Prashanth Krish | Portfolio Yoga

2 Years of Momentum Investing – An Overview

“When the student is ready the teacher will appear. When the student is truly ready… The teacher will Disappear.”― Tao Te Ching

2017 in hindsight was a fantastic year for the change in scenery from Bangalore Stock Exchange where I had spent a better part of my time since I came into the market made way for time at the office of Capitalmind.

I have been a systematic trend follower for a long time, but owing to reasons including running inadequate capital, I had never ventured into Systematic Investing in the way I did post my joining Capitalmind.

I wrote about my first year of Momentum Investing last year and thanks to a run-away market, the outcome was way better than what I could expect. 2018-19 though has turned out to be a test though given my own experience in markets post the dot com bubble and the infra bubble of 2008, this isn’t anywhere close to the worst one could expect, it did provide with a deeper look at what to expect and how things could change rapidly.

Two years is still a small period and the performance can only be ascertained to be good or bad post at least a decade. Yet, more the time spent on an endeavour, better one’s understanding and in that respect, 2018 while not fruitful in terms of gains was a good year in terms of understanding the points of strength and failure of the strategy.

When I started trading the strategy, it was more rudimentary in approach based on available data sources. The back-test too was on a smaller data sample. This year, thanks to my friend and mentor, @jace48, I was able to test the strategy comprehensively for the period starting in 2005.

Testing on a long period of data allows one to get a better feel for the strategy though a back-test can never replace real application with all its issues. But without a back-test, risking real money is equivalent to betting blindly in the hope that Lady Luck will always be in one’s favour.

The Back-Test

The strategy was back-tested for the period 2005 to 2018 using the same attributes and filters that is being used in the real world. Since slippage and others costs aren’t taken into account, we need to be aware that the results could slightly overstate the reality. To compensate for that, the returns below were adjusted by removing 0.50% per month (6% return reduced per year)

Of the 165 months in which the strategy was tested, the strategy delivered positive returns in 106 of them versus negative returns in 59 months. 2008, 2011 and 2015 were negative years reflecting the general trend of market being weak during those years.

Momentum or for that matter, any strategy that is long only will fall mostly in line with the broader markets. Risk measured through draw-down from peak or even Volatility of returns and Return compared to other available asset classes are the only way to test whether a strategy is worth pursuing or not.

The results showcased above are for trading a portfolio of 30 stocks, rebalanced monthly. While the logic was 30 was to compensate for the fact that when we trade using momentum, we aren’t really looking to understand neither the nature of the business or the cycle it currently is, testing for different portfolio sizes showed up exactly the same. The optimal portfolio size is between 25 to 30 stocks.

50 Stocks offer the lowest draw-down but returns dwindle as well. On the other hand, if one were to trade just 10 stocks, returns go down the drain while risk explodes. A 50 stock portfolio can be seen as advantageous even though returns are a bit lower if the capital is too large and liquidity is starting to hurt deployment. In most other cases, 25 – 30 stock portfolio should suffice.

Draw-down comparison shows how deep the 10 stock portfolio moves in 2008 versus the best (among the worst) which is 50 stock portfolio. Excluding 2008, while others get close to merging with one another, the 10 stock portfolio draw-down stands out as the worst at any point of time.

Now the Reality:

In 2018, the strategy delivered a loss in 8 of the 12 months. But the standout was that the loss for the calendar year was just 15.57% which was more inline with performance of Nifty Mid Cap 100. This even though we began the year with a median portfolio market capitalization of just 5000 crores which put the portfolio well and truly into the Small Cap bracket.

Confidence in strategy is the only way one can sustain the barrage of weakness we saw in markets and which was reflected in the portfolio loosing for a consecutive 6 months through 2018-19. If not for the back-test and the reading which provided a better understanding of what to expect, its easy to see why investors would rather cut position and wait in cash than continue to take all trades as the strategy expects one to.

The portfolio had a max draw-down of 25% though its bit disappointing to see that we haven’t yet recovered from that fall with the current draw-down still at 20% from the peaks we had reached in January of 2018. The equity curve chart pattern though offers some hope J

Be it Momentum or Value, strategies that require one to track portfolio’s, change as required and be up to date on what’s happening if only worth the time and trouble if the returns are more than what one could have achieved by just buying a simple ETF or Mutual Fund.

Since the momentum strategy is agnostic to market capitalization, the best benchmark would be the performance of multi-cap funds over the same period. The best fund over this 2 year horizon is SBI Focussed Equity Fund which in its Direct plan which delivered a CAGR return of 15.37%. Adjusted for AUM, the overall returns from all Multicap funds came to 9%.

Comparatively, despite the multiple months of negative returns, the strategy ended year 2 of operation with 18% CAGR returns. While this is still below what top class fund managers target and return, given the early days and the overall market environment, feel its not something to sneered at.

Here is the NAV chart from start;

I have compared the performance against Nifty Alpha 50 since that is the index that matches the philosophy of the system though it being limited to the top 200 stocks works against it during good times while saving it during bad (lower draw-downs).

Recently, well known Value Investor Rohit Chauhan shared the performance of advisory model portfolio over the last 8 years. What was amazing was that the performance was very close to the back-test results of my own Momentum Strategy (with Momentum doing slightly better). But better or worse is not the question, the fact is that systematically following a strategy can for the investor deliver more than what markets in general can.

