Oct 18, 2024
• Much-anticipated Fed cut of 50 bps delivered.
• Indian markets demonstrate resilience even as economic growth cools a bit.
• Result season to increase volatility in stocks.
• Portfolio management services continue to be relevant to investors, despite recent underperformance.
The Fed Delivers
The much-anticipated rate cut by the Fed came through in September 2024. Fed chair Jerome Powell acknowledged softness in the economy and disinflationary impulses while delivering a 50-bps rate cut. However, a few days later, a surprisingly strong jobs report forced market participants to scale back their expectations of future rate cuts. The markets are now divided on the magnitude of rate cuts expected by the end of next year.
Market implied probability of Fed rates by end of 2025
Source: CME Group, Fed Watch Tool
The said job reports had nuances – the aggregate number of hours worked declined. This is important because overall income growth (or decline) impacts consumption and the number of hours worked is an important variable that impacts income growth.
Aggregate number of hours worked
Source: U.S. Bureau of Labor Statistics, FRED
Also, much of the job creation is in recession-proof industries such as education and healthcare. Industries linked to overall economic growth, such as manufacturing, are not creating many jobs. Investment Strategy 17 October 2024
The Eurozone’s economic outlook weakened further in September, with GDP growth slowing due to weak industrial production, especially in Germany. Manufacturing PMIs remained in contraction, while services saw marginal improvement.
China’s surprise stimulus buoyed sentiment, with some global brokerages recalibrating their GDP growth expectations upwards for the current year as well as 2025. Chinese equities rose nearly 35% in three weeks. The final plan lacked details, and the markets gave up some of the gains. Economies in downturns due to excessive debt tend to take a long time to turn around, as there is reluctance to take on leverage even if debt becomes cheaper.
India macro update
India’s economy has experienced a slowdown in growth momentum, with both consumption and investment showing signs of cooling. The Economic Activity Index – Gross Value Added (EAI-GVA) decelerated to 6.1% in August, down from 6.3% in July, marking the slowest pace in 22 months. Industrial activity has remained sluggish, while the services and agricultural sectors provided have provided modest support.
Looking ahead, real GDP growth for Q2 FY25 (July-September 2024) is expected to moderate to around 6.0-6.5%, below the Reserve Bank of India’s (RBI) projection of 7.2%.
The Reserve Bank of India (RBI) maintained a cautious stance in September 2024, keeping the policy repo rate unchanged at 6.5%. The central bank reiterated its commitment to controlling inflation while supporting growth, though rising global oil prices and sticky domestic inflation may complicate future policy decisions.
We expect the softness to persist throughout the current quarter, as government spending is expected to pick up only in the last quarter of this financial year.
India equities
Indian equities delivered a mixed performance in September, reflecting both global macroeconomic pressures and slower domestic growth. While the broader market showed resilience, sectoral divergences became more pronounced, driven by varying domestic growth trends and global uncertainties. Nevertheless, India remains one of the best-performing equity markets for the year.
Source: Bloomberg, Sanctum Wealth. Above returns are price returns in local currency terms
Despite a global risk-off sentiment, Indian equities remained relatively resilient, with Nifty delivering nearly 2.3% return in the month of September with gains driven by sectors like metals, consumer, auto and private banks, while PSU banks and technology corrected.
Source: Bloomberg, Sanctum Wealth
Domestic institutional inflows were positive for the 14th consecutive month with inflows of the past nine months of ~USD41bn exceeding that of the entire CY23 by 83%.
As we head into the results season, we expect higher volatility in stock prices. This may or may not be reflected in the index. As stocks get priced closer to perfection, any surprises (positive or negative) are priced very quickly with pronounced moves, not giving traders much room to react. We observed this trend last quarter as well, which eventually was reflected in the performance of many portfolio/fund managers. Performance dispersion of managers during these periods tends to be high. Therefore, taking a long-term view on managers becomes imperative.
The market regulator, SEBI, has often expressed its concerns around the increased participation of retail traders in the derivatives segment. Data shows that these traders lose money most of the time. To curtail this speculative impulse, changes are being introduced in the derivative segments which are expected to negatively impact volumes. This, however, does not impact the flows into cash equities.
