Asset Allocation | Portfolio Yoga

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.

Paying for the Right Advise

The fact that Fees eat up returns is well known and yet there persists an idea that somehow Indian funds are different and that even though they are charging a bomb to manage money, all is well. This undying spirit is being broken as with new regulations, Active funds will find it difficult to beat the indices without doing things differently which in turn can expose them to short term under-performances that don’t easily go well with investors and advisors alike.

We pay fees in many ways – some like in case of doctors and lawyers directly and some like mutual funds indirectly. But pay we must to grease the system on which it runs for there is nothing like a free lunch. This blog may seem free but by spending valuable time which could have been spent elsewhere you are making a payment to me.

Save More, Spend Less is an age old adage that will never get old. The only sure path to savings is by spending less. Spending less doesn’t just mean about cutting down on non-essential spending but also scrutinizing spend in case where it’s not directly visible.

Selling fixed deposits of Banks will not yield you any commission, but Selling Fixed deposits of private companies yields a nice little commission. The reason is not far to seek – Fixed Deposit at Banks doesn’t need selling – it’s a pull product. Since Fixed Deposits at a private company aren’t in the same risk bucket as Banks, they need to be sold – they can be seen as Push Products. Without the guy to push, you on your own may not be willing to park your excess money even though the interest rate looks attractive.

In the world of Equity Investing, Direct Investing is more of a pull product. Stock Brokers have strict regulations when it comes to advertising and with they being nothing more than a conduit to invest in the stock markets, rare are those who actually go out and advertise.

But when it comes to Indirect Investing, the product now becomes a push product. It doesn’t matter how good the product is, if there is no one to push it, the product may soon become irrelevant. Exchange Traded Funds are disliked for the simple fact that no one gets paid to sell and hence if one were to ignore the investment of the Pension funds, the total asset under management is less than what Mutual Funds as a whole gather every month these days.

While much of the world is moving towards paying for advise, our inability to overcome the hurdle of having to pay separately for advise leads us to paying a much bigger fee for advise that may actually be not worth paying for.

Over the last few years, we have seen a mushrooming of fintech companies {so called because they combine finance with technology} who provide an ability for investors to buy into mutual funds.

Recommending funds isn’t as tough as it’s made out to be. Select the top fund houses, select their top schemes and you are more or less done with the shortlist of funds available for investment. Final addition would be to maybe mix and match different market styles so that one has exposure to Large, Mid and Small Cap.

The bigger problem and one that is worth paying money for is Allocation – how much should you invest in Equity and how much in Debt. The percentage should be based on your risk profile, your requirements and finally your ability to stay with it during the bad times.

The best allocation would be one that has the lowest risk and yet meets our goals without one having to sweat it out. If only life was as simple as tweeting or blogging.

Harry Max Markowitz won the Nobel Prize in Economic Sciences for his work in modern portfolio theory, studying the effects of asset risk, return, correlation and diversification on probable investment portfolio returns.

While the theory is cool, it’s practically impossible to come up with the optimal portfolio alloction given the constraints of having to know literally the impossible. So much so, when asked about his own portfolio allocation, Markowitz is supposed to have replied

I visualized my grief if the stock market went way up and I wasn’t in it — or if it went way down and I was completely in it. So I split my contributions 50/50 between stocks and bonds.”

Knowledge of complex mathematical numbers in itself is meaningless if we are unable to control our emotions and no matter how strong we feel we are, we all panic if we have positions that are higher than what is comforting.

Few days back, Josh Brown of the Reformed Broker fame had an interesting blog on “What People will Pay for”. I urge you to read that.

Josh is the CEO of Ritholtz Wealth Management and the stuff they do is not trying to pick the best mutual fund or ETF out there. Compared to India, they have a plethora of options out there, so the focus for them is fees.

At the lower end, they charge as much as the distributor of the mutual fund gets here – just that rather than just pointing at the right fund, they are willing to stick their neck out and provide an asset allocation plan that is suitable for the customer.

10 years back, markets at the current time were on the way down, a month from now, they were spiraling out of control before they finally bottomed one fine day in October. By the current time in 2008, Nifty 50 was down 32% from the peak.

The best fund from that point to today was DSP BlackRock Small Cap Fund which over the last 10 years has given a compounded return of 20.36%. But how many advisors would have advised to buy such a fund and more importantly, advise you to invest enough to make a difference to your Net worth?

