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Prashanth Krish | Portfolio Yoga - Part 8

Author: Prashanth Krish

Can Momentum Strategy Avoid Manipulated Stocks

The big fear for most investors is about getting caught on the wrong side of a stock that went up only due to manipulation and once the deed has been done, has lost all of its gains without providing investors an opportunity to exit.

I recently did a Twitter Spaces talk and this was one of the questions raised. While getting caught in manipulated stocks is possible regardless of the strategy one follows, the lack of narrative and fundamental reasoning for Momentum leaves us particularly exposed.

Pump and Dump is something that is not new but one that has been evident from the time we had stock markets. The oldest example of that would be in the South Sea Bubble. 

There are basically two kinds of Pump and Dump that happens. One involves manipulating the accounts so as to suggest the company is doing way better than it is really doing while the other involves just squeezing the price higher without fundamental triggers.

Cases like Satyam Computers, Vakrangee among others belonged to the first group. The accounts were not a true reflection of what the reality was and this enabled the price to shoot higher. 

Cases of pure Pump and Dump of stock prices are dime a dozen. Stocks seem to go higher and higher for no reason and with very little volumes before a reversal happens and all the gains are lost.

The pure price based pump and dump is actually easy to evade for Momentum Investors. Have a high enough bar of how much value a stock should trade on a normal day (for a long enough period) and voila, 99% of such stocks will get automatically rejected. Pump and Dumps that don’t have a fundamental backing generally are operated by a small coterie and are not really well traded.

The fundamental driven frauds are much tougher in that sense. When Vakrangee for instance was going up, it was accompanied by positive spin. Some positive tweets / articles of those times

Heck, the stock even made it to MSCI Largecap Index. Not that everyone was gung ho on it, Nooresh Merani and Amit Mantri were among the few to question it 

But there was not a single tweet I could find that had the words Vakrangee and Fraud. Of course calling out Fraud on even Fraud companies in India is Risky and one would rather not be invested than question companies that have connections which can result in midnight calls or even sent to jail.

I got caught in my personal account in Vakrangee. While I did interact with very many intelligent folks, I decided to hold onto the stock since selling would be essentially breaking the cardinal rule of Systematic Investing – adding the discretionary element that one hopes to eliminate.

I was lucky in the sense that when the stock made its top, my return from the stock was at 100% and when I got the ability to exit, it was back at my entry price. So, even after a 50% fall, I got out at cost with the only loss being opportunity cost.

I was not having a Momentum Investing strategy when Satyam Crashed but the crash unlike that of Vakrangee took place at the high point. Rather, the stock was down 78% from it’s all time high and down 67% from its 52 week high. Momentum strategies would have long ignored this stock and would have had no impact whatsoever.

Yet, there is no saying the next stock that may be part of a Momentum Strategy and turn out to be a fraud. Or for that matter, stocks can fall big time within the timeframe of a rebalance without there being any fraud.

In March 2020 for instance, one of my PF constituents was AU Bank. The stock was bought on the 1st trading day of the month at around 1150 and by the end of the month was at 500. A 57% fall in one of the stocks can be fatal to any Portfolio and my was not immune especially since I was having a significant weight to financials which bore the brunt of the damage.

What saved me though was that I have always felt that since we are dealing with a lot of unknowns, a good amount of diversification while reducing the returns slightly can enhance from the risk management angle. In a 30 stock portfolio, each stock has a weight of just 3.33% (approximately) and even if a stock was to go down 50% before you can exit, the damage (assuming the rest of the stock overall did not fall like a pack of cards), the damage to the portfolio is just 1.67% – something that is honestly very much bearable.

Other risk management techniques that can be used are trailing stops, stops based on either the equity curve or based on moving average on a benchmark index among others. The risk of trying to manage risk though in a way can actually enhance the volatility since there would be more stocks in motion (going in and out).

While four years is too short a time frame to judge a strategy – Meb Faber recently tweeted that he believed that to clearly judge a strategy as being good or bad required 20 years of data – my experience tells me that with a good set of filters and maybe once in a way allowing the luxury of not entering a stock even if it tops the momentum list (I did it with Adani Green, Tanla among others), risk of getting into stocks that you don’t have a easy exit can be vastly avoided. 

At Portfolio Yoga, our aim is not to maximize reward but to maximize the ability to deploy a larger capital. A 20% gain that comes via a risky portfolio is worse than a 15% gain that can come through a lower risk (there is nothing like no risk) portfolio but one where you can confidently deploy a much larger percentage of your money.  