We continue to book profits in mid- and small-cap stocks in our asset-allocated model portfolios and increase allocation to gold. We believe that the RBI rate-cut cycle could be shallow and hence we are not adding further to our duration exposure.
Active vs Passive; Mutual Funds vs PMS
The recent underperformance of Portfolio Management Services (PMSs) relative to mutual funds (MFs) and their respective benchmarks has led investors to question the need for PMSs. Additionally, the 2024 budget has increased taxes on equity, which affects PMSs more significantly due to their pass-through structure (i.e., taxes are payable on each transaction). Therefore, we aim to assess two key points: first, whether active funds add value to portfolios, and second, whether PMSs are less efficient?
Passive funds, including index funds, ETFs, and factor-based funds, now account for nearly 17% of total mutual fund AUM, up from about 5-6% a decade ago. DSP Mutual Fund projects that this will rise to 25-30% by 2030. While EPFO flows have significantly contributed to the growth of passive funds, even after excluding EPFO flows, the share of passive funds continues to rise.
We have previously highlighted that, following SEBI’s recategorisation of mutual funds, large-cap MFs have limited ability to invest outside of large caps and given the reduced information asymmetry in this segment, they are unlikely to consistently outperform their benchmarks. This is clearly visible in the data below. Conversely, small-cap funds exhibit higher levels of information asymmetry, allowing them to outperform their benchmarks more consistently over any three-year rolling period. Midcap and flexicap funds have cycles but still tend to outperform more consistently than large cap funds.
Source: Morningstar
Data from June 2009 to June 2024
Benchmarks- Largecap- Nifty 100 TRI, Midcap- Nifty Midcap 150 TRI, Smallcap- Nifty Smallcap 250 TRI, Flexicap- Nifty 500 TRI< br/> Benchmarks- Largecap- Nifty 100 TRI, Midcap- Nifty Midcap 150 TRI, Smallcap- Nifty Smallcap 250 TRI, Flexicap- Nifty 500 TRI
While we have compared returns for median funds in the table above and throughout this note, it’s important to highlight that consistently outperforming the median is challenging. Fewer than 5% of funds exceed the median more than 75% of the time, and very few manage to do so for four consecutive years or longer. Therefore, every fund has its cycle, and selecting funds based on qualitative factors—not just past performance—is crucial.
Next, we address the question: whether PMSs add value? Unlike mutual funds, PMS data is not readily available, so we selected some of the largest and most popular PMSs for this analysis. As shown below, PMSs have outperformed mutual funds both in the percentage of times they exceed their benchmarks and in average outperformance. However, it is important to note that when PMSs do underperform, they often do so by a significant margin.
Source: Morningstar
Data from June 2009 to June 2024
PMS data shared by the counterparty or from Finalyca. The returns are time-weighted rate of return (TWRR) post expenses
Now, let’s consider the impact of the pass-through structure of a PMS, where taxes apply to every transaction. For several PMSs, we analysed short-term and long-term capital gains/losses over the last five years and their effect on returns. We found that the difference between pre-tax and post-tax CAGR was typically less than 1%, and even for high-churn PMSs, it was close to 2%. Additionally, as PMSs churn, the cost basis resets higher, meaning taxes at withdrawal may apply only to partial gains. In some cases, the actual tax outgo may be lower than if similar returns were achieved in mutual funds. Given the significant average outperformance of PMSs over their benchmarks, the impact of the pass-through structure is minimal.
One reason for the higher outperformance of PMSs is their active share, or the proportion of the portfolio that differs from the benchmark. Most PMSs have less than 15% overlap with their benchmarks, while mutual funds typically have about a one-third overlap. In the case of large-cap MFs, over half the portfolio often mirrors the benchmark, which may explain their lack of outperformance.
Source: Morningstar for mutual funds, Finalyca for PMSs
Sanctum internal calculations
Data as of 31st July 2024
In conclusion, while most PMSs have underperformed their benchmarks this calendar year, we believe this is part of the current cycle and that they will bounce back sharply. Therefore, investors who can tolerate higher volatility with PMSs may achieve greater outperformance relative to their benchmarks.