If I filter for all funds that today have more than 1000 Crores in Assets ignoring all sector / thematic / ETF’s and Index funds, the Median return drops to 14.40%. Asset weighted return comes in at 15.20%.

Nifty 50 Total Returns for the same period comes to 11%. Choosing other major indices could have given higher returns, but the point as I wish to make is not about returns.

A couple of weeks ago, I ran a poll on how often investors measured the growth of their net worth. Given my inclination to tweet slyly and sarcastically, I wonder if that had an impact for the majority claimed to do it on a daily basis. Literally none of them said Never.

But honestly, do you know how much your net worth – liquid that is – grew in 2017 or has grown in this year? While we measure every other thing to the second decimal, it’s surprising to me that most don’t bother with the growth of their net worth.

Growth in liquid net worth is directly dependent on the split between equity and debt. It doesn’t matter if you have the best mutual funds out there if they constitute just 10% of the total net worth for the end result will be worse than someone who has invested 50% in Nifty (which as per data above is close to 45% lower).

Advisors are dime a dozen – but how many are willing to sit with you, talk through your fears, your goals, your savings and the devise the asset allocation that suits you and the plan you need to follow to get to the goals you have in mind?

Asset Allocations can either be dynamic or static. For long, at this site I have been publishing an Asset Allocation Mix that one could reference as a guide to how much to be invested in the markets. That is a form of Dynamic Asset Allocation.

On the other hand, Harry Markowitz follows what can be seen as a Static Asset Allocation. Both have their advantages and disadvantages and its important to understand what suits your style of investing, your risk temperament before deciding on one or the other.

This is what you need to pay an advisor for. This knowledge is neither cheap nor easy to obtain for it requires one to really understand the ultimate requirement of the client and how best he can be served.

No one knows which will be the best fund with 10 year returns in 2028, but with a good asset allocation plan, you can sleep well in the knowledge that come 2028, you have a certain probability of meeting your goals if returns are as per one envisaged based on data of the past.

Now, that advise is worth a fee.

The Search for Investing Nirvana

Investing can be pretty simple and yet we assume simple isn’t good enough and keep searching for elegant solutions even if they are complex and have risks of an unknown nature. Free is discarded in favour of paid solutions even though the free ideas may have as much value as the paid ideas.

We are a product of our beliefs and biases and no matter what others say, we refuse to cow down and accept that maybe we are looking at the wrong direction.

In 2003, I had amassed enough money to become a broker at a regional stock exchange. Since at that point of time, I was also looking at investing the same into Real Estate (specifically a house), I have always wondered how life would have evolved if I had followed that direction than the one that led me to markets, full time.

While the business barely broke even even after a decade, no thanks to lack of my marketing skills, Real Estate took off like no other. But here is an interesting thought that came about when I was having a talk with a good friend of mine.

We both have been in markets for more than two decades and yet, neither of us had even invested into mutual funds – either lumpsum or systematic investing. Its not that we didn’t know of the advantages, my family first big non UTI mutual fund investment was in the year 1994.

Yet, our beliefs in our own abilities made us invest directly and while some investments worked, some didn’t, I for one never came to create a portfolio of a size that I could have had by just investing a small sum regularly. I didn’t have to buy the best fund or the second best one, all I had to do is get that nudge to invest a small sum and forget about it.

My friend wondered what if we had invested a small sum of money in funds managed by others. While returns may be more or less depending on the fund we invested, the fact would have been that we would now be the proud owners of a few millions and all this without any effort.

As he recounted this old joke,

There’s an old story about a guy taking a smoke break with his non-smoking colleague.

“How long have you been smoking for?” the colleague asks.

“Thirty years,” says the smoker.

“Thirty years!” marvels the co-worker. “That costs so much money. At a pack a day, you’re spending $1,900 a year. Had you instead invested that money at an 8% return for the last 30 years, you’d have $250,000 in the bank today. That’s enough to buy a Ferrari.”

The smoker looked puzzled.

“Do you smoke?” he asked his co-worker.

“No.”

“So where is your Ferrari?”

Many of us don’t smoke or drink, but do we really have saved more than those who spend money on such activities? There is always something else that catches our fancy and attention and onto which we would have very likely spend the money. Knowing is not the same as Doing.

On Twitter, I see financial advisors ridiculing people who invest in a large number of SIP’s. The CEO of a fund house has multiple times commented that by investing in one too many a fund they will earn nothing more than the market.