I hope that I can continue to invest and grow the capital and showcase a decade of performance 8 years from now. This post is an attempt to enable a better understanding of momentum as an investment strategy that can stand against other factors on its own merits.

I had recently given a talk at Bangalore Investors Group. You can check out the slides here.

When Risk Comes Calling

I started my career as a Fixed Deposit agent canvassing Fixed Deposits for Non Banking Financial companies. Given that I was really young and not really educated formally in the field of finance, I was barely able to convince potential customers of depositing their hard earned money in the companies, many of which they hadn’t heard about. That left me with my only trusting client whose money I managed to invest – my Grandmother’s.

While lack of formal education or experience was a negativity and I really didn’t fully understand the value of money at that point of time, I did understand one thing – invest in only firms that have a AAA rating.

I had zero clue about how that rating came about it other than the fact that it signified the company was a good one to invest in. I avoided investing in even companies with AA rating other than for one investment I got my grandmother to invest into which was a subsidiary of Apple Finance (which had a AAA rating) – Apple Credit Corporation. The reason for investing in a AA company was simple – higher interest rate. ACCL offered a Cumulative Deposit with 21.5% interest payable on maturity.

But the investment in itself was small – a kind of take advantage without having to really worry if the risk came home. Thankfully none of the FD’s I had my grandmother invest ever defaulted – maybe more to do with Luck than Skill, but it still felt like an accomplishment at that point of time.

The Indian Express today had an article which puts the total amount of bad loans written off by Public Sector Banks at 5,55,603 during the period when the current Prime Minister, Narendra Modi has been in Office. While it’s easy to jump to the conclusion that much if not all of the bad debts is because of the government, the real facts aren’t and will never be so straight forward.

Banks are in the business of giving out loans and not all loans despite most backed by some sort of collateral come good. But thanks to the fact that Banks are able to borrow cheap and lend at a substantially higher level, Banks are able to make money post the write off’s. HDFC Bank for instance has a cost of deposit at 4.82% vs average yield of 9.22 leading to a Net Interest Margin of 4.4%.

Banks understand Risks and even in the worst instance, there are back-up’s that ensure that the small investor’s money is never at risk. After banks, the largest lenders are Non Banking Financial Companies. Once again, they make money by ensuing that they have a difference that can take care of any bad loans that shall accrue during the course of their business.

In recent times, Mutual Funds which are flow throw vehicles have come to become on the largest lenders – and sometimes the lender of the last resort. In March 1999, India had 44 Income Schemes which in total managed 1848 Crores. This was 15% of total amount mobilized by Mutual Funds across all Schemes – Debt and Equity.

By April of 2009, total number of Income funds exceeded 500 while total assets under management had moved to 1.97 Lakh Crore. This was 47% of total amount mobilized by Mutual Funds across all Schemes – Debt and Equity.

Come 2019, and we today have 1250+ funds with total assets of 7.20 Lakh Crore. Percentage of Income funds as part of total assets declined to 30% as the percentage of equity funds have advanced strongly in the last decade (from 23% to 32% – 2009 vs 2019).

Since numbers without relative context don’t provide a real understanding, how about comparing to a real large bank. Bank of Baroda is India’s second largest public sector bank and it had at end of 20018 advanced 4.27 Lakh Crore.

Growth of Assets always has a price that needs to be paid. Small Cap fund managers for instance will either need to shut the inflows or move to Mid Cap stocks once the assets they manage start to move higher than what can be possibly deployed with manageable risk in Small Cap stocks.

Debt Fund Managers have for a while been facing a similar problem. How to deploy the large amount of money that was being mobilized while still ensuing that the risk was contained. The easiest was to deploy would be to buy Government Securities. That assures zero risk of capital loss but comes at a lower yield and if the fund wants its own pound of flesh, it makes the fund unattractive to Investors whom it wants to pitch for investment.

The riskier the investment seems to be, the higher the interest rates are. While State Bank of India can mobilize Fixed Deposits at less than 7%, a Cooperative Bank such as Mahaveer Bank offers 8.50% for a similar tenure.

Similarly, the way mutual funds are able to attract more assets under their management is by generating a higher return which in-turn asks for higher risks to be taken. The key difference between a Bank that takes similar risks to a Mutual Fund is that the Mutual Fund is like my Grandmother – I am taking risks on “behalf” of her. If a company defaults, I being the middle man have no way of compensating her.

Yet, in the quest for returns, Funds have taken fool hardy risks and for a while this seemed like the way to do business. Funds suffered literally zero defaults as ample and easy finance by Banks ensured that even the most tyrant promoter paid up his dues on Bonds the funds have bought.

The first sign of change was when companies that had kept rolling their bonds thanks to the unlimited tap given out by Public Sector Banks defaulted. The reason for the default basically lay in the change that RBI mandated Banks to make which mean that ever-greening was a thing of the past.

Yet, the caravan continued to roll on as Fund Managers (save for a few) were able to avoid that hurdle and it was back to business as usual. The more massive hit came from an unexpected source – IL&FS.

