Can Mutual Funds stop the bear run?

The last 6 months have been really troubling for stock market all over the world. While Dow reached it 2 years low, Nifty dipped below its sentimental level of 4000. In such a volatile market investments made for short term made people lose drastically. The recent dip of NIFTY index from 6280 to 3800 made even the value investor worried.

Looking at the major inflow in the market, we see that two major players – Domestic mutual fund (DMF) and Foreign Institutional investors (FII); behaved differently in the market. While FII pulled out money amounting around 25000 Crore, mutual funds cumulatively invested 9000 Crore in the market. More over the pattern shown in the diagram above explains that; at every fall FII were the one who pulled out money while in most of the dips, mutual funds invested in equity. With more than 600 stocks trading at below its’ 52 weeks lows, fund managers find it quite attractive to take position while FII who are there in market for short term took their money out in panic. As discussed in the previous posts, the compounded annual return is more than 30% for NIFTY index; hence such unexpected fall should be taken as an opportunity by both mutual funds and retail investors to invest rather than to stay away from the market. Staying invested for medium to long term will certainly be rewarding.

Looking at the major players in the market, the question arises about the driving players in the market at present? Is it the FIIs who are running away from the market or the Mutual funds who are investing quite cautiously? FIIs’ pull-out of 25000 crore has been really a reason to worry. This exit has been the major factor of indices taking a dip, but with more than 20,000 crore fund and cash equivalent uninvested, asset management companies (AMCs) have the potential to change the sentiments and encourage people for value investing. Surprisingly this time, the retail investors in Mutual funds have not rushed to redeem the allocated units hence fund managers have more flexibility to move their investment into blue chips which are available at quite a reasonable price.

Why many mutual funds fail to perform?

Mutual fund is a wonderful financial instrument for people who have neither time nor the inclination to test their understanding of the stock market. It helps people with a very small amount of money to diversify their portfolio to minimize the risk. But even then quite often amateurs easily outperform many mutual funds. In fact in long run most of the mutual funds underperform in comparison to their respective benchmark index.

As Peter Lynch says, this is not because of the inability of the fund managers, but it is the inherent fear of losing. Success is one thing, but it is more important not to look bad if you fail. Managers are quite aware that if they lose even 20-30% of investors’ money on company like Reliance, people will question Reliance for its failure than the manager to predict such movement. But a 10% loss on IFCI could call for reasoning behind such investment. It is better to fail on conventional stocks to keep the job safe than to try unconventional stocks and brings the job in jeopardy. That is the reason why most of the fund managers keep looking for reasons not to buy exciting stocks.

The other issue with mutual fund is the fee that management charges to their investor for managing their fund. An entry load of 2.25% brings down the returns by a significant level and again the exit load (In case of most of the mutual funds) of 2.25% further takes away return from the investors. According to Buffet, in Wall-Street, such management fund causes mutual funds giving less than 80% of return in comparison to the index funds.

Another hurdle with mutual fund is the regulation imposed by monitoring authority like Security and Exchange Board of India (SEBI). The upper cap of stake on a particular stock forces fund managers to look for some less attractive stocks than to increase stake on stocks which are bound to give better returns. Specially, in case of Small-Cap, size prevents manager to buy in such companies, because it is not possible to buy enough shares to have noticeable improvement in fund’s performance.

In such a situation, one of the alternative investors could think of is putting money in index funds, which do not need any management and hence can save the entry and exit load. Index funds are kind of exchange traded fund, where individuals’ money is put in different constituents on the index in proportion to their weight in the index. For example the index fund of NIFTY consists of 50 stocks which are constituent of S&P CNX NIFTY, and the money invested in this index-fund is proportionally distributed among these 50 stocks. One can also look for funds which have outperformed the index consistently in past 3 to 5 years. There are a few good mutual-funds which have beaten the index by a significant difference and hence preferred even after the management fee. More importantly, an individual needs to look at the fund-managers’ performance rather than the funds’ performance. As change of management could lead to change in ideology and can have impact on returns as well.

Aren’t stocks riskier than other financial instruments?.. and the more after the recent fall?