But I think what is being missed out here is the fact that, what if they aren’t really looking at beating the markets in the first place. What if the rationale for them investing in ‘n’ number of funds which has a large over-lap is to ensure better sleep at night?

Assume you have a Crore of Rupees and wish to invest in the Debt market, specifically Liquid Funds. Liquid fund returns of most fund houses are close to each other which means that you aren’t likely to do better by trying to choose one over the other.

Given that info, would you feel comfortable investing all the money in one fund or deploying the same in multiple. When the basic objective is to park money that can grow safely, would you try to maximize or diversify and ensure sounder sleep even though returns maybe a bit less or more than what you could have achieved otherwise.

If maximization of returns is your requirement, you are better off investing directly in stock versus mutual funds since you may by pure chance be invested in a stock that shoots off like nobody’s business providing you with riches you didn’t dream of obtaining.

Dynamic / Tactical Asset Allocation is a very new idea. But for long term performance, do they really add value or are they just bells and whistles that are nice to speak about but imperfect when it comes to applying them in real life?

Harry Markowitz won the Nobel Prize in Economics for his pioneering work in Modern Portfolio Theory and yet when it came to his own asset allocation, went onto allocate it equally between Equity and Debt regardless of the wonders he could have achieved by just following his own strategy.

We keep searching for the best mutual fund and the top fund of this year is not the same in the next year forgetting that simply investing in the cheapest ETF can over time maybe provide as much returns as all the constant churn would provide.

In the past I have been critical of blindly sipping into mutual funds. But thinking on lines of this being a nudge to save, a SIP in expensive markets is better off than having no SIP for we are unlikely to save the money elsewhere and instead spend in on things we may not cherish the day after purchase.

On the other hand, those who SIP forming estimations of grandeur returns thanks to historical data are likely to be disappointed as well. SIP is a nice way to shove money into savings that may otherwise end up being spent. Will it really help you take the Trip to Europe is a different question altogether.

The Rout – What Now?

A few days ago, Larry Williams made a poignant statement

“There is no technical indicator that will call the top based on what little I know about the markets I’ve never found one that can do that.”

Markets after being bullish for so long a time that people forgot that it can also go down once in a way gave way in dramatic fashion post the day of the budget. While the convenient excuse is that the break down was due to introduction of Long Term Capital Gains tax, the fact remains that re-introduction of a tax that has been talked about for quite some time now cannot be enough reason.

To me, the bigger reason is Valuation and the Trigger is not LTCG but Political Uncertainty. Both these factors are enough to damage long term trend but not enough to erase all the gains that have been accrued so far.

This evening I was having a discussion on markets with my good friend, Vijay Sambrani who believes that given the way markets have acted around the 100 EMA in recent times, that would be a good number to watch out for trend reversal.

The chart above is the plot of Nifty 50 with the blue line being indicative of the 100 EMA. 2017 was one of the few years where this would have been a fabulous signal to watch for trend reversal. It currently stands at 10,390 which would require a fall of 370 points before it gets tested.

Markets have been on a roll for quite a long time now. Not since 1990 had we seen a year where markets hadn’t closed below the budget day close for a single day. In 2016 and one again in 2017, we saw markets not closing below the Budget day close for a single day. A kind of record for the ages.

While we Indian’s can blame our government for the correction, a similar strong dip was seen in the US of A. This is a cause of concern since like the Indian Markets, US market too has seen a near 45 Degree slope of rise in markets with very little volatility.

Is this the End

While literally everyone was waiting for a dip to buy as long as the trend was up,the moment it has started down, the question being asked is whether the trend has reversed for good and would be it better to exit completely rather than add to existing position.

In US as in India, Treasury Bond yields are inching up and this will have a impact on the bottom line of companies, especially those that have a overhang of Debt. It also serves as a warning that the market is anticipating a upswing in Inflation which is once again negative.

While yesterday’s fall was huge, from valuation perspective it has barely made a scratch on the surface, let alone a dent as it usually does.

The last proper correction in the Indian Markets started in March 2015 with the final lows seen only in February 2016. While the drop was one of a long duration, the depth wasn’t with the markets dropping just 23% from its peak. Compare this to the fast and furious crash we saw in January 2008 when markets dipped 30% in a span of two weeks.

Corrections are healthy in the sense they remove a lot of dead wood from the market letting it get ready for the next stage. But they are painful for as investors, seeing our wealth vanish day in and day out isn’t a pretty sight no matter if we know that this is temporary and in the long run, our wealth will grow back as markets rebound.