When IL&FS bombed out, it hurt not only itself but a lot of companies that had got used to raising cheap finance by selling short term bonds – many secured by nothing more than their bubbly shares. This today is what the drama around the Fixed Maturity Plans and tomorrow could be of many other plans as well.

Take for example, Adani Infra (India) has raised funds by selling its Bonds to Mutual Funds (Kotak Fixed Maturity Plan – Series 186 for instance has 10% of its assets). Bonds of this company are rated AA. In its Rating Rationale, Brickworks says this,

“The rating factors, inter alia, the strength of underlying security in the form of pledge of listed equity shares of APSEZ and ATL with the current promoter pledge of 35.5% and 44.7%,respectively, structure of the NCD, resourcefulness of the promoters of the Company, and financial flexibility of the group.”

The basic rationale behind the rating is the pledge of shares. But what use are shares if you cannot sell them in the markets without depressing the stock to an extent that rather than the borrower being hostage to the lender, it becomes the other way as we are seeing in case of Zee and what we will see in many over leveraged and over extended companies in the months and years to come.

Mutual Funds aren’t Banks, Period. The blame also falls squarely on the government which through its taxation policy has ensure that small investors pay a much lower tax on gains from Mutual Funds versus monies deposited in Banks.

This has distorted how people invest and has let investors take risks higher than what they knew them to be. Debt funds losing money due to bad calls isn’t atrocious as it may sound – it’s the way they have been sold (as alternative to fixed deposits) that is the root of the problem.

But till the time the government wakes up to the distortion, the best way is to invest in funds that are large (preferably the largest around) in the space of Liquid, Ultra Short Term and Low Duration. If you want to be really safe, get into Liquid funds like Quantum which have a portfolio of only GSec’s and Government held Entities. But the yields are lower as should be the way.

Stay away from anything that is closed (Fixed Maturity Plans) unless it’s a small investment and the Indicative Yield seems attractive enough to take such risks.

In my opinion, it’s a fruitless venture for most to chase Alpha in Debt. You are paid way better in Equity where the upsides of being right can be monstrous versus just getting paid interest and principal on time.

Is Momentum Strategy Inherently Risky?

With Momentum as a investing strategy gaining more followers, one of the common threads in all discussions I see is that they are described as inherently more risky – more risky than what I wonder. Equities itself is Risky – if you aren’t willing to bear the cost of temporary loss, maybe this isn’t a asset class you should be getting worked upon.

After all, the basic rationale for investing is to ensure a better life in the future but if that comes with stress that takes a toll in terms of health, such a investing strategy isn’t worth following even if the returns on paper seen awesome.

But before we dive into Risk of Momentum Strategy, the broader question is, What is Risk?

Warren Buffett defines risk as Permanent loss of Capital. When you book a loss in a stock, you are essentially booking a permanent loss since regardless of where the stock moves from hereon, it will not impact your bottom line.

The fear of stocks bouncing back post booking of loss aided by Anchor Bias means many a investor are willing to stick with a stock till its either too painful to hold or till the exchange itself decides to delist. While the loss till the point of time of booking can be considered a quotation loss, in reality even before the final blow is laid, even the investor knows that there is very little chance of getting his money back.

Every Infotech stock went down post the boom and bust of the Dot com bubble. Recovery was seen in just a handful of stocks that survived. 90% of stocks don’t even exit today making it seem that even if one had got caught in the boom, one would have recovered his investment if he had patiently waited it out.

The key in such investment is to know when it’s a temporary loss and when it has turned into a permanent loss and one worth exiting. This of course isn’t as easy for bad stocks have recovered from what at one point of time would have been seen as a write-off while good stocks have fallen more quickly than you could have said 1-2-3

The basic philosophy of Momentum Investing lies in its belief that the market knows better – in other words, markets are efficient for most periods of time and there is no reason to fight that. Its much easier to row a boat with the flow of water than to row against the flow.

We believe in betting on great industries only when the herd is betting on the same. The moment that herd starts to dissipate, we exit our position in favour of something else that has caught the attention of the crowd.

This may appear to be speculative and risky, yet this is one of the only strategies that can be tested to see the weakness and the risks it carries. When deciding how much to risk on a stock or a strategy, it’s always useful to know Ex-ante rather than Ex-post when you can do little but hope that the trend reverses back.

Momentum Investing in may ways can be compare to Micro Cap Investing – both are risky yet both have the capability to deliver higher returns than any comparable strategy.

When you buy a stock, you aren’t buying a ticker symbol but buying a part of a business is the new age voodoo when it comes to investing. Nothing wrong with the thought perse, but unlike say in US where most managements don’t hold enough stock to even block resolutions, promoters here hold majority or more making it tough for both the small and the large shareholder to question.

Take for example the crack in price recently when Prabhat Dairy sold its dairy business to Lactalis for Rs1,700cr. Theoretically as a shareholder you should rejoice for this means that the price has nowhere to go but up considering that the market cap is less than half the cash inflow the company shall see.

Instead, what we saw the stock fall of 24% in the week when the announcement was made as the market believes that the management shall not share the spoils with investors who hold nearly 50% of the company’s equity. So much for buying what seemed like an undervalued business.

A previous example and there are many such examples would be of Lloyd Electric which post selling their brand let no money flow to the minority investors.