On that note, let me leave you with this post from Seth Godin – Optimized or maximized?

Trend Following is Dead, Long Live Trend Following

2020 was an awesome year for trend following traders. They made money when the market went down in March and made money when the markets rebounded for the rest of the year. 2021 on the other hand seems like a year (and one that is not even half done) and I am pretty sure most clients have either quit or close to quitting the strategy that seems to see no end to whips. 

I used to be a systematic trend follower (and a discretionary trend follower earlier) for a while before I realized that this game was not for me. The reason is not that I did not have a good system to begin with – in the long run every trend following systems generates returns that are slightly lower than the underlying on which it trades but with a much reduced risk (risk being measured through draw-downs).

If markets have a risk of 50% draw-down, the idea here is to try and limit the damage to say 25% so as to allow 2 times leverage (or 3 if you are iron hearted) and which allows for the absolute outperformance of the underlying. For example – assume you have a system that will generate 1000 points on Nifty vs say 1200 points Nifty would have generated for a buy and hold investor. But the buy and hold investor would also go through a pain of a 50% drop in value at some point of time. 

If you are a Buy and Hold investor and try to leverage on Nifty at just 2 times, once you hit the 50% drawdown (in reality it will be even earlier), your capital is fully destroyed. But if your system which generates a lower return than Buy and Hold also has a max draw-down risk (in theory again since we can never know the reality until it strikes us on our heads) of say 25%, you can safely leverage 2 times or even 3 and yet not fully lose your capital at the worst possible times.

Like Momentum Investing which is hot today because its out-performing the other alternative strategies (are we really I wonder sometimes but that is a question for another time), last year one could see the launch or rocketing up of many trend following strategies built on Nifty.

Way back in 2012, my Job was to Build / Test and Implement trend following strategies on proprietary money. Very soon after we went through a very tough phase of non trending markets (rather the Index). It was tough and yet we came out alive.

The reason we came out alive had less to do with the system (though I am sure helped in a way) but more importantly because we were diversified across multiple Indices and Stocks. While the Index itself was choppy, this was not the case with a few of the stocks and those cushioned our draw-down quite a bit.

Like in Investing, Diversification can save the day for many traders. But there is a problem and that is Capital (not to mention Time). A long while back, I had written a rudimentary post on how much capital would be required (Capital Requirement for a trader).

Since then though, experience (both personal and of others) has taught me that I was very conservative. I think if you really want to be a successful trend follower today, I believe that the capital requirement would come to a Crore of Rupees.

The reason for the high capital is not for the ability to withstand draw-downs but ability to deploy it in multiple Indices / Stocks / Currencies / Commodities. Stocks have a very strong correlation with Index but Currencies and Commodities don’t for most part. By having a broad portfolio of underlying to trade with, you reduce the risk of getting whipped out of one’s capital because one bad underlying one has set out to trade.

A large capital also allows you to trade multiple strategies which further add value (think of trading both a short term trend following vs a long term trend following system for example). But more the strategies and more the underlying on which to trade is not easily possible without a team that can support such an operation or automation.

Trend Following has a very low correlation and hence is an attractive strategy that one can add to one’s arsenal. But it comes with its own caveats and limitations which one should be fully aware of. If you cannot afford a large capital (1 Crore at the minimum), the attractiveness of the strategy goes down faster than the option decay you see on the expiry day. 

PS: The featured image is of the Equity Curve of Dunn Capital. Look at the pain (draw-downs) that have been felt over time (Image Source: Trend Following Performance: Huge Returns).

4th year of Momentum Investing – Getting Rich

In the world of Momentum Investing, our belief is that the probability of past winners continuing to be a winner in the future is high. In some ways, this is the same logic of Growth Investing (which is not a factor based strategy as such). Here instead of looking at price, the idea is to look at the business and try to figure out if the past growth can continue into the future. 

Compared to Momentum Investing, Growth (at a fair value for Buffett fans) Investing is something that allows a much larger capital to be deployed since the average holding time is measured in years vs months for Momentum.

But this is true across the financial spectrum. Angel Investing can be hugely beneficial if you strike it big, Angel investor Garry Tan for instance invested $300,000 into Coinbase and one which was worth $2.4 billion at its listing. Forget even bothering to calculate the CAGR

But Angel Investing is not dominated by big money but by small Individual actors who are willing to risk their personal money (not other people’s money) on ventures they feel holds promise. Big money on the other hand is attracted to PE funds which come into play at a much later time frame in the company and at a much higher valuation. 

