In line with its aggressive Rs. 56,500 crore disinvestment target for this fiscal, the government has announced the second tranche of its CPSE (Central Public Sector Enterprise) ETF. AN ETF, or exchange traded fund, functions like a mutual fund; but it's units trade on the exchange in real time.
The FFO or Further Fund Offer, as it has been termed, will run very briefly from January 17th to January 20th. If the previous tranche is anything to go by, we'll likely witness an oversubscription well beyond the stipulated ceiling limit of Rs. 6,000 crore. Previously, the government had received applications for Rs. 4,363 crore for the CPSE ETF in 2014, of which it had to refund Rs. 1,363 crore to investors. In India, there's something magical about the word 'government' that magnetizes even risk-averse investors into equity-investing action!
The CPSE ETF invests in stocks of 10 PSU's namely: ONGC, Coal India, IOC, GAIL, Oil India, PFC, Bharat Electronics, REC, Engineers India and Container Corporation of India. Veritable heavyweights, all! The fund has been managed by Reliance Nippon Life AMC since last year, after it acquired Goldman Sachs Mutual Fund's assets.
The launch of the FFO is nicely timed, with the ETF having outperformed broader indices and other large cap mutual funds handsomely in the past 12 months, having delivered returns of 30.04% on the back of some strong tailwinds.
Should you join the storming herd of CPSE ETF applicants, or sit quietly on the side-lines? Let's evaluate this decision in light of the scheme's salient features, as well as other available options.
There are three main USP's of this fund. First, retail investors are being offered a 5% discount for investing during the NFO (New Fund Offer). Second, the expense ratio of this scheme, at 0.07%, is indeed extremely low. Expense ratios comprise of the portion of the fund that is utilized towards fund management expenses, and typically range between 1.5% to 2% for mainstream equity mutual funds. Third, the portfolio comprises of lower-valuation (P/E wise), distinguished PSU's, and is therefore being touted as a relatively 'safe' way to invest into equity markets.
To begin with, let's consider the 5% discount. First things first, if you're entering this fund with the intent of 'flipping' your units soon after the NFO to earn a quick 5% plus return, you're making a grave mistake; if you're unlucky, you could wind up losing big. This fund, and for that matter any equity oriented fund, must be invested into for a minimum time horizon of 5 years. Keeping that in mind, the 5% upfront discount, when amortized over a 5-year holding period, actually works out to an effective 'outperformance' of a shade under 1% per annum. Add to that the 2% or so savings in expense ratios, and you effectively have a head start of 3% per annum over mainstream equity oriented mutual funds. The question is: does this annual 3% cost advantage justify an investment decision?
On that note, let's consider the third touted advantage, that is the whole 'safety' angle. PSU's traditionally command a lower P/E ratio that their higher growth counterparts, and it's therefore unfair to judge the future growth prospects of a PSU vis-a-vis let say, high growth private company blue chip stocks, based on P/E ratio alone. Also, though the overall P/E ratio of the fund is low (12.77X), there are some high P/E stocks in the portfolio too - Container Corp and Engineers India are both trading at 30X plus earnings.
Also, worth noting is the fact that the CPSE ETF portfolio, at 10 stocks, is extremely concentrated - functioning almost like a PMS. Owing to the restricted number of stocks, sectoral diversification is absent. At present, 77.4% of its portfolio comprises of energy stocks! The role of diversification in risk control, both at a sectoral level and at a stock level, are well known. It is widely believed that 30 stocks represent an optimal level of diversification, from the perspective of balancing out risk and reward.
Contrary to the mistaken belief that the CPSE portfolio is relatively non-volatile, it's concentrated structure and lack of sectoral diversification might actually serve to increase the risk of the portfolio; perhaps even mitigating a large portion of the risk reduction arising from the fact that the portfolio comprises of large cap PSU's. This volatility can be put in perspective in light of the best and worst 12 month performances of the fund: 30.07% (Apr 16, 2014 - Apr 16, 2015) and -27.34 % (Feb 27, 2015 - Feb 29, 2016). In the same period between Feb, 2015 and Feb, 2016, SBI Bluechip Fund's NAV fell by 10.7%. Another large cap equity fund, DSP BlackRock Focus 25 (which also runs a concentrated portfolio), fell by 16.3%.
Given that the low-risk argument is questionable at best, how has the fund fared against large cap mutual funds? Not very well - since inception, the fund has returned 12.6% per annum. Compare this with the performance of SBI Bluechip Fund (18.5%), DSP BlackRock Focus 25 (19.1%) and Birla Sun Life Top 100 Fund (15.9%), and the cost saving suddenly appears nugatory (Bear in mind that the stated returns from the three mutual funds are post-expense ratio consideration)
Admittedly, PSU stocks could witness some outperformance in the next couple of years because of government initiatives. Having said that, it also becomes difficult to justify an investment decision into the CPSE ETF based on cost savings and portfolio construct; top performing equity mutual funds almost certainly present a superior long-term investment option from a risk-reward standpoint, higher expenses notwithstanding. Smart investors are advised to steer clear of the CPSE ETF related brouhaha and seek out top ranked large cap mutual funds instead.