As a shareholder, you can cry, crib, scream and make a ruckus. What you cannot do is change thing for the management holds all the cards. Bet with good management is the lessons well-meaning fellow investors will tell you without telling how the hell is one supposed to discern that. Zee, a stock held by Mutual Funds and Institutions alike fell 26% on reports of possible debt issues and corporate governance.

How Risky is Momentum:

I was chatting with a friend the other day and he said that while he understood the value of Momentum as part of his portfolio, he wouldn’t be comfortable investing a large part of his equity portfolio in that given the “Riskiness” of the portfolio.

This made me wonder, how do we measure risk and whether Momentum is really Risky. Here is a table I prepared comparing Nifty 50 representing the Large Cap Index, Nifty Mid Cap 100 representing the Mid Cap stocks in the market and Nifty Small Cap 100 representing small cap stocks and compared data versus Nifty Alpha 50 which is follows a Momentum philosophy. The data used is Weekly with time-frame being from 2004 to 2019.

Do note that while for while the other indices are weighted by market capitalization, Nifty Alpha 50 is weighted by Alpha and this can make a large difference in volatility.

What can we summarize from this?

The weekly change, measured either by way of average or median is highest for Nifty Alpha 50. Not surprisingly, the worst weekly return honour is bagged by Nifty Alpha 50 though the best weekly return isn’t. In other words, when things go bad, Nifty Alpha 50 can go bad pretty fast.

Yet, it has closed more weeks in positive territory versus other indices. More than returns, this is important from the physiological point of view.

Let’s turn our attention to 3 year rolling returns. Nifty Alpha 50 is the undisputed leader here – but this higher return comes with deeper draw-down {Minimum is the % return at the end of the worst 3 year period} and higher volatility.

While Nifty Alpha 50 on an average generates 44% higher return than Nifty 50, it also has 81% higher volatility. No Pain, No Gains.

Investing in Nifty 50 also means that you have a higher probability of being in positive at the end of 3 years versus other Indices. While Momentum is Persistent, when it comes to Consistency, at least during the period of testing, Nifty 50 comes on top of the game.

Draw-down for Nifty 50 is the lowest and highest for Nifty Alpha 50. Do note that higher the draw-down, longer the time for recovery. While a buy and hold approach will work on all the indices, the ability to hold for a long duration is the key to getting the historical returns.

Finally, overall returns. What would investing 1 Rupee in each of the Indices at the start of 2004 been worth today?

Overall, it indeed seems like investing in Nifty Alpha 50 is riskier than investing in say Nifty 50. But just looking at numbers in isolation can lead to wrong conclusions. So, lets try to go for a holistic approach.

Looking through the Lens of Asset Allocation:

Interest rates in developed nations are so low that the only path to generating higher returns is through investing in alternative asset classes like Equity. India is nowhere close to that situation with short term debt funds generating nearly 8-9% return per annum.

Debt funds are able to generate this with little volatility – the assumption here is that you don’t go for funds peddled by those looking for commission and one where there is a risk of both credit and interest rate.

If you can generate 9% with very little risk, what should be your minimum acceptable return for generating return with risk in assets where there is risk of loss of capital?

The key to deciding how much to invest in Equities regardless of strategy comes down basically to two key numbers – the return you require to reach your goals and the volatility (lets measure this as maximum drawdown from peak) you are willing to bear.

If you are able to reach your goals if you can get a compounded annual return of 12% over ‘n’ years, how should you allocate? Do note that that equity returns are lumpy while debt are much smoother. Most years, you shall either generate return much higher than your target or a return that is much lower than the one you seek.

Based on data from Nifty 50, you can get 12% returns by being 100% invested in equity. But being totally invested in equity brings its own set of risks even for those who think they can take such risks.

Assuming an 8% return on Debt and 18% return on Equity, equity to debt ratio of 40:60 should provide you with that return while at the same time halving more than half the max drawdown you may experience.

What if you assume that equity will deliver 15% vs 18%? This will change the Equity:Debt equation to 57:43 in favour of Equity. But if you can get a return of 24% on equity, you need to risk only 15% of your assets in equity to generate the required return.

Higher returns by equity can compensate by enabling you to reduce the overall risk of the portfolio by adding debt component and yet achieving similar returns. The higher returns like what we see in Momentum index while seeming like risk actually can reduce risk of one’s overall portfolio of financial assets.

Market crashes are mostly due to reversal we see in the economic growth of the country which in-turn means greater risk of unemployment. It’s during those times that one can be assured if the debt component is significantly higher for it gives comfort that not all is lost.

Learning the Wrong Lesson from Bogle.

Human Life Expectancy today is 79 years. Most of us live out the lives in a fashion that none other than family members can remember one after we pass away from this world. Those who achieve greatness in their lifetime are generally remembered for at least one more generation before the memory stats to fade away.

Peter Houston, invented the first roll film camera but it was George Eastman who was well known thanks to he being the licensee of the patent on roll film and starting Eastman Kodak Company. Anyone born in the last couple of decades will barely remember roll film based cameras while the coming generation will mostly know camera as something that is part of a phone.

Throughout history, very few innovators have also been able to make a name by building a business around it. Exceptions to the rule are people like Henry Ford who founded the Ford Motor Company in 1902. Thomas Alva Edison was another for who hasn’t heard about General Electric.