This is quite common doubt among most of the people who stay away from the market and are satisfied with meager returns from their fixed deposits or bonds. It is quite probable that market condition change with time, causing a great company to lose its business and its stock to fall. But, rarely a stock is priced below its fundamental value and if at all it does, there could not be a better opportunity to buy such strong stocks. A realistic investor will move from stock to stock with the change in market condition hence averting any such loses.


In last 5 years, NIFTY Index has moved from 1051.80 on June 16^th 2003 to 4517.10 on June 13^th 2008. Had someone invested in Index fund 5 years ago would have made an average of more than 60% return at simple interest and more than 30% return even if taken in compounded terms. And all this return would have come without any botheration of switching from one stock to another(except for the fact that constituents of Nifty are changed).A 30% return overshadows all the misgivings about the risk involved with investing in equity. Equity might be riskier in short term but it becomes safer as the duration increases. The graph does reflect unexpected fall in 2004, 2006 and again in 2008, but such negative returns has always remained for short term and a long term investor would not bother for such movement. Such an impressive return even after taking the latest fall into account gives a clear impression that investment in fundamentally sound company would rarely disappoint.

A retail investor is often scared of speculation in market. Speculators are bound to be there, and this in fact helps in increasing the volume of trade. It brings down the impact cost, as a buyer will always find someone available to sell at that price and vice versa. Most of the speculation happens in small-cap companies. But looking at the fundamentals will easily filter out such stocks from investment perspective. Moreover the speculators have also started moving to derivatives from these small-caps, making equity more reliable.

Investor loses when he buys the right stocks at the wrong price and at the wrong time. Recent fall of DLF Limited is an example of such a stock which came below its issue price. A month back buy of this stock could be termed as right pick at wrong time. Though the stock is fundamentally strong, the recent slow down and doubt about the economic growth in coming days brought down the price of infrastructure firms drastically and DLF was no exception.

People start believing stocks to be prudent investment when it is not. Last year was golden year for many people who blindly invested in stocks without looking even at basic fundamentals like balance sheet & income statements and made decent gain. Stock was hyped all the way to be the obvious choice, but the correction taken place this year has made people believe it to be riskier and safe to stay away thing. And this happened when many stocks are available at bargain price which should have been bought.

To sum up – People lose in market because they seem to be more comfortable in investing in business they are entirely ignorant about. The stock becomes riskier for those who get into market without any planning and knowledge. Hence, one needs to do self analysis to see how much of risk he is comfortable with, whether he is a short term investor or a long term investor, and how will he react to the sudden, unexpected and severe drops in the prices.

What moves Sensex or Nifty?

We have seen in the previous post the constituents of Sensex/Nifty and their weights in the index. Lets see what is the effect of price change of a stock on the index. We will take the example of S&P CNX Nifty. As discussed before Nifty is an index based on full market capitalization i.e. the index is proportional to the sum of the market capitalization of all its constituent stocks. The weights of the stocks in the index will vary. Lets take the data of 31 December 2007 for understanding the concept. Nifty closed at 6138.6 on December 31, 2007. The top four weighted stocks in Nifty were:

Stock Name	Market Capitalisation	Weightage
	(Rs. Crores)	%
Reliance	4,19,043	11.89%
ONGC	2,64,568	7.51%
NTPC	2,06,879	5.87%
Bharti Airtel	1,89,100	5.37%
Total	35,22,527	100%

Suppose Reliance's stock price changes by 10%, how will Nifty change?
This is a very simple question. Since market capitalization is directly proportional to stock price, Reliance's market capitalization will increase by 10%. Assuming other constituents of Nifty unchanged this will lead to an increase in Nifty value by:

Change in Total Market Capitalization of all constituents of Nifty = Change in Market Capitalization of Reliance = 10% of 419043 = 41,904.3

New Total Market Cap = 35,22,527 + 41,904.3 = 35,64,431.3

New Nifty Value / New Total Market Cap = Old Nifty Value / Old Total Market Cap

So, New Nifty Value = 6138.6 * 35,64,431.3 / 35,22,527 = 6211.625

Change in Nifty value = 73.025
% change in Nifty = 1.1896%

We got that a 10% change in Reliance's stock price will change Nifty by 1.1896%. This is same as the weight of Reliance in Nifty. So, all this calculation was meaningless and we can find the change directly from the weight of that stock in Nifty :).

