Is portfolio churning necessary?

Suresh Krishnamurthy

THE mutual fund industry in the US has been booming in the 1990s, with assets under the management registering dramatic growth.

A notable feature of this growth in assets is that the bulk of the funds have been flowing into various index funds -- funds that invest in stocks forming part of a particular index, such as the S&P 500 Index, in the proportion in which they are weighted in the Index. This mainly has to do with the belief, supported by extensive research, that fund managers are unlikely to beat the indices.

In contrast, the flow of investors' funds in Asia has been mainly into non-index funds. In India, among the many mutual funds, only the UTI, IDBI and Templeton offer index funds. In short, active fund management is both encouraged by mutual funds and sought for by investors. Asian markets, including India, because of the lack of proper information flow, offer a fertile ground for managers to practise active fund management to beat the indices and reward the investors with risk-adjusted returns far in excess of the gains in the indices. The performance of mutual funds in 1999-2000 is ample testimony to this approach.

Active fund management strategy is reflected in two ways -- stock selection, and active buying and selling. Stock selection is:

-- allocation to stocks of a weight different from its weight in the indices, and

-- investments in stocks that do not form a part of the index. In India, active fund management strategy has taken both these forms.

However, it is as yet difficult to ascertain if a combination of superior stock selection and active portfolio churning would benefit investors. Or if just superior stock selection would do. The revenue accounts for 1999-2000 of the 19 equity schemes analysed suggest that superior stock selection alone would have sufficed.

Prima facie, given the poor flow of information and the lack of proper corporate governance, there is still considerable space for active fund management in the form of stock selection.

However, is there a need for portfolio churning? Fund managers often point out that given the trends in the Indian market, active portfolio churning is necessary. As it happens, a look at the investment trends of mutual funds since January indicates that they have been engaged in extensive portfolio churning. Mutual funds have transacted to the tune of Rs. 34,697 crores between January and July for a negative net investment of Rs. 649.50 crores.

This gives a transaction value 53.4 times the net investment. Foreign institutional investors transacted Rs. 98,417 crores, and made a net investment of Rs. 4,982 crores. This gives a transaction value that is 19.8 times the net investment. Mutual funds have, thus, been churning the portfolios even more than the FIIs.

This, essentially, raises the question whether such a degree of portfolio churning can enhance the performance of a mutual fund equity scheme. Ideally, a mutual fund scheme that books profits or losses consistently based on pre-set target returns is likely to be viewed favourably by investors, as such fund management does minimise the risk.

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However, revenue accounts indicate the reluctance of funds to take losses, which is as important as booking profits. Also, the trend in the stock market between February and March this year indicate a herd instinct among mutual funds. This means that, in the event of a sharp drop in stock prices, liquidity dries up considerably.

The lack of buyers in March of Himachal Futuristic Communications -- these days among the top five most traded stocks and a mutual fund favourite -- is a grim reminder. As such, funds are unlikely to offload as much stocks as they would want to. Moreover, the nature of stock selection in view recently has only enhanced the fund's risk profile.

The kind of active fund management in evidence in the first quarter of 2000 left a lot to be desired. It is not surprising that most of these funds have underperformed the indices considerably. Having invested a larger proportion in New Economy stocks, they could not have outperformed the narrower indices -- Sensex and Nifty -- during a downturn.

The portfolios were stacked with high volatility stocks with poor track records in terms of corporate governance. These stocks would have done well only if the bull market had persisted. As the bull run petered out, the fall in net asset values was precipitous. Continuing with such an investing style is not likely to reward investors.

It is true that all mutual fund equity schemes cannot be tarred with the same brush. In fact, equity schemes offered by the same fund have followed different investing styles. However, almost all equity schemes are managed actively with a fair degree of portfolio churning. Also, it needs to be emphasised that all mutual fund offer documents and prospectuses pay a ritual homage to long-term investing. This means that either their practice is in marked deviation to their stated objectives, or their investment strategies need to be explained in greater detail to investors.

More precisely, the risk disclosures need to be strengthened considerably. A cursory statement that net asset values would move up or down in line with the movement of stock prices cannot qualify as proper risk disclosure, given the investment strategies adopted by the various funds. While managers should be allowed the freedom to manage funds in accordance with their beliefs, the investor needs to be kept informed of the risks and rewards.