend that investors should analyse their risk when we talk about having exposure in midcap and smallcaps, like how you said that just rebalance it depending on the exposure in your portfolio?Do you also think it is time to modify your risk appetite towards this particular category, especially when the risk is still not very high and certain pockets are still very attractive?
Pratik Oswal: I do think so. The portfolio today should go beyond the largecaps and the reason why I say this is because largecaps in India, say the Nifty 50 for example, when it was formed in the 1990s, was a very large part of the market. It constituted all the largecap stocks. Today the top 100 stocks are largecaps. Today the breadth of the market has increased to such a point where if you are playing the largecap space, you are playing a very small part of the market today.

We feel there are a lot of investment opportunities happening in midcaps and smallcaps. Obviously smallcaps are highly risky but I do feel that an average midcap stock today is Rs 75,000 crore, maybe Rs 60,000-70,000 crore. They are behaving like largecaps. So, it is important that investors keep that in mind and maybe it makes sense to add a slightly higher midcap quotient if you are risk averse, because of the opportunities in that space.How much of this investor interest are you seeing coming in from passive investment in midcap and smallcap specifically?
Pratik Oswal: When it comes to passive funds, a lot of the action happens in largecaps, specifically Nifty 50 and Sensex. If you look at the overall flows in the market, about 80% to 90% of the flows happen only in Nifty and Sensex and this is purely because of the pension funds. So about 80% of all flows into passives happen towards EPFO, pension funds, institutions, family offices and they tend to stick to Nifty 50 and Sensex. So, mid and smallcap is still growing at a very fast rate, but in comparison it is still very small.

When you talk about having a passive strategy for these market caps, how do you generate alpha and how do you beat the expertise of a fund manager or that is not the logic over here at all?
Pratik Oswal: The logic is to keep it simple and track the index. The ability to really pick and choose the right fund is a lot more complicated than it is because you have so many options. The reason why passives work across different categories is because it makes life simple. You are essentially buying the benchmark, you do not have to worry about underperformance, poor performance. If you want to invest in a mutual fund over the next 30 years, which mutual fund are you going to choose? Passive funds make selection a lot easier. What we have also seen over the last five years is that the performance of passive funds are now almost on par with actively managed funds, especially in mid and smallcaps as well. So, I think there people are not really missing out on a lot, so simplicity is one big reason…

Is it also because of the market movement right now that we are witnessing or even in the lull market we have seen this kind of performance?
Pratik Oswal: In general, what happens is if you look at the US, their passive funds are doing better than actively managed funds because the markets are very efficient.

The markets are developed over there.
Pratik Oswal: They are very developed, very efficient. India is obviously not that way, so there is a lot of opportunity to generate alpha no doubt, but when it comes to passive funds, it is really simple. It is also very low cost. There is a lot of interest in funds which are low cost because the moment you have low cost funds, more of your money is invested in the underlying stocks, so basically you can really play a much bigger part into your existing stock portfolio.

I think there is a lot of interest in people wanting to buy low cost funds.

Third, again as I said, the performance of any other midcap or even a smallcap passive fund, I would say they are in the top 5 top, 10 funds overall. The performance is pretty good and most importantly, there is a lot more awareness about passive funds than there were five years ago. I think no one really knew that passive funds were beyond Nifty and Sensex. In fact when people say passive, they mean Nifty and Sensex, but actually there is a whole host of passive funds.

So, we have across asset classes when you talk about equity..,
Pratik Oswal: Yes, you have equities, you have fixed income, you have commodities, you have sectors, bank index, IT index, healthcare index. You have factor funds. There are strategy funds where you can buy into strategies like quality, growth, momentum. So, there are maybe 250 passive funds today in India and there are two options. There are ETFs and index funds. People can really choose what they like.

But that is also making it complicated?
Pratik Oswal: I do not disagree with that to be honest. The choices have made investment a lot more complicated but my belief is that most people should stick to the simple funds. As AMC, we have to cater to a large amount of customers. We have retail investors. We have HNI investors. We have institutions, family offices. We really need to think about all our customers and unfortunately we cannot target certain funds to certain customers. It is open-ended. So, we will continue to launch new funds based on demand coming in from our investor base. But for most investors sticking to a very simple Nifty 500 or a midcap or a smallcap is something which we believe is the best way in order for you to really select the right fund for the portfolio.

So, you spoke about launching funds and there is a double-digit figure I think that is coming up in next two years as far as launching passive funds are concerned. So, what is it all about? You will be talking about it a lot more in the coming days, but then just to give us an idea.
Pratik Oswal: I think we currently have about 33 to 35 passive funds.

Is that the highest number of funds you have in the entire industry passive?
Pratik Oswal: I think so. I cannot confirm, but I think we should have the highest number of funds across both the ETFs and index funds and we are looking to maybe double that over the next two or three years’ time so that is a plan in action. I do believe that the idea here is to really cater to all our customers. We have maybe a million plus customers who are investing in our funds.

This is just the retail number that you are giving me or retail is a major chunk of this?
Pratik Oswal: This includes everything — ETFs, index funds, including everything. So, it is a good customer base and we keep on getting demands from them and the idea for an AMC is to not really promote all 50 funds, but to really talk about a few funds and if there is demand for funds, then they can use this to invest.