Nifty falls below 6000 mark first time in 2008 led by Mutual funds sell off

Indian stock market has seen heavy sell off in the past two days. The benchmark indices Nifty and Sensex have touched a low level of about 4-5% from the closing value two days back. We will try to analyse the reasons for this abrupt selling, but first we shall look into the trends of the Indian stock market for past one year. The following graphs are self-explanatory:

Variation of Nifty-50 over one year. Returns in excess of 50% in one year.

Past one month variation in Nifty index. Highly volatile. Nifty fell sharply in mid December 2007, and also rise sharply the next week. Touched new highs of 6300 in January 2008 before falling back sharply below the 6000 level in mid January. Will Nifty rise back sharply as seen in December last year, perhaps no one can say so for sure.

The last two days heavy sell off can be seen in this chart. On January 15, and 16 Nifty has fallen sharply and only in last hour of trading on January 16, bulls have tried to come back.

Reasons for sharp fall:

If we look at two big group of players in the Indian markets, the FIIs and the mutual funds, the perception of both are not same. While mutual funds have been one of major reason as they have sold off heavily in equities in the last two trading session, FIIs have been buying steadily though their activity has slowed down.
One of the apparent reason is the Reliance Power IPO, India's biggest IPO so far, which opened for subscription on January 15, 2008. The size of the IPO is about 3 billion dollars and it got fully subscribed within minutes of its opening. The excitement about the IPO has lead to it getting more than 10 times offer for subscription on the first day itself. This is remarkable considering the size of the issue. About 27 billion dollars have shifted to Reliance Power and it appears that a substantial part of it has been coming from the stock markets. There is a craze for IPOs and this has led to spectacular performance of the IPOs in the last year. Moreover, at levels above 6300 for Nifty many investors don't see any significant upside and have taken their money from stock market to the IPO which has higher chances of giving them 40-50% returns on listing.

How did various Indian stock market indices performed in 2007

Returns of the four major indices of National Stock Exchange(NSE) of India in the year 2007 are are:

CNX 100	CNX 500	Midcap	Nifty
56%	61%	78%	53%

While late rally in midcap stocks lead to its overall better performance, CNX500 also outsmarted Nifty50. This suggests that the appreciation of stock prices in the year 2007 was across the market and not limited to the stocks in benchmark indices like Nifty and Sensex.

The graph showing the variation within the year of the above indices:
Relative performance of the four indices is shown in the graph below:

Correlation of Sensex and Nifty

How much correlated are Sensex and Nifty? Lets look at the graphs of the two indices for last five years:Analyzing the data for last five years using regression shows a high correlation between them. Lets look at the picture for last one year.

Based on the past data, one can easily conclude that Sensex and Nifty are highly correlated indices.

What is S&P CNX Nifty? What constitutes Nifty?

S&P CNX Nifty (Standard & Poor's CRISIL National Stock EXchange index-NSE fifty) is the benchmark index of NSE reflecting the performance of Indian stock markets. The fifty stocks in the index have market capitalization more than that of rest of the traded stocks at NSE. Nifty is managed by India Index Services and Products Ltd. (IISL), a joint venture between NSE and CRISIL.

Nifty is computed using market capitalization weighted method. Hence, the level of the index reflects the total market value of all the stocks in the index relative to base period (index base value of 1000 on November 3, 1995).

The stocks for inclusion in Nifty have to satisfy several criterias like liquidity (measured by impact cost), market capitalization, floating stocks, etc.

