Overweight positions in banks, industrials helped HDFC: CIO Prashant Jain

A number of factors have made life difficult for the country’s large-cap fund managers in the past few years. For instance, in 2017, market regulator Securities and Exchange Board of India (Sebi) mandated large-cap mutual funds to invest 80 per cent of their assets in top 100 stocks by full market capitalisation. This put an end to the opportunistic practice of style drift whereby funds bumped up holding in mid or small-cap stocks to shore up returns. The introduction of the total return index (TRI), which includes dividend as part of returns, also raised the bar for active fund managers. Lastly, the market became acutely polarised since 2018, resulting in the outperformance of fewer stocks.

Given this background, an outperformance of nearly 9 percentage points over the Nifty 100 benchmark is no small feat. Indeed, the HDFC Top 100 fund beat both its benchmark and its large-cap peers by a wide margin between July 1, 2018, and June 30, 2019. 

Fund manager Prashant Jain owes the outperformance to the fund’s focus on fundamentals and valuations. “HDFC Top 100’s portfolio construction is based on the assessment of long-term fundamentals of companies and their relative valuation, as we believe that markets track corporate earnings over the long-term,” says Jain.

Overweight positions in corporate banks, industrials, and energy and underweight stance in consumer discretionary contributed to the outperformance. The fund enjoyed a particularly good run between January and March this year (return of 8.24 per cent), with overweight positions in corporate banks and utilities boosting returns. July-September last year (return of 4.95 per cent) was another good quarter.

Despite the stellar performance, Jain is candid in admitting that the going has not been easy: “While HDFC Top 100 has fared well, the last year or so has been challenging for active managers, especially those managing large-cap funds.” Jain attributes this to the introduction of the TRI and select outperformance of a few index heavyweights.

“When large caps move sharply and you are underweight on that space it does make the situation challenging,” confesses Jain. That said, he believes this is only a phase and will pass. “There was a time when mid- and small-caps did much better than the large caps and now that is reverting to the mean. I see nothing wrong with this. How long will the polarisation last? It’s a view that will differ from fund manager to fund manager. In my opinion, the market would be more balanced over a two-three year horizon,” says Jain.

He would know. Jain is well-acquainted with market cycles, having been around for more than 25 years in the industry. Stock selection for him has always been about unearthing the company’s medium to long-term potential — not just through hard numbers but also qualitative parameters. 

“Apart from quantitative aspects, we focus on qualitative aspects like management quality, corporate governance and track record,” says Jain.

This may include examining corporate governance reports featured in companies’ annual reports. Or looking for recent and past instances of violation of legal or environmental laws, history of penalties imposed by any agency, suits or claims that are presently sub-judice and levels of information, disclosure and transparency. “For companies that are less researched, wherever required, an independent check with the company’s business associates and customers is undertaken,” says Jain. 

The last few years were marked by a muted growth in the earnings of Nifty50 companies. Weak profit growth was the result of poor performance of few sectors like capital goods, corporate banks and health care. 

The Nifty is trading at 18.8 times its estimated FY20 earnings, according to analysts. Jain believes valuation multiples look reasonable now, especially in the light of improving profit growth outlook. 

“The market holds promise over the medium to long-term. With the sharp decline in mid- and small-caps over the past 15 months, a significant divergence with large caps is not likely going forward,” says Jain. He lists out adverse global events, rise in crude oil prices, sharp moderation in equity-oriented mutual funds flows, and delays in NPA (bad loans) resolution under National Company Law Tribunal (NCLT) as key risks in the near term.

Among market segments, HDFC Top 100 is currently overweight on corporate banks, utilities, energy and industrials. Key underweight sectors include retail banking and finance, consumer staples and consumer discretionary.

With the outperformance, the fund’s size has swelled. As of July 31, HDFC Top 100 managed assets worth Rs 17,095 crore. Jain brushes aside any concern that size could impact the fund’s outperformance in the future. “There are no large funds in India relative to the market. India’s equity market capitalisation is about Rs 138 trillion. Compared to this, a Rs 17,000-crore fund is minuscule. In fact, all mutual funds in India collectively own about 7.5 per cent of the equity market,” says Jain.

He is also unfazed about the growing prominence of passive funds. While a sizeable amount of institutional money is now flowing into these funds, retail investors are yet to meaningfully take to them. Does Jain see a shift to passive funds in India accelerating in the coming years?

“Several factors are at play. What exactly happens, at what pace, is difficult to say,” feels Jain. 

He alludes to the differences between US and Indian markets and explains why passive funds have taken off in the world’s biggest economy. In the US, for instance, the ownership of funds as a percentage of the market is at about 40 per cent. This is an extremely high number and makes it difficult for active funds to beat the market. In India, on the other hand, the ownership of mutual funds is between 5 per cent and 10 per cent, and the ownership of equity by households is very low. 

While there might not be a sudden shift from active to passive funds, Jain concedes that active funds may lose out if they fall behind their benchmarks consistently. 

“Ownership of equity as well as ownership of funds as a percentage of the market will increase over time. In the end, over long periods, if active funds don’t beat the benchmark regularly they are likely to lose market share,” says Jain.