In many ways Momentum Investing I think can be compared with Micro Cap Investing. Once again, Microcap investing is a do-it-yourself model with investors investing in companies that have very little or no coverage at all. Most small cap funds don’t go below 5000 Crores in Market Cap while there are 1700+ companies that are having a market cap of 1000 Crores or less and are profitable. 

Momentum in recent times has attracted superlative interest thanks to the strong returns that have been generated. But this is not really out of the ordinary.  As the saying goes, every dog has its day so is the same with factors. 

Nothing comes easy. Not Momentum, Not Value, Not Quality and Not Micro Caps. But each of them have made people rich (mostly those who have managed funds for others but also a few investors who have stuck to the thesis).

Recently there has been extreme clamour for DIY momentum portfolios. With the ability to execute with just a single click, this has made it easy for even those with no understanding of markets let alone factors to try and ride the trend. 

Fascinating years for most markets are generally followed by dull years when the markets tend to go nowhere and the only thing you can do is stick to the strategy and hope for the best. From my own Momentum Backest for instance, the high of 2008 was broken by the strategy only in 2014. How many will have the willpower to go through such a long period of literally Zero returns I wonder.

The returns from investing in Mutual funds for the same period would not have been any different but at least you had no decision or action to execute every week or month. Yet, Mutual Funds on a whole saw outflow of funds from 2008 to 2013 (cumulative). The outcome for the investor in essence will not be based on the strategy but his own behavior and how he would be able to overcome the same during the tough times.

Concentration or Diversification – the age old question

“There is one other rule you ought to keep in mind and that is to concentrate, and not only in the Zen sense. Sweet are the uses of diversity, but only if you want to end up in the middle of an average.” Adam Smith, The Money Game

Other than in my early years, I have for most part been a concentrated investor / trader. For a long time, my only positions were in Nifty (leveraged). Concentration I firmly believe is the key to wealth but as it happened in my own case, the risk is that if it doesn’t work out, you are doomed to failure. 

While not all great investors of time have been concentrated investors, they have whenever opportunity came forth for a great trade were willing to go way beyond what they would generally be comfortable with.

Check out this article on famed “Value Investor” Bill Miller for instance

While investors get to make a lot of noise when Rakesh Jhunjunwala picks up stocks, 50% of his portfolio is just Titan. I on the other hand get antsy when a stock in my portfolio breaches the 6% mark. 

In the world of Portfolio Management Services (something I try to track closely), most portfolio managers believe in concentration with portfolio size being around 20 stocks. There are of course outliers on both sides. From a 5 stock portfolio to a 50+ stock portfolio. 

I don’t know how many clients of PMS firms have become rich thanks to the astute investments by the fund manager but the biggest gainer generally happens to be the fund manager. This is because of two reasons

One: Most PMS firms have a performance fee (in addition or in lieu to management fee). What this does is provide for the fund manager kind of leverage that most of us cannot fathom.

As an example, think of a fund manager who has 1 Crore of his own funds invested into his own fund which also happens to have 100 Crore of Client money. Assume a 10% performance fee. In a year like the one just gone by (FY 2020-21) where the Index itself doubled (nearly), the performance fee would be 10 Crores. 

While his own investment too would have yielded him a Crore of Rupees in Profit, it’s the Performance Fee that takes his own return to one that is 10 times others. It’s as good as if he had taken a 10 Crore Position using his 1 Crore as Capital (10x Leverage). Bill Hwang, the ill famed fund manager was leveraged 5 times on his capital but unlike with management of other people’s money, the downside belonged to him only (and hence his meltdown of sorts)

While the first reason is the one most advisors would want to become a fund manager but something outside the scope of most of us, the Second reason is what we as investors can coattail. 

Two: Most fund managers have total skin in the game. Most of them have much of their net worth invested in the same stocks / portfolio that they are advising to clients. This is real concentration – concentration in a single strategy / fund. The risk is of course if the fund manager doesn’t perform (in which case the question that needs to be asked is, why is he managing other people’s money).

If the objective is to try and achieve a return of around 18%, this cannot be achieved by investing across PMS / Mutual Funds / Advisory Portfolio’s. If the objective is to achieve a return of around 12%, you don’t need anything other than a simple Index Fund that tracks the Nifty 50. A mix would hopefully provide a return that comes close to the middle – 15%.

