Passive mutual funds are boring 🥱

Make way for custom-built mutual funds

This is edition 333 of Beyond The First Order, a premium daily newsletter that demystifies the hidden models, incentives and consequences of the most significant events across India and Southeast Asia

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Good morning,

The world was divided on lockdowns. Is it good or bad for mental health? We finally have some answers. The world is equally divided on re-opening, especially schools. There, some states in India have chosen to ignore medical advice on appropriate re-opening. Re-opening for tourists, too, is equally complex as Thailand is finding out. What is uncomplex, though, is the transformation in passive mutual funds. 

Tailor-made portfolios is where the money lies

Last week, Vanguard, the pioneer of index fund investing–where a mutual fund just replicates the stocks in an existing index such as the Sensex–decided to break with tradition. It made its first acquisition in its 46-year history by straying away from its roots of low-cost index-tracking funds. 

The company it acquired, Just Invest, is an upstart based on a ‘direct indexing’ strategy. Which means that it tailors a portfolio according to what a client wants. 

So, if you don’t want to replicate a broad index but want your portfolio to be free of tobacco companies, you get it with direct indexing. In India, that means buying the Sensex 30 index without India’s tobacco giant ITC. Want to avoid companies that have a questionable record of animal cruelty? You get that, too. If inclusion and diversity are how you decide to allocate your money, then that’s what direct indexing can help to do.

This is quite different from an index fund’s philosophy of buying all the stocks in an index. And unlike a fund where you just get units and don’t own the stock, in direct indexing, you become part owner in the shares. Buying stocks directly rather than through a fund can be more optimal from a tax perspective. And no one really likes paying taxes, so direct indexing takes the cake.

By using algorithms to do the screening, elimination and automation to ensure that the strategies can be easily replicated, direct indexing is straddling the middle ground between boring low-cost index tracking and the adventurous world of active fund management, where professionals try to pick the best stocks. 

Vanguard’s not the first big-name to dip its toes in this segment. In June, global investment bank JPMorgan announced its acquisition of Open Invest, a values-based advisory company specialising in ESG investing. That’s another form of the ‘direct indexing’ strategy of giving clients what they want. 

Why is it all the rage?

  1. Plain vanilla index funds have been taking the mutual funds space by storm. Since asset management companies can’t really squeeze out a lot of fees from this product, direct indexing helps it to eke out just a little more.
  2. Investors are turning more value-conscious. In the US, there have been concerns that people’s retirement money or their index fund money is unknowingly going to gun manufacturers. Direct indexing can help to avoid that from happening.

Investors get what they want and index fund creators like Vanguard can earn more. It’s a win-win. 

What about in India?

Smallcase, a custom-portfolio builder which allows investors to create their own portfolio with a few clicks, is modeled on US-based Motif Investing. Motif started off by offering theme-based portfolios that index funds didn’t offer. Smallcase claims to have enabled Rs 8,000 crore (US$1.06 billion) of investments through its platform in the year ended March 2021, with the number of users jumping 3x—from 900,000 to 2.8 million. So clearly, it’s having its moment in the sun. 

While the platform hasn’t ventured into direct indexing by way of offering ESG screeners or elimination of oil companies or tobacco companies from a portfolio, it could take another leaf out of Motif’s book. In 2019, Motif ventured into direct indexing strategies by offering what it then called the first free direct indexing product tracking the US S&P 500. If Smallcase wants to extend its capabilities a bit more, it could eat mutual funds’ lunch. 

PS 1: Motif was acquired by the brokerage Charles Schwab in 2020. So, the next time a mutual fund in India thinks of making an acquisition, instead of just buying another mutual fund, maybe they could consider what Vanguard, JPMorgan, and Charles Schwab are doing and acquire a fintech company like Smallcase.

PS 2: If you’d like to understand how stock market indices are constructed in India, I recommend reading NSE, BSE, and the benchmark blues by Seetharaman and Anand.

But school means more to older children

It has been 18 months since the pandemic hit and on Wednesday, the Indian Council of Medical Research (ICMR), the apex body responsible for coordinating India’s pandemic policies, suggested that the younger children can start heading back to primary school. 

The only condition that ICMR laid out was that the adult staff at the school be vaccinated. The rationale from a medical standpoint is that younger children are less likely to fall severely sick as compared to adults and older children. So, ICMR suggests that primary schools could reopen before secondary schools. 

ICMRs decision was followed by an appeal to reopen schools from two international organisations last week—the United Nations Educational, Scientific and Cultural Organization (UNESCO) and United Nations Children’s Fund (UNICEF): 

As of today, primary and secondary schools are shuttered in 19 countries, affecting over 156 million students. This should not go on. Schools should be the last to close and the first to reopen. In their efforts to limit transmission, governments have too often shut down schools and kept them closed for prolonged periods, even when the epidemiological situation didn’t warrant it. These actions were frequently taken as a first recourse rather than a last measure. In many cases, schools were closed while bars and restaurants remained open.

