Home >Money >Personal Finance >‘What gets people into trouble every time is hunting for a fixed yield’

Indian investors, already feeling rattled by the ongoing debt crisis, received another shock when Moody’s downgraded its outlook to negative for India. Kunal Kapoor, global CEO of Morningstar, talked about the implications of the downgrade, the rise of passive investing in India, and the problems and potential biases of India’s bank-led distribution model for mutual funds

Moody’s recently downgraded its outlook on India to negative, bringing it a step closer to the lowest investment grade rating. How should Indian investors view this move?

Our philosophy has always been about investing for the long term and so the question to ask is: should investors bother or not? For most investors, the day-to-day noise of investing is irrelevant and they need to focus on the long-term outlook. Certainly, there will be different macro and micro factors that have an effect for a short period of time on the way people think about investing. However, if we take a step back and think about India from a long-term perspective, it has good growth potential. For the average investor, worrying too much about the here and now does not make sense. The key is to build a portfolio that is right for your risk profile and that has the ability to help you reach your goals.

Do Indian investors, particularly mutual fund investors, suffer from a home country bias?

Absolutely. In almost every country, we see this is the case. This is because we tend to invest in what we can understand and can touch and feel. In some countries, including India, it’s been hard to invest outside the country and so you’re forced to have that bias. Sometimes your country can have more interesting prospects and you might have that bias as well. To the extent that you are able to invest beyond your home market, it adds strong diversification to a portfolio. India is a pretty small percentage of the global market capitalization. If you are trying to build a portfolio that mimics global market cap, India is a much smaller part. However, most people are probably not going to go that way. But in general, you want to at least think of having a stake in the overseas markets, that’s somewhere north of 15%.

There’s been a debt crisis in India over the past year since the IL&FS default. Mutual fund investors have also been hit by it. The Securities and Exchange Board of India (Sebi) has tightened rules in response but does it need to do more?

What gets people into trouble all the time is a hunt for yield. Everyone thinks that oh, I saw a higher percentage and they guaranteed that I’m going to get my money back. Rather than getting 8%, I’m going with the 9% or the 10%. But, in reality, how do you earn more interest—by lending money to a riskier enterprise. You are being paid to take on that risk. Often, if you take on that risk, there is a chance of default.

Regulators can help up to a point. Everywhere in the world, including in India, you want to be thoughtful about how you are looking at fixed income rates because there is risk associated with them. The more you push the yield up, the more credit risk you are taking and more the chances of a potential loss of capital. Should the government or regulator do more? Possibly, but ultimately the best self-correcting mechanism is for investors to understand the trade-off. You want to make sure that investors are educated. I think that pays more in the long term than anything else.

Over the past 12-18 months, there has been a rising trend of under-performance by actively managed funds in India. Is it the right time for passive investing?

For a long time, people have been asking, will the shift ever happen in India? It was fair for that conversation to occur because you had outperformance taking place in India. There were stock pricing inefficiencies that were being exploited. However, if you see the data, particularly in the large-cap area, the inefficiencies have started to narrow. Investors have also started to push more money into passive. As you’ve seen elsewhere in the world, it’s a trend that’s likely to persist. It’s a secular trend towards lower fees and more transparency. Those things are likely to continue driving the growth of passive investments in India.

It’s important, though, that it’s not framed as just an active versus passive debate. People always assume that there has to be one or the other, a winner and a loser. The only winner here is the investor because you have more choice and lower costs. The key thing when you’re building a portfolio is to build it in a way that makes sense for you and that may mean you have some passive and some active or maybe all passive and all active.

I believe you should think about it from the perspective of best in class and passive is a valuable option for investors who prefer that approach and do not want some of the shorter term swings in performance by an active fund.

The mutual fund distribution landscape is dominated by banks. A recent study showed that banks tend to recommend a disproportionate number of schemes from the fund houses they are associated with. What’s your view?

Around the world, when a firm controls its own distribution, there tends to be a bias towards its products. I’m not sure that bringing more regulations is always the answer. Certainly, if there is something harming the investor, it is the prerogative and the duty of the regulator to step in.

What you really want to ensure as a regulator is that you have a perfectly competitive marketplace. What I mean by that is that you want a marketplace where the investor has the ability to make choices. The investor should be educated and informed enough to know if indeed there are conflicts. In other parts of the world, regulators have required people to disclose conflicts and I think that’s a sensible way of approaching it.

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