My own objective is to achieve the best returns possible. Risk as I have come to understand is part and parcel regardless of the methodology or factor or strategy you invest into. As long as you can keep behavior under control, you should be fine.

When I started my Journey into the world of Momentum Investing, I had no real goals as such other than wanting to be invested in a strategy that gave me confidence both during the good times and the bad. 4 Years later, I think the conviction if anything has only grown. 

Some Numbers:

Compounded Annual Growth Rate since Inception stands at 28.21%. This is way too high and not possible to continue for long.

NAV with Benchmark: There are essentially two benchmarks I use. 

Nifty 500 for comparison with a passive market Index.

Second is to seek to beat the best Mutual Fund performance for the same period (my Inception to date). Since this is forward looking, the Mutual Funds generally keep changing over time. Last year it was Axis Bluechip Fund while this year it was Parag Parikh Flexicap Fund (if I used the filter for only Flexicap funds) or Quant Active Fund. 

Since the Investment was not a lumpsum but added over time, XIRR is a way to compare with a passive benchmark which can be invested into. I used Nifty Next 50 since in 2017 when I started this, that was the hot index everyone was recommending to invest into

If you were to observe, you can see that outperformance has been strong at times and other times the performance is more or less equal to that of the fund. I was checking for a longer period (using the back-test data) and saw the same happen over and over again. 

What this showcases I feel is that while Momentum can provide for strong out-performance in the long run, this can only be achieved if you were also willing to stay through the periods when the returns are either in line or sub-par.

Drawdown:

While risk can be measured in various ways, drawdown is the most visible. Last year when I wrote, I had just experienced the worst drawdown since I had started this portfolio. The portfolio was able to hit the all time high only in November of 2020. The last time NAV had seen an all time high before this was in January 2018. While it was painful not to have a new high for all these times, it was helpful in the sense that it provided me enough time to boost up the capital invested. Capital deployed increased by 335% and hence while in absolute terms the return is still just around 87%, in monetary terms, it has been pretty big.

Monthly Returns

Just as sort of record keeping, I have been posting the monthly returns on Twitter. Provides a context with respect to how the market and the model is behaving.

Overall, I feel comfortable with the strategy and its performance. While I am sure that I shall see the Yin and Yangs in terms of performance, I feel the strategy as a whole should hold up over the years and decades to come.

Given the social circumstances outside, this has been an astonishingly good year from the investment perspective. Until next year ..Be Good. Be Safe

Previous Posts:

Year One: Momentum Investing – An Experiment with Real Money

Year Two: 2 Years of Momentum Investing – An Overview

Year Three: 3 Years of Momentum Investing

NFO Review: Mirae Asset NYSE FANG

International funds have been around for long. Value Research says that the oldest fund in existence is Principal Global Opportunities Fund which was launched in 2004. As on date there are 46 funds that come under the category of “International Funds”. 

For a really long time, International funds did not command any interest. Even today, the total assets under management is just around 21K Crores of which the top 3 funds (two of which belong to Motilal Oswal) have cornered 40% of the total assets.

Only in the last couple of years have International funds started to gain some traction. For instance, currently Motilal Oswal’s Nasdaq 100 ETF has a AUM of 3,203 Crores. Thes same fund in March of 2018 had an AUM of just 72 Crores.

Performance drives Assets under Management. This is a universal truth. Very few investors or advisors will stick to a fund that is underperforming its peers. There are exceptions always like the HDFC funds in India but this is mostly true for most funds.

Look at the performance over the last 4 years between Nasdaq 100 (^IXIC) and Nifty 50 (^NSEI). Nasdaq 100 being denominated in USD while Nifty 50 is in INR.

For most part, Nasdaq has been outperforming Nifty and this margin has increased big time once the Stay at Home policies kicked in response to the Corona crisis. Tesla for instance shot up 743% in 2020 alone. Why would a car company’s stock shoot up during a crisis when you barely got out of the home? One – there was a fundamental change. The EPS went from Negative to Positive and Secondly the future earnings go rerated. Trailing Price to Earnings ratio shot up above the 1000 mark. The share got split in 2020 making it cheaper for the YOLO community to invest as well.

Tech has been the driver for a while now. If you were to co-plot the S&P 500 where the weight of Tech shares have oscillated over time but is not a entirely technology index vs a pure technology index, you can see that despite the fall in 2000, Nasdaq has delivered 3x the returns of S&P 500.