The losses that children and young people will incur from not being in school may never be recouped. From learning loss, mental distress, exposure to violence and abuse, to missed school-based meals and vaccinations or reduced development of social skills, the consequences for children will be felt in their academic achievement and societal engagement as well as physical and mental health. The most affected are often children in low-resource settings who do not have access to remote learning tools, and the youngest children who are at key developmental stages.

The losses for parents and caretakers are equally heavy. Keeping children at home is forcing parents around the world to leave their jobs, especially in countries with no or limited family leave policies.

That’s why reopening schools for in-person learning cannot wait.

There are several compelling reasons to open schools. Especially in India, where a large majority of children depend on schools for nutrition in the form of mid-day meals. A study recently said that the interruptions to schooling and to the mid-day meal scheme could have long-term impacts on the nutritional health of an entire generation.

There are risks, of course. Doctors are not sure what could happen if a child is infected with the common cold or another viral disease and Covid-19 at the same time. In India, specifically, the second wave saw cases of a rare, inflammatory and potentially life-threatening condition called multi-system inflammatory syndrome (MIS-C) among children (BFO#289).

However, the actual decision-makers—some of the state governments—have chosen not to weigh the risks and benefits or consider ICMRs advice. The state governments of Haryana, Punjab, and Chhattisgarh have said they will open schools for older children rather than younger ones. Older children seem to be the priority for decision-makers. Even though their health is at a higher risk, according to the ICMR. This decision-making seems less about the medical realities and more about the academic imperatives. 

For mental health’s sake: to lockdown or not to lockdown?

Last year, when countries across the world imposed lockdowns to prevent the spread of Covid-19, a debate raged on whether the hardship caused by the lockdown was worse than just letting the virus run its course given its ‘low’ mortality rates. That the ‘cure’ was worse than the disease.

New research published in the British Medical Journal (BMJ) says that the study of all-cause mortality across 94 countries revealed more deaths in countries with fewer Covid restrictions, and that lockdowns may have reduced the annual mortality by up to 6% just by eliminating the spread of the flu. 

So, fewer deaths. But did lockdowns have a worse impact on mental health?

And that’s where things seem to get a little trickier as it gets difficult to accurately distinguish whether lockdowns cause or are just associated with a decline in mental health. 

Also, there’s an often overlooked aspect of mental health during the pandemic— the fear of infection and of losing a loved one:

Missing school clearly affects children’s mental health, but so does losing a loved one to COVID-19. Recent estimates suggest that the number of children who have lost a parent to COVID-19 is extremely high, with a recent paper estimating that 43 000 children have lost a parent in the USA. The same study estimated that 2 million children have lost at least one grandparent to COVID-19.

It’s only now that research is catching up and even throwing up puzzling observations. Like a survey of 450,000 Americans by Sharecare, a digital health firm, and researchers from the Boston University School of Public Health showing an uptick in wellbeing from lockdowns. This, despite setbacks to their financial status.

More country-wise analysis which also breaks down income as well as demographic differences will continue to educate us on the true impact of lockdowns. For now, it seems like lockdowns that led to fewer deaths may have been, in fact, better for mental health, too.

Thailand’s travel reopening struggles to win tourists

Thailand’s efforts to reopen its tourism sector aren’t exactly off to a flying start. Well, there’s been plenty of flying… just not many passengers.

A trio of neighbouring tropical islands, including popular destination Koh Samui, reopened flights from overseas last week. The big sell is that rather than being confined to a state-mandated quarantine—Alternative State Quarantine (ASQ)—for two weeks, you can head straight to an idyllic island for 14 days before becoming eligible to visit other parts of Thailand.

The Samui Plus programme, as it is called, aims to welcome 1,000 tourists a month. It sounds modest, but the programme was slated to generate THB180 million (US$5.5 million) in revenue and provide a template for other island destinations to re-open on more visitor-friendly terms.

Initial uptake has been slow, with just 20 passengers arriving in the first week across ten hugely inefficient flights. Thai authorities are already raising the potential for arrivals to be free to move to other ‘quarantine’ islands after a week, but so few tourists means there’s some way to go for that to be of any substance.

That’s because apart from Covid, attracting tourists for lengthy stays is a tough task. The average stay at a hotel in the country is less than 10 days, according to Statista. Now, mix in the need to fly halfway across the world during a pandemic… 

That’s it from us for this week. If there are subjects you’d like us to explore, we’d love to hear from you.

We’ll see you on Monday.

Stay safe,

PS: Don’t miss our special story today. It is free to read till 12 noon IST.

This week, used car startup Spinny raised US$108 million led by Tiger Global. The New York-based hedge fund has reportedly closed 15 deals in 2021 to date, with many more reportedly coming. Our special story from today is a dissection of Tiger Global’s India strategy and its need for big exits. It’s free to read till 12 noon IST:

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