What made you come up with a microcap? Microcap fund of funds, if I am not wrong?
Pratik Oswal: No, it is an index fund.

It is an index fund. So, yes, why that idea? Looking at the market trend or you thought there is an appetite for that kind of a risk among investors because the idea is really great, but then we also have to do risk management for viewers. You think they are ready for it?
Pratik Oswal: Most investors are not, to be honest. Microcaps are very small. People tend to misunderstand microcaps also.

It is just too much risk and you will lose all of your money.
Pratik Oswal: Yes.

So, the limitations are a lot. If we know there is no research, there is no company clarity. I mean what a lot of people, analysts also face which is we see a lot of them not covering a lot of companies as well. So, how are you going about it?
Pratik Oswal: Yes, so it is an index fund, so it does not really matter how many analysts there are, if there is any coverage. In fact, the only way to play microcaps today is through an index fund. There is no other route because there is no material on how these companies are, what they are doing, what their performance is like, what their business models are like.

I think microcaps can be played through an index fund. We were the first ones in India to launch midcap, smallcap, multicap, sector funds in the index fund space five years ago and we believe that microcaps are big enough for us to launch a fund into it. We believe that a lot of investors today are looking at microcaps as a way of wealth creation and it has done well to be honest. It has beaten everything else, but I also think that it comes with a lot more risk and volatility. So, investors need to be aware of their risk profile before investing in microcaps.

However, they are still quite large, so the average microcap company will be about three-and-a-half thousand crore market cap, so they are not really like very small companies, they are decently sized and I would say that a lot of our investors are using SIPs as a way to invest which I think is a good way of creating wealth in that category because it is very volatile, so the only way to really build wealth is to do it slowly.

So, passive SIP book, if I just want a number from you, an approximate number coming in from retail investors specifically, maybe in the last two or one-and-a-half years. How much has it grown for you and in which categories because you have passive funds across categories – index and ETF. What is the kind of number in the SIP book that we are seeing?
Pratik Oswal: Yes, so honestly, we were unfortunate two years ago when we had to really shut our international funds. At some point, we had about two-and-a-half lakh SIPs coming into our international funds only and we had to literally overnight stop those flows. Now they are on again, but a lot of flows we have lost over the years.

I would say that SIP numbers compared to where it was two years ago are actually less today, which is funny because a lot of the flows came into internationals where we are number one. But I still feel it is a very healthy growth. We have more than one lakh SIPs coming in a lot of our domestic funds at least, so it is pretty healthy. I would say that when it comes to passive funds, SIP is not the dominant way of investing. Most people tend to use lump sums, a lot of people want to use passives as a tactical way of playing the indexes.

How can you do that just in case?
Pratik Oswal: If someone has a bullish call on smallcaps for the next three months, they can just buy a smallcap index fund and they can sell it after three months. So, tactical play has also improved a lot, increased a lot.

So that is very interesting.
Pratik Oswal: Also, a lot of interest is coming in from family offices institutions. So, if you look, globally in the US, 60% to 70% of all their passive funds are bought by all these institutions and family offices which will probably happen in India over the next 10 years. So, those will be a dominant AUM force in India when it comes to passive.

All the AMCs are talking to regulators going back and forth even with the RBI but then right now, if someone is listening to you and wants to replan their international investment exposure in the portfolio, what is the right way according to you to go about it?
Pratik Oswal: There are still some funds open for SIPs and lump sum. You could look at investing through mutual funds as well. There are two options, mutual funds or LRS. LRS obviously comes with pros and cons. You have a limit but for most retail investors the limit is big enough for them to invest. I think LRS comes with a lot of hidden costs which investors should do some due diligence on.

The cost of remitting money and then getting back to your bank account is a bit cumbersome, there is more paperwork, there is a TCS that they have to pay for it. So, mutual funds are much simpler, but unfortunately most mutual funds are now shut. There are few of them still open. Investors can look at them for international diversification. We are hopeful as an industry, we have been lobbying very hard to ensure that these limits open up, may not be big limits but whatever limits there are, retail investors will really benefit because most investors across the world in any geography have some of their money outside of the home country so I think it is important for us to also have some of our portfolio outside and to be honest with mutual funds investing overseas the money will come back eventually because someone will sell at some point.

So, it is going to come back to us, hopefully a larger amount. Overall, mutual funds are more transparent, low cost, and overall it is good for flows because over the long term we can see some coming back.

One passive investment mantra to our viewers directly into the camera.
Pratik Oswal: I think when it comes to passive funds, this is to all the viewers, please keep it very simple. I think there are a lot of options out there, there are ETFs, index funds. I would say between ETFs and index funds, keep it very simple, do whatever you think is convenient, do not overthink it. When it comes to passive funds, most people would recommend keeping the basics in your portfolio, do not go too crazy with sectoral funds or whatever it is that is what my recommendation is, keep it simple.

And for someone who wants to begin their journey of investment a passive fund can be good, that should be the first fund ever?
Pratik Oswal: Yes, absolutely. I think it is the simplest fund. A passive fund can be a good start to start your investing process. We always tell investors that you should begin as early as possible because true wealth happens to compounding and to compounding to happen you have to invest very early. So, all investors should invest as early as possible because you have to invest 10, 15, 20 years to really create wealth.

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