Mirae is now coming up with a fund that aims to outmaneuver Nasdaq 100 by investing in just the best 10 stocks (mostly by way of Market Cap / Opportunity size I assume). After all, if 100 is better than 500, surely 10 is better than 100 🙂  

In India, we barely have any access to top edge technology firms. Most of the better ones in India are privately held and the big daddies who are listed are more of service oriented companies where you can get a steady return vs the lumpy nature of returns promised by the leading edge tech firms.

When I started on my Momentum, I tested for position sizes from 5 to 100 and time frame from daily to yearly. The idea was to check what would be the most optimal. Optimal doesn’t have to be the Best. I finally settled upon 30 Stocks and a monthly rollover. If I wanted to target the most profitable I would have probably gone for 20 stocks and a much lower frequency of rebalance. 

The key reason I went for an optimal and not the best possible portfolio structure performance wise was because I was building the portfolio for myself and I wanted this to be my one and only portfolio. I was and even today happy to sacrifice some gains for the ability to deploy the majority of my networth in this strategy.

There has always been confusion as to how much of International Stocks should be part of one’s own portfolio. While Warren Bufftett has invested outside of the United States, it’s barely anything compared to his investments in America.

Bogle dismisses international diversification. Buffett, meanwhile, says an index fund portfolio of 90 percent S&P 500 and 10 percent Treasurys is probably good enough for most investors.

But their advice is for Investors of the United States. What about for Investors in countries such as India? Does it make sense to diversify your savings to investing outside of the home country (home country bias is a bias that is seen everywhere) or does it make sense to stick to what we know best.

For any investment to make sense, it has to be a significant part of one’s portfolio. An investor with an investible surplus of say a Crore of Rupees won’t be making any difference if he invests anything lower than 10 Lakhs. But a larger allocation comes with its own risks. While it’s been a long time since the Dot com bubble, do note that Nasdaq not just fell 78% from the peak but it took the Index (where the constituents keep changing over time) nearly 16 years to move past that high watermark. 

For the S&P 500, the high of 2000 was tested as early as 2006 and finally broken in 2013. Max drawdown S&P saw was to the tune of 50%. While the Indian markets too got pummeled post the Dot Com crash, the Index recovered and broke the high of 2000 as early as late 2003. 

The biggest advantage of International Investing is the currency hedge it offers. If you had invested in the Sensex at the peak of 2008, today you would be thinking you are sitting pretty. After all, Sensex has moved from 20,000 odd then to 50,000 odd a few weeks back.

But if you were an investor in the same Sensex but had invested using the US Dollar, your gains would have been just around 75 (absolute not CAGR for the entire period of Jan 2008 to April 2021).

900010 = Sensex, 900030 = Dollex 30

For those of us who are in the developing nations, one way to ensure that our purchasing power is kept constant is to invest in asset classes that are denominated in the US Dollar. This is one reason why Gold has emerged as a way to save for its movements are not based on the demand supply in India but demand supply worldwide and one that is denominated in Dollar.

But should that mean you should go out and invest in a 10 Stock portfolio that comprises the hot names of today? While the stocks will change over time, the risk is two fold – 

One: Most of these companies have grown way too big and while that brings stability in the business, it also means that the future returns will not be as attractive as the past. 

Secondly big companies can get caught in Regulatory issues concerning market domination. Facebook and Google are facing that already in the United States while Alibaba has been made to pay for the missteps of its founder Jack Ma. 

Technology will rule the next century, that is guaranteed. But the Winners and Losers will not be easily identifiable in hindsight and by the time a winner has been found, it may be too late to enter even though they may still provide market+ returns.

A small allocation will not move the needle and a large allocation will mean that you should be willing to bear a risk of deep drawdowns that will definitely be seen by products of this nature. If your time horizon is 20+ years and you have the ability to not panic when the chips are down, this could be an attractive investment, else it’s worth giving a pass. The Nasdaq 100 is still a much better bet if you wish to bet on technology firms.

Is too much of a good thing Bad?

Markets opened this Monday with a ferocious fall and one that see med to proclaim – the end is near. The reason for the fall – rising Covid cases and anticipation of a lockdown in certain parts of the country. By the end of the week, the situation has actually worsened with news of rising deaths and infections, lockdowns in place in Mumbai with weekend lockdown in Delhi and yet markets are higher than where they were at the start of the week. 