The present constituents of Nifty are:

Company Name	Industry
ABB Ltd.	Electrical Equipment
ACC Ltd.	Cement
Ambuja Cements Ltd.	Cement
Bajaj Auto Ltd.	Automobile - 2/3 wheeler
Bharat Heavy Electricals Ltd.	Electrical Equipment
Bharat Petroleum Corporation Ltd.	Refineries
Bharti Airtel Ltd.	Telecommunication
Cairn India Ltd.	Oil Exploration/Production
Cipla Ltd.	Pharmaceuticals
Dr. Reddy's Laboratories Ltd.	Pharmaceuticals
GAIL (India) Ltd.	Gas
Glaxosmithkline Pharmaceuticals Ltd.	Pharmaceuticals
Grasim Industries Ltd.	Cement
HCL Technologies Ltd.	Softwares
HDFC Bank Ltd.	Banking
Hero Honda Motors Ltd.	Automobile - 2/3 wheeler
Hindalco Industries Ltd.	Aluminium
Hindustan Unilever Ltd.	Diversified
HDFC Ltd.	Finance - Housing
I T C Ltd.	Diversified
ICICI Bank Ltd.	Banking
Idea Cellular Ltd.	Telecommunication
Infosys Technologies Ltd.	Softwares
Larsen & Toubro Ltd.	Engineering
Mahindra & Mahindra Ltd.	Automobiles - 4 wheelers
Maruti Suzuki India Ltd.	Automobiles - 4 wheelers
NTPC Ltd.	Power
National Aluminium Co. Ltd.	Aluminium
Oil & Natural Gas Corporation Ltd.	Oil Exploration/Production
Punjab National Bank	Banking
Ranbaxy Laboratories Ltd.	Pharmaceuticals
Reliance Communications Ltd.	Telecommunication
Reliance Energy Ltd.	Power
Reliance Industries Ltd.	Diversified
Reliance Petroleum Ltd.	Refineries
Satyam Computer Services Ltd.	Softwares
Siemens Ltd.	Electrical Equipment
State Bank of India	Banking
Steel Authority of India Ltd.	Steel
Sterlite Industries (India) Ltd.	Metals
Sun Pharmaceutical Industries Ltd.	Pharmaceuticals
Suzlon Energy Ltd.	Electrical Equipment
Tata Consultancy Services Ltd.	Softwares
Tata Motors Ltd.	Automobiles - 4 wheelers
Tata Power Co. Ltd.	Power
Tata Steel Ltd.	Steel
Unitech Ltd.	Construction
Videsh Sanchar Nigam Ltd.	Telecommunication
Wipro Ltd.	Softwares
Zee Entertainment Enterprises Ltd.	Media

Sector	No. of companies in Nifty
Automobile	5
Cement & Construction	4
Diversified	3
Electrical Equipment	4
Engineering	1
Financial	5
Gas & Oil	3
Media	1
Metals	5
Pharmaceuticals	5
Power	3
Refineries	2
Softwares	5
Telecommunication	4

The weightage and market capitalization of the constituents of Nifty as on 31 december 2007 are shown below:

