At the outset, Prashant mentions that the role of active fund managers lies somewhere in between passive investing which is propounded by John C. Bogle, the founder and retired CEO of The Vanguard Group and Warren Buffet’s belief that there are significant opportunities in markets and one should not overtly focus on benchmark. However, he clarifies that beating the benchmark is not easy. It is not just everyone’s cup of tea. To generate alpha, a fund manager needs to take a long-term view, have deep understanding of business fundamentals and most importantly respect the benchmark.
Prashant says, “If we look at previous track-record of markets then we realise that every now and then markets mis-price assets and create excesses. This over valuation in certain pockets of markets necessarily means that there are other fundamentally strong investment opportunities, which are undervalued.”
As an active fund manager, the challenge is to avoid the excesses and invest in fundamentally strong investments, which are undervalued. He goes on to explain that while these excesses take a few years to correct, once they do, the alpha generation opportunity is massive.
To drive the point home, he shares a few historical examples. In 2000, while IT stocks were trading at 200 trailing PE, engineering companies were trading at 4 PE. Despite this, almost 75% of the markets including professional fund managers were investing in IT stocks. However, if we look at their returns in the succeeding 3, 5 and 10 year periods then the engineering companies delivered 40 times returns compared to 3 times returns generated by IT stocks.
Fast forward to 2008, when infrastructure and engineering companies were trading at higher valuations compared to FMCG and pharmaceutical companies. In the next few years, while engineering companies saw a drop in their share price, the FMCG and pharmaceutical companies generated robust performance.
Recently, a similar trend was seen in the valuation of midcaps v/s Nifty. Before the recent correction, midcaps were trading at lifetime highs at a premium to Nifty. These high valuations were also an example of investors chasing momentum as over long term Nifty tends to trade at a premium to midcaps.
He stresses that markets provide opportunities; however, it is necessary to take a balanced and rational approach towards investing.
Comparing the prominence of passive investing in USA, he highlighted that in USA, mutual funds hold 50% of the market. Thus, it is difficult for active fund managers to generate outperformance. In contrast, mutual funds in India hold 6% of the market. This gives Indian active fund managers leeway to outperform the market. He also added that as Indian mutual funds grow over the next 10 years, it will become more difficult to beat the benchmark; however, individuals who can identify mis-priced opportunities will be able to generate excess returns in those markets too.