India has stumbled and stumbled badly when it comes to vaccinations. Today we are well behind the curve with the only hope being the virus will burn itself out before we are able to reach out and vaccinate the vast majority of citizens.

In March when India went for a total lockdown (in hindsight a pretty bad move, Pakistan is an example of what an alternative could have been), there were hardly any cases. Despite a strong lockdown across the country, the case count rose rapidly to the extent that I cannot remember a country which opened a lockdown when the number of cases were in such an accent.

Somewhere in mid September, the number of new cases started tapering and then started to fall. By February of this year, the vaccination drive had started (limited to healthcare and frontline workers but at least there was hope) and the number of new cases had dropped to what we had seen way back in June 2020. Life was supposed to get back to Normalcy.

The virus though had other plans. Markets on the other hand for now seem to have brushed off any negativity arising out of the lockdowns / rise in case loads. While they aren’t at their highs, they have kind of tapered off and are around where they were in mid January of this year. Time based corrections are relatively better off than price since it rarely induces panic from the investors point of view.

The broader markets continue to remain strongly bullish. Here are some charts and a short analysis of the same. First, a set of charts which are bullish in nature

% of stocks in positive momentum.

The chart contains two indicators. Stocks that are having positive momentum with a lookback of 1 year and Stocks that are having positive momentum with a lookback of 6 months. Both are extremely positive indicating that the broader trend is still very much bullish

Volume Demand & Supply

This indicator is a sum of total buy volume vs total sell volume over the last 10 days and has been oscillating since Nifty hit its peak in January. For now, this continues to be bullish. Since this indicator has a lag, key is to use this in conjunction with other indicators

% of stocks outperforming Nifty over the last one year return

 65% of stocks listed on the NSE have in the past year delivered returns that are greater than Nifty 50 returns for the same period. As the chart indicates, this can remain elevated through and through the duration of a bull market and isn’t very volatile. 

All the above charts showcase that the trend is still very much bullish and it pays to remain long for now. But then there are these charts which seem to suggest caution going forward

% of Stocks trading above the 200 day EMA

On the face of it, this looks good standing tall at 73% currently. But historically once a peak is done, we have seen even in a bull market this ratio steadily decline. What this suggests is that while in the first leg of the bull market literally everyone is a winner, as the bull market proceeds, the number of stocks that continue to move higher will steadily reduce. While this has low implications for Momentum directly since we are always with the top quartile, it does suggest that churn would be higher and returns below par in the coming months (years?)

No of Days Index was positive in last 1 Year

This is a rolling number that keeps track of how many days of the past 260 days has the Stock or Index closed in positive territory. Currently at 160, we are close to the peaks that have been achieved in the past. Expect more negative volatility in the days to come

Sensex One Year Returns

Another rolling chart that plots 1 year return. We have had one of the best one year returns since 2010. The one year post such high returns in the past – meh.

Conclusion

While I am no way close to becoming skeptical about this rally let alone become bearish, I think that one needs to start tapering our expectations. In addition, I feel that this is the time when you should take a hard look at the portfolio stocks (excluding stocks bought due to strategies such as Momentum) and clean out the weak stocks which hopefully will also help build a small war chest. 

Which is Better – DIY or Mutual Funds?

The last one year has been fantastic for literally everyone other than those who held too much Cash or were straight away bearish. Nifty went up nearly 60% in the last one year. 65% of stocks traded on the NSE did even better than that. Trend following systems had a splendid time as did Value or Growth factors. Only the quality factor trailed a bit but in the long term, they have performed much better than most other factors.

A good bull market brings a lot of hubris to those who were lucky to be part of the wave. From thinking about quitting one’s job and taking up trading / investing as full time to deciding to invest everything based on one’s own analysis, it’s easy to assume that we know better and it’s worth changing. 

Bull markets like the one we saw in the last one year are kind of pretty rare. While we have been in a bull market from 2013 onwards, the first leg of the bull market is the one that really shores up the returns. The next couple of years while good are generally in no way comparable to the first.

In the last few days there has been a lot of hoopla around Index funds raising their expense ratios. This is because the expense ratio went up from 0.10% to 0.20%. I am if you are a regular reader of this blog and belong to the old school, the school that cost me 2.5% for purchasing a piddly stock, 0.20% to me is still way cheap given how impossibly tough it is for Individuals to actually replicate the same directly in the markets. 