John C. Bogle who passed away recently will be someone who will be remembered for a very long period. But will he be remembered right is the question that haunts me today as I read through the Eulogizes.

Yes, he was not just the founder of Vanguard which today ranks among the top fund houses in the world. He is celebrated for founding and popularizing “Index Funds”. Today, his view that rather than attempt to beat the Index, it’s far better and wise to just mimic the index performance through Index funds and Exchange Traded Funds is fast becoming mainstream with even Warren Buffet, the guru of active investing advising investors to go “Passive”

But is that what Vanguard stands for today? While billions of dollars have flown into passive funds in the recent past, Vanguard as of June 30, 2018 was managing just over One Trillion Dollars invested in active funds. Yep, you heard that right – the apostle of Passive Investing runs over 80 active funds.

Recently, one of the better writers of our time, Morgan Housel came to India to deliver a lecture at the India Investment Conference. He is a fantastic writer with focus being on behaviour finance. In one of his earlier interviews with Vishal Khandelwal, he mentioned that his investment consisted of only Vanguard Total Stock Market Index. He talked about the same in an interview to ET Now a few weeks back as well.

Morgan works at Collaborative Fund. Collaborative Fund is a Micro Venture capital that has through 4 funds raised $250 million from investors for investing into start-up’s. If active investing were to be graded based on the risk profile of the investment, active investing would be right up there along with Private Equity and other new age investing beliefs.

“Don’t look for the needle in the haystack. Just buy the haystack!” wrote John C. Bogle in his book, The Little Book of Common Sense Investing.

David Swensen, the chief investment officer at Yale University writes,

“Understanding the difficulty of identifying superior hedge fund, venture capital, and leverage buyout investments leads to the conclusion that hurdles for casual investors stand insurmountably high. Even many well-equipped investors fail to clear the hurdles necessary to achieve consistent success in producing market-beating active management results.”

In his book, Unconventional Success, he presents the following table;

In other words, most investors in PE funds, Hedge Funds and Venture Capital funds will generate sub-par returns. Yet, Trillions of Dollars chase the fantasy of being able to invest in the fund that may fund the next Facebook or next Alibaba.

I am a great fan of Morgan Housel’s writing yet wonder if he truly believes in what he says & I quote “I don’t think investing needs to be complicated so I keep it as simple as I possibly can” – needs to be dished out to investors of their own funds.

I think the biggest contribution of Bogle was not the fact that its impossible to beat the market – its tough, but not impossible but showcasing the fact that fees has a very high impact on returns. Lower the fees, higher the returns – its that simple.

Vanguard’s own active funds charge a median fee of just 0.05%. This low fee ensures that the fund manager need not take unnecessary risks to generate Alpha.

Just to give a comparison with mutual funds in India, most of them charge on an average around 2.05% for regular funds and 1.20% for Direct Funds (Asset Weighted). Easy pickings in the past have meant that even post high expenses, many a fund manager has been able to handsomely beat the benchmark.

New rules combined with huge inflow of funds seem to rock the gravy train as funds will find it extremely tough to outperform the passive indices. Cutting down on fees is the easiest way to generate better performance, but why bother when funds are flowing into active funds like no tomorrow.

“Kitna deti hai?” was a campaign launched by Maruti to showcase our obsession with mileage. Then again, how can we be blamed given the high cost of fuel thanks to loads of government taxes. Every car manufacturer wishes to maximize the miles per litre. While a lot of savings come from optimizing the engine, one of the ways to add mileage is by reducing the drag of the vechile.

The higher the resistance a vehicle offers to the wind, lower the mileage. Car Manufacturers spend big money trying to optimize the design that reduces the same while still adhering to the overall design concept. A Formula 1 for example has the lowest amount of wind resistance but is unlikely to in favors if introduced as a family vehicle.

Friction in finance eliminates returns – higher the friction, greater is the reduction in return for every unit risked. Ritholtz Wealth Management offers Financial Planning and invests their clients money into cheap, low fee products.

But much of the savings they produce to the client are eliminated by their own fee which is a percentage that is many a multiple of the fees charged by actual money managers. This again is friction and the client finally ends up with much lower return.

The biggest fear of Universities and Research Labs are of their best and brightest weaned away from Campuses and Labs to Wall Street. After all, no University or Lab can compete when it comes to the pay Wall Street is willing to offer.

This pay though comes straight out of the pocket of investors. In good years, the fund manager takes not only a management fee but part of the profits as well. In bad years, he is more considerate and takes away just the management fee.

Do that for decades and the investor ends up with just a small part of the overall profit that has been generated using his capital. Mutual Funds aren’t that bad, but their Alpha contracting, the fees over time will eat up into significant returns.

Warren Buffett charges a minuscule percentage for managing the Billions he is in charge of. It’s been calculated that if Buffett had charged what is charged by much of the fund industry – 2% management fee and 20% share of profits, his investors would have stood to lose a lot.

Eliminating friction is a step towards achieving your financial goals faster. The lower the costs, better the return – its as simple as that. The reason to choose an Index Fund rather than active fund lie in the fact that identifying active fund that shall be the winners of the future is incredibly difficult.