S.N.	STOCK	Market Capitalisation (Rs. Crores)	Weightage %
1	ABB	32,046	0.91%
2	ACC	19,227	0.55%
3	BAJAJ AUTO	26,590	0.75%
4	BHARTI AIRTEL	1,89,100	5.37%
5	BHEL	1,26,773	3.60%
6	BPCL	18,932	0.54%
7	CIPLA	16,529	0.47%
8	NTPC	2,06,879	5.87%
9	DRREDDY	12,312	0.35%
10	GAIL	45,970	1.31%
11	GLAXO	8,701	0.25%
12	GRASIM	33,573	0.95%
13	AMBUJA CEMENT	22,379	0.64%
14	HCL TECH	21,882	0.62%
15	HDFC	80,804	2.29%
16	HDFC BANK	61,223	1.74%
17	HERO HONDA	13,905	0.39%
18	HINDALCO	26,366	0.75%
19	UNILEVER	46,868	1.33%
20	CAIRN	45,749	1.30%
21	ICICI BANK	1,35,658	3.85%
22	INFOSYS	1,01,153	2.87%
23	UNITECH	79,424	2.25%
24	ITC	78,875	2.24%
25	RPL	1,00,530	2.85%
26	L&T	1,21,406	3.45%
27	MARUTI	28,732	0.82%
28	M&M	21,182	0.60%
29	IDEA	36,658	1.04%
30	NATIONAL ALUMINIUM	31,246	0.89%
31	ONGC	2,64,568	7.51%
32	STERLITE	73,314	2.08%
33	PNB	20,952	0.59%
34	RANBAXY	15,874	0.45%
35	RELIANCE POWER	50,451	1.43%
36	RELIANCE INDUSTRIES	4,19,043	11.90%
37	SAIL	1,17,531	3.34%
38	SATYAM COMPUTERS	30,260	0.86%
39	SBI	1,24,793	3.54%
40	SIEMENS	31,867	0.90%
41	SUN PHARMA	24,208	0.69%
42	SUZLON	57,985	1.65%
43	TATA POWER	31,958	0.91%
44	RELIANCE COMMUNICATIONS	1,53,921	4.37%
45	TATA MOTORS	28,601	0.81%
46	TCS	1,05,435	2.99%
47	TATA STEEL	68,356	1.94%
48	VSNL	21,787	0.62%
49	WIPRO	76,769	2.18%
50	ZEEL	14,180	0.40%
	TOTAL	35,22,527	100.00%

Data Source: NSE

Derivatives market turnover in India

Derivatives market in India is mainly in two categories: index derivatives & stock derivatives. Index derivatives includes futures and options contracts based on the benchmark index, the most famous of them being Nifty - 50 index. The trading of contracts with Nifty-50 as underlying is done through NSE and the contract size is 50. With a value of Nifty at 6250 this sums to a contract size of 312500 rupees. There are three types of contracts depending on the settlement date: 1 , 2 , 3 month contracts. The contracts expiry date is set on thursday of the last week of each month, and a new contract is initiated on the next trading day.

The derivatives trading in India was started by NSE in June 2000 with the introduction of Nifty Futures. Index options were introduced one year later in June 2001. Since then the turnover in index based derivatives in NSE has grown several times. The following graph shows the turnover trend in NSE index derivatives (futures and options)

NSE launches MINIFTY for retail investors

India's biggest stock exchange National Stock Exchange (NSE) on December 27, 2007, has introduced a new contract, MINIFTY, in with S&P CNX Nifty Index as underlying. The new contract is a small derivatives contract and has a lot size of 20 for fures and options. The main contract NIFTY has lot size of 50. With the value of underlying at about 6250 points the total contract size of MINIFTY can be estimated about 125,000 INR. With the introduction of this contracts NSE, India's biggest derivatives exchange, expects the retail investors' participation to increase significantly. Currently NIFTY futures and options are the highest traded index derivatives in India with an average daily turnover of about INR 20000 crores (200 billion INR). With the introduction of MINIFTY there are arbitrage possibilities between Nifty and mini Nifty derivative contracts.

Nifty 50 is the benchmark index of NSE which captures the Indian stock market movement and is based on 50 highest market capitalization securities.

Thus, the cost of taking a derivative position on the index has reduced from around Rs 3 lakh to a little over Rs 1 lakh.

Bombay Stock Exchange (BSE) has also introduced a mini contract named MSX in the futures segment. The contract is based on BSE's benchmark index SENSEX and has a lot size of 5. The SENSEX is currently at about 20800, making the total contract amount to be just above Rs. 100,000. BSE's main product in the futures segment has a lot size of 25.

Securities and Exchange Board of India (SEBI) has approved the introduction of seven new derivative products for the Indian market. SEBI has put a minimum contract size limit of Rs. 100,000 on the contracts at the time of introduction in the market.

Nifty touches 6300 mark for the first time

India's stock market index S&P CNX Nifty, which includes top 50 listed companies, has scaled new highs by crossing the 6300 mark for the first time on 4th January. The index has risen by more than 50% since last year and is one of the best performing global index of the year 2007 . Most of this rise has been fueled by the FIIs which have been pumping exorbitant amount of money into the Indian stocks. The country has been growing exceptionally well with last years growth in GDP of about9% per annum