The other day I was talking to a prospective client and he mentioned that his weakness was his own behavior. While he felt that this was a negative and it indeed is, I felt that the positive was his ability to understand his own point of weakness. Very few actually are able to analyse their own Strength and Weakness let alone work on how to eliminate the weakness. 

If you were to invest say a sum of 50 Lakhs into a PMS, over time you should expect to pay the fund manager approximately 2 to 3% of fee or 1 Lakh to 1.5 Lakhs per year. A mutual fund bought through a distributor would cost you similarly. A DIY on the other hand can be multiple times cheaper than this. Even after the fee hike, an Index fund will still cost you just around 10K per year which is more or less in line with most advisory fees. 

If the returns are the same, it’s easy to wonder as to why people are willing to pay such a high fee when the same products are available at a fraction of the cost. Unlike a MF where your return is the same as others for the period you have invested or Unlike a PMS where your return will be in the same ball-park of returns generated by the fund manager across all clients, with DIY, there is no knowledge of whether even the advisor was able to reap the returns he showcases as having achieved.

I keep seeing stock advisors berating mutual fund returns vs their own returns and recommend that investors are better off with them vs Mutual Funds. The markets being as it is has helped sell that idea a lot. To me though, this is a very wrong advice for the single reason that the greatest reason for our inability to even garner a fund’s return is our behavioral gap and if that is the case with funds where our decision making is actually limited, how much of the gap shall one see in case of stock based portfolio’s is anyone’s guess.

Another frequent question I am asked by new clients is whether they should buy the stocks that are part of the portfolio but have moved up a lot since their induction into the portfolio. The question in itself is not wrong but betrays how we think when we are buying stocks. No one is immune to it, even I after seemingly having experienced and knowing my weakness still wonder many a time as to whether the stock which has now qualified to be part of the portfolio deserves to be part of the portfolio given how much it has already run up in recent times.

A mutual fund or a PMS doesn’t give much thought to such considerations even though the risk from the stock is the same at both places. In other words, for the fee you have paid, you are not just getting a list of stocks to execute but the ability to execute without your own behavior impeding future returns.

So, what is the key difference vs DIY, especially with respect to stocks?

In 2009, DSP Blackrock Smallcap Fund had fallen 75% from its peak. In other words, if the peak equity value was Rs.100, it was now just 25. If one’s portfolio had performed that way, it’s unlikely the investor would have ever recovered his money let alone come roaring back and this particular fund did. By the end of 2017 this fund was the best performing equity fund.

In March 2019, exactly 10 years from the bottom, the NAV was 54 (which itself was 28% lower from the peak it touched in early 2018 of 73) and the 10 year CAGR return came to 28.30%. Not bad for a fund I assume most advisors and investors would have written off in 2008/09.

While one of the key differences in returns between DIY or even a PMS and a Mutual Fund is the way profits are taxed, the biggest advantage of a Mutual Fund is that you are essentially passing off not just selection of securities but the execution to someone else.

Last March as the fear of Corona spread and the market panicked, my portfolio got crushed. Between the starting of the month to the deepest point of drawdown, I lost 32% of the value of my portfolio. From being in profit, I was suddenly starting at a loss of 22% of the total invested capital. Since I had started investing from May 2017, this meant that I was negative after continuously investing for nearly 3 years.

In hindsight what saved me I think was the reading of books which suggested that this too shall pass. If I was younger, I wonder if I could have kept my calm and carried out what the system suggested for when fear strikes the mind, the best systems are overridden. 

One of the simplest ways to trade the market is using a simple trend following system. Buy Nifty when it’s above its 200 day EMA and sell when its below generates returns that are slightly lower than Nifty (no leverage) but with nearly half the maximum drawdown. Yet, very few can really practice this simple strategy for trend following asks you to buy after the index has gone up quite a bit from the lows while asking one to sell after it has fallen quite a bit from the highs. Both are tough from the behavioral point of view. 

It’s for this reason that most investors try to time the market by trying to buy when it’s low and sell when it’s high. Given that other than in hindsight we never know when the final highs and lows are made, this generally results in massive underperformance. 

Being a Technical Analyst for a very long time, I have always ridiculed the phrase “you cannot time the market”. While I agreed that you cannot time the market to perfection, I have always felt that timing the market does add value. But if you were to think about it from the behavior point of view, trying to time the market for most investors fall flat because their behavior obstructs them from doing the right things.