Low Fee Active Investing is the path forward. Everything else is secondary.

Book Review: Masterclass with Super-Investors

While books on Investing are plenty, very few are authored by Indian’s themselves and an even smaller sub-sect of them are actually worth spending time and money.

Masterclass with Super-Investors is one of the rare books that qualifies on both criteria. The book has been written in the style of Market Wizard series by Jack Schwager. The authors have chosen Individuals most of whom are well known in the Industry and gone ahead trying to understand their path, their successes and their failures.

While the book is a good read for all class of investors – from beginners to experienced professionals, I do think that those without a firm grasp of the framework and who haven’t seen the cycles may actually get the wrong impressions on how to go about generating wealth through markets.

While the investors come from different paths and time-frames, there are acts and out comes that are similar in nature. In this short review, I shall limit myself to the take-aways that I found that while may not be the root cause of their success was a tremendous catalyst.

The first thing that you notice as you read through is that most of the big money was made by buying in the bear markets and participating in the ensuing bull markets. While for some it was the 1992 Harshad Mehta run, for many it was the 2000 Dot Com bubble.

Of course, as a participant in the 2000 bull market, I know that while making money was easy, holding onto the gains wasn’t. Credit definitely belongs to these individuals who were able to maximize the opportunity that was provided and yet were able to get off the tiger without being eaten.

Big money for most was through concentrated portfolio selection. Even post their success, most investors profiled here have a portfolio not exceeding 25 stocks. Big Bets in their initial years in market contributed significantly to getting them a head start.

Another common thread you will find across most of the investments that they have chosen to showcase is that they were mostly into small and micro-cap companies. Shyam Shekar for example talks about his investment in Hatsun which he started investing when its market cap was 40 Crores. Rajashekar Iyer talks about his investment in Nagarjuna Construction when its market cap was 37 Crores.

Yet another common thread save for a couple of investors were their expectation of returns. Most investors are of the opinion that they won’t invest if they don’t see a possibility of doubling their money in 3 years (CAGR of 26%). Vijay Kedia in that sense is an outlier for he won’t invest for just a doubler in 3 years but looks for companies which bears qualities that may provide him a 10x.

When it comes to Asset Allocation, majority of investors are fully invested into market with a couple of exceptions who have substantial holding of Real Estate. This is not surprising since they having seen their success and build conviction, many see no point in adding instruments that will derail the growth.

Personally for me, Hiren Ved chapter appealed the most. Most of the other chapters are very much readable though a couple felt like hot air. But over-all, this book is definitely worth reading, especially if you have participated in a market cycle.

In his presentation at Value Investing Pioneer’s Summit 2018, Samir Vartak had the following take on investor expectation

“If investor’s goal is to beat the market by 4-5%, he or she should not bother about this hard work. Easier way would be to invest in a steady long term portfolio of businesses, sit back and relax.”

The Hard Work referred to being Analyzing & Investing in Stocks. In fact, investing a few Multicap funds should generate Index+ returns and all this without needing to get off the couch. Doubling your capital in 3 years requires a lot hard work + Luck. Ability to do that consistently for decades is what separates the men from the boys.

As Morgan Housel wrote, “There are a million ways to get rich. But there’s only one way to stay rich: Humility, often to the point of paranoia”

You can buy the book from here: MASTERCLASS WITH SUPER-INVESTORS

Expectations, Probability and Reality. Can you really make 100 Crore by Investing 10 Lakh

Most kids coming home from their exams don’t expect anything less than a First Class. Parents don’t expect anything less than their ward getting into the IIT’s of the world. Investors assume that they can easily generate returns that would put even Warren Buffet at his prime to shame.

On Twitter, experts for most of the time seem to showcase how great their stock selection / trade selection was – look at how the stock bounced right off the support. Fundamental biased investors generally are eager to show how easy it was to know that the stock was a fraud, post the event even though when the stock was actually doing far better than the market, there are few sane voices questioning the same with data.

When the market was running up in the years prior to 2018, Mutual Fund managers were more than happy to show how great investing is. Now that the Large Cap Index in itself is still doing good but stocks have crashed, the excuse is that it’s “darkest before dawn”.

The reason investors aren’t able to stay the course is not because they are greedy or lack discipline but because they were misled on the expectation of the returns they could achieve for the risk they took.

Thousands of home buyers today have either paid or still paying for houses that may never be delivered. They weren’t greedy other than being dreamy about owning their own house – they were misled when it came to the risk they took when they signed on the dotted lines.

On the very long term, markets have gone up and hence if you keep investing, you will do well is the mantra of every analyst in town.

Take a look at the chart below – this chart is the Total Return Index of S&P 500 since 1871. The growth is just amazing with hardly any drops.

But the reality wasn’t so easy queasy. Can you see the small dip during the early 1930’s? Well, that was what is today known as the great depression. A famous pic from those times

By the time, the low was made, the Dow was down a preposterous 89% from its peak. US hadn’t seen a crash of that magnitude before or later. Yet, the Index recovered and those fortuitous to be holding on to the survivors would have made it back. But do we really expect ourselves to survive such a carnage without a change in the way we invest?

While the Bombay Stock Exchange is the oldest stock exchange in Asia, we don’t have data on stock prices of historical years. Sensex which is the bell weather index came into life only in 1986. Since 1986 to today, the Compounded Growth rate has been 13.50%.

To make that 13.50%, you should have been able to participate in the Sensex for the last 32 years and going through long periods of negative return. In other words, you would have been required to be a Saint. Of course, all this is theory since there was no easy way to participate in the Senex other than to construct the same on your own in the same weights. The first index fund came into life only in July 1999.

Acclaimed Guru and Stock market expert, Ramesh Damani recently gave a talk with the clickbait topic

“How to make 100 crore by investing 10 lakh: Ramesh Damani”

He talks about the huge advantage of starting to invest early and has the following side

Staring to save early is good but does that really provide the edge. There are two things worth noticing in the slide – One, the period of Savings and two, the small number at the last which says “Interest Compounds at 15%”.

Sensex has compounded at 13.50% and since this doesn’t include Dividend Yields which can come to 1%, 15% seems pretty much achievable. But does the static convey the real picture?

While I don’t have data on Sensex PE in 1986, in January of 1991, Sensex was trading at trailing four quarter price earnings ratio just below 10. We have seen this low a number only once post 1991 and this was in 1998. Neither the crash of 2000 nor the crash of 2008 brought down the market to such a cheap level.

Ramesh seems to have taken the 15% number from Sensex of the past 30 years. But the larger question is whether the last 30 years is representative of the next 30. No one knows how the next 30 – assuming you are saving for your retirement will generate.

But was Karishma really able to out-perform Kareena? Lets run it through real Sensex numbers to see how they performed. Remember, Karishma saves for just 7 years while Kareena saves for 27 years. If both invested in debt yielding 15% CAGR, this holds true – but markets don’t give out 15% or even 13.50% returns year on year.

Since we have only 33 years of clean data, lets give Karishma the first 7 years (1986 to 1992). For Kareena, we shall start investing in 1992 and invest till 2017. So, how do they fare by end of 2018?

Karishma has invested 50 thousand for 7 years which is equal to 3.5 Lakhs. This is now worth a fabulous 1.58 Crores – in other words, her investment has generated a XIRR return of 14%.

Kareena started off in 1993 and invested until 2017 for total investment of 12.50 Lakhs. Her current value is a mere 70.50 Lakhs. XIRR comes to 11.50%.

So, what happened. How did Kareena beat Karishma even though she invested for a longer period and through multiple bull and bear markets? Is this all the magic of Compounding?

The reason is simple – from when Karishma started to invest till date, index had a CAGR growth of 14.13%, for Kareena this number comes to 10%. In other words, much of the difference can be accounted by the timing.

Karishma started to invest when Sensex was around 500 levels and ended her investment when Sensex was around 2500. For Kareena, the start point was at 3350 and ending at 34,000.

Since both of them investe in the same instrument, we can get a better understanding by looking at how many Sensex units Karishma got for her 7 years of investment and how many years it took Kareena to accumulate the same.

Karishma over the seven years accumulated 440 Sensex units (Investment divided by Sensex). Kareena was able to accumulate just 195 Sensex units over her entire investment.

It’s similar to someone investing 50 thousand in Eicher Motors when it was a small cap stock versus investing 50 thousand when Eicher became a large cap. Return generated by the early investor is tough to match. As the adage goes, the early bird get the worm.

Personal Finance blogger, M. Pattabiraman had a very interesting video where he showcases how timing can influence returns for SIP’s.

Mutual Fund SIPs will not work without luck!!

Given what we now know and understand, what then should one have expectation of returns. Let’s assume if you were to invest a sum of money with a horizon of 10 years, what expectation you should have at the end of 10 years.

A lot depends on where you invest, but for simplicity sake let’s assume that you invest in a large cap fund that shall mirror Index returns.

Lets start with a much smaller time frame than 35 years – 10 years is seen as Long Term and if we can get things right in this time frame, we may as well have a chance to get things right on the longer time frames as well.

For this analysis, I shall use Nifty 50 weekly data which starts in mid 1990. Using weekly gives me more data points than monthly and hence better granularity. What is the range of returns we have seen for a period of 10 years?

The answer is that it can range between a negative 1.60% to a positive 20.28% with average return being 11.65%. That range of returns is just too wide to use it for figuring out how much can we get for our investment ‘n’ years later.

Here is a chart that plots the data (n = 959).

How to read the chart?

The chart showcases the percentage of weeks where investment would have yielded the returns as shown in the Horizontal (x-axis). To get a better measure, you can simply cumulate to the bar you think is the return you need and subtract the same from 1. This is your probability of getting such a return.

So, the probability your return is greater than -1.58% will be 99.69%, the probability that your return would be somewhere near 20% is 0.52%. If you were to take a view of a coin toss, the 50^th percentile so as to speak will lie at around 13%.

While just blindly investing in a growing market will at some point of time provide you with strong positive returns, the inability to project the same can hamper our ability to stay the course. When we are hit with draw-downs, the last thing we calculate is that if the current return is well within the overall bell-curve of returns possible.

Assuming that 6% is the minimum returns we wish to generate from equity, what were the historically bad years to start a 10 year investment in Nifty 50?