If you haven’t’ experienced a real bear market (March 2020 wasn’t one of them), I strongly believe that the majority of your exposure to markets should be via Mutual Funds (Large Cap Index Funds preferably) with a small minority (say max at 30%) devoted to do it yourself models if you are interested.  No one gets a free ride in markets and we all pay the tuition fees to the market. Having a smaller segment of your portfolio in DIY ensures that the tuition fee is bearable and doesn’t create havoc with your long term goals.

Thoughts on Trading

I think I can understand what Bill Hwang is passing through these days. I went through a similar scene way back in 2007. One day I was on a high after hitting a jackpot and realizing that if I played it right, I could make a good living out of it and the next day (2 months later, but you know, time flies), I was literally bankrupt. 

Like Bill, the cause of my own troubles were leverage though the strategy was different from what caused his doom. My leverage while high was supposedly safe since I was trading a safe option strategy that I thought I had perfected. Markets though seemed to believe otherwise.

As a broker, I have seen hundreds of investors like me coming to the market with great hopes only to be crushed mercilessly by the markets. I remember some study that claimed that most traders go bankrupt (or rather lose the entirety of their capital invested) in the first 6 months since they start trading. Of course, its one thing to go bankrupt and quite another to quit the markets – many keep coming back with new capital and new ideas hoping to strike it lucky. 

As I write this, I was reminded of an old interview of Nithin Kamath (the only broker who is willing to showcase the dismal risk reward relationship for traders despite traders being his bread and butter)

Zerodha makes stock broking pay at Rs 20 – The Hindu BusinessLine

When I lay out the risks of trading, I am told that such risks exist everywhere and hence should not be overemphasized. But wrong are they. Entrepreneurship for example is hard and most parts frustrating but a lot of entrepreneurs are about to live an okay life without ever becoming the next Zuckerberg. Markets on the other hand rarely provide opportunities where you can live a good life by being a small trader and yet never encounter the bankruptcy kind of risks.

Between the time I entered the Stock Exchange Premises and today, I have heard numerous brokers biting the dust. Unlike clients whose death is fast and furious most of the time, the death of brokers (mostly small, rarely large) is more of death by a thousand cuts.  

What is surprising is that brokers aren’t outsiders who could be excused as being naive to the risks of trading. Most of them have seen the story with their own clients and yet, the urge to trade seems to overcome the pain of the stories they have heard or experienced first hand.

Is it false confidence or is it bravado or something else I always wonder. What makes people who are otherwise the smartest in the room choose the most riskiest way to make money. 

Trading is tough not because it’s one with 50-50 odds but one that has a negative sum game. Between the broker and the government, the winner makes less than the loser over and over and over again. This counts not to mention the fact that thanks to path dependency, the odds aren’t perfectly stacked in a straight line.

Sportsmen go into slumps. If one has not established himself by the time his slump comes in, he generally gets dropped from the national team and would have to work his way back (many just don’t get that second chances though regardless of how they perform). But at least they have the opportunity to play the game at a lower level, establish their form once again and keep knocking the doors for being allowed to play at the highest levels.

In trading, there are no local clubs where you can tune yourself up before competing with the big boys. Of course, there are courses you can take, books you can read among other things but finally, winning is more like getting into the IIT without actually having studied.

Then there are agent provocateurs. From the broker to the friendly twitter fellow who seems to keep winning everyday, one is always given the hope that successful trading is possible – you only need to keep trying. 

One of the biggest hurdles for most traders is lack of capital. Most including myself tried to trade with a capital that just wasn’t sustainable for trading full time (and trading is always a full time activity regardless of what anyone else says). 

When you find yourself in a hole, stop digging is a wonderful quote. Trading is addictive for after all there is no other business that can throw out cash like this does if you are on the right side. But recognizing when you are wrong is more important for that enables one to change the strategy or better off, quit trading before it damages one’s life.

Personally after more than 15 years of full time trading, I quit the exercise in 2017. Life has never been better. I recognized belatedly that right from my capital to my psyche, I wasn’t ready to be a trader regardless of how many systems I built or strategies I tested. I know of successful traders and this for me says that all is not lost. But I know way too many smart guys who have lost everything. I do know that I am not as smart as those guys and thank my stars for the change I could bring to myself.

I doubt writing about the risks of trading is going to change anyone’s mind for we all have strong opinions strongly held, but hey, if you are open to new thoughts, let this be one. As a stock broker, I haven’t seen a Rich Trader. Not that they won’t exist, even 1% of traders if successful can be a few thousand fellows if not more but they are as rare as they come.