We had 156 weeks where investing would have yielded a return of less than 6% after 10 years. The worst years to invest were 1994 followed by 1993 and 1992. Compared to this, 2007 / 08 which too makes a presence was a walk in the park. Investing in almost any day of 1994 and greater than 80% of the days of 1992 and 1993 would have generated returns below 6%.

Comparatively, just 7 weeks of 2007 (bunched around November and December) and 2 weeks of January (first couple of weeks) were the worst weeks.

As much as we think we know the future, it’s one thing to know and quite another thing to live through the same. Draw-downs take a toll not just in terms of money lost (notional or not) but also has a massive impact on our confidence.

The great Stephen Hawking was diagnosed with ALS when he was 21. This being a non-curative disease, Doctors at that time gave him a life expectancy of 2 years. He lived for 53 years more.

In an interview to New York Times magazine in 2004 he said

“My expectations were reduced to zero when I was 21. Everything since then has been a bonus.”

From Warren Buffett to Rakesh Jhunhunwala to Ramesh Damani, I doubt anyone invested with intention of using the proceeds at the end of ‘n’ year for specific purposes. Having zero expectations from your investment in markets can be tough, but if you were to accept that, the task of becoming a better investor becomes easier for nothing the market throws at you will impact you negatively.

In God we Trust, Rest bring Data

The position of the RBI Governor is one of Prestige than Comforts. While the RBI Governor draws a Basic Salary of 2.5 Lakhs per month, the CEO of HDFC Bank, the premier most private sector bank in India draws a Salary of 80 Lakhs per month in addition to perks such as ESOP’s which can add a lot to the tally.

Allan Greenspan will be known by millions of people more than those who knew who the head of Citibank was during his tenure. Same is the case with RBI, the Governor’s are those willing to sacrifice a nice salary that could be obtained for being in charge of driving the decision making process at the RBI.

One of the perks of being the head of the Central Bank in most countries is that while they are answerable to the government of the day, they enjoy a very high degree of freedom in exercise of powers that accompany the office.

Yet, clashes between the Central Bank Chief’s and the Elected governments aren’t rare. Just last week when State Bank of Pakistan hiked Interest Rates, the Prime Minister expressed surprise and while talking about maintaining autonomy of State Bank of Pakistan (which is the Central Bank of Pakistan), he asked that in future no such decision be taken without taking the government into confidence first.

Recently, Trump accused Federal Reserve Chairman Jerome Powell of endangering the U.S. economy by raising interest rates.

Politicians around the world are the same. They wish that they have a Central Bank that is Autonomous to the outside world and yet follows the dikkat of the government. From Modi to Imran to Trump, all of them want their Central Banks to lower Interest Rates.

The biggest borrower in all countries remains the Government and a high interest rate means that much of the government budget gets eaten away by interest payments. Lower the interest rate, better the ability of the government to borrow more without feeling the pinch.

For a moment assume India to be a Company and RBI to be the Auditor. If you are long stock of India and the Auditor after fighting the management for some time resigns due to “personal reasons”, how trustworthy do you think the accounts are – especially since a recent growth number brought out by the company was riddled with deficiencies.

Resignation of the governor of RBI is not the end of the world, yet it’s an important pivot and one that could well define how India fared.

The reason fiat money works is because of Trust – you remove or even start questioning the Trust and the Fiat currently starts looking more like an ordinary paper than a value of exchange. The last time an RBI governor quit in protest due to “differences with the finance minister” was in the 1960’s when we were a much smaller and closed economy.

Emerging economies including India have had a great time in recent years thanks to the low interest rate and ballooning balance sheets of the Central Banks of US and Europe. But that easy money supply has more or less ended. US Fed is already well on course to contract the size of its Balance Sheet by removing 50 Billion from its Balance Sheet every month. ECB too will be starting the process most likely at the meeting to be held 3 days from now (December 13). With easy money on the way out, attracting FDI / FII money will become tougher for India is not the only emerging economy that is seen as attractive.

When a company loses the confidence of the investors, its tough but bearable to a extent. But when it loses the trust and confidence of the Bankers, it can be a death knell, especially if the company requires outside finance for growth.

India is at a stage where we require tremendous amount of foreign capital to enable the country to life itself from the emerging nations to the developed nation state. This money though doesn’t come easy and instances like these will have people questioning the Risk Reward characteristics of investing in India in the first place.

“This too shall Pass” is a favourite phrase used by many to describe events that seem big at that juncture but will be all forgotten in time – anyone remember the Greek / Cyprus crisis that was supposed to doom the Global markets for instance? Yet, the markets don’t simply sail over such events – there is a opportunity for those willing to take the risk and threat to those who are already overexposed to the risk.

Markets will go through a tough period – weak hands will be thrown to the wolves while the strong hands will endure the pain to see the light of the new day. As long as you can sustain the pain and have invested in stocks that themselves can survive the oncoming tsunami, All izz Well.

But day’s like this aren’t forgotten for the lessons that could be learnt are too important and timeless to be overlooked by future historians. For Investors, the ride is about to get a lot more volatile.

The Back-Test

Now the Reality:

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How Risky is Momentum:

What can we summarize from this?

Looking through the Lens of Asset Allocation:

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How to read the chart?

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