Between 1962 and 1965, the Dow Jones Index nearly doubled in value. This rally was not a one off as markets had steadily climbed from 1942 on-wards and while there were regular doses of correction, the trend of the markets had more or less remained bullish.

10x from the starting point, the markets though finally ground to a halt. Unlike in 2008 when markets crashed in no time at all, this was a slow motion act. While Markets went down and went up over periods of time, it never really breached significantly the highs of 1966. The final break above the high of 1973 (a 4% higher top above the high of 1966) came in late 1982 – a full 16 years from the first major peak.

Indian markets too have seen long period of literal numbness in markets. Take the peak of 1992 – the Harshad Mehta peak. It wasn’t breached 2004 though we did see it being broken in the fag end of the Ketan Parekh peak of 2000. The 2008 to 2014 range is well known.

On the other hand, we have had (in the Dow for instance) crashes like the 1987. It came in the middle of a strong bull rally and while the cut was sharp and deep, markets recovered and moved well above the 1987 peak in early 1991.

From a middle class perspective, the Budget was one of disappointment, investors in markets got skittled by the 10% LTCG that has been re-introduced. Businessmen were literally hauled through the rocks as Demonetization and later the implementation of GST had a impact.

The short term negative impact of GST were well known and given how our skills at execution, it was not much of a surprise to see it being done in a lackadaisical fashion. But the key thing is that this is now done. Another year or so, GST will have ironed out all the issues that currently hamper trade and a few years from today, we shall wonder how we could do business without GST.

World markets are a different animal. After years of easy money, the lightest indication of a reversal in that strategy is sending chill waves throughout the bond world.

Crude Oil which post the Shale Oil episode was never seen as something that will trouble anyone has nearly doubled since the lows of January 2016.

Valuations as measured by Trailing 4 Quarter Standalone earnings did not reach anywhere close to where it went in 2008 or even 2011. While the attraction to the mean is high, that would require a fall of around 26% from here (assuming growth is flat). Not a one day affair but not unlikely either.

Last year saw massive influx of investor money into Mutual Funds as other investing options started to under-perform. Many were drawn by the short term returns that have been generated by funds and will see stress when markets start to react. But not all will run for other options to invest aren’t anyway better than earlier which would mean a lot of money would stay.

A bigger concern would be in Arbitrage funds – these funds which had the tax advantage of Equity while behaving like Debt has lost that Arbitage with the introduction of the 10% tax on Dividends and Capital Gains. Post this move, it makes little sense to stay in those funds for why take a higher risk for returns that are closer to Debt (though they are still a bit tax advantaged).

With 60 thousand Crores under their kitty, we should see some pressure coming in as they will start to cut down their positions in market. Even assuming they come out of just 50% of their positions, that would require absorption of 30 thousand Crores of Delivery. Arbitrage funds being Long Stock, Short Stock on Futures don’t suffer regardless of the movement of the underlying given that they are fully hedged.

What to do Now

Its all easy to talk about the great opportunities one missed out in hindsight, but when the real opportunity comes, there are plenty of reasons not to take the very trade that may in the future seem as an attractive proposition.

No one can say for sure how deep the current draw-down will be before the reversal starts. Until 2008, a 30% drop over a period of 6 months was a usual phenomenon. This changed post the crash of 2008 with the new drops ending around the 20% barrier.

With Fed unwinding its Balance Sheet, it wouldn’t take a Genius to figure out that things may not be the same again. Currently Nifty 50 is just 4% from its all time high and yet we are seeing nearly 50% of stocks trading below their 200 day EMA’s.

The broad market divergence could mean that this is just getting started. Or on the other hand, stocks can go down much lower before we end this round of bearishness.

Lets compare for example, the percentage fall from peaks for stocks currently versus what they had witnessed at the end of the Bear run in 2012

By the time, the bear market got over, a lot of stocks had seen draw-downs from peak of 35 – 55%, a huge difference from the current falls of between 15 – 25%. In other words, there could be a lot more pain if this markets starts to become bearish going further.

The Asset Allocation Model as of end January remains unchanged and while it would start climbing up slowly as market becomes cheaper (due to either fall in the Index or better earnings growth or a combination of the two).

My view is that what we will witness in the Indian Markets will be the equivalent of the 1987 crash in the US. Once the dust settles, this would be seen a opportunity that shouldn’t have been missed. Political Certainty or not, the current reforms will have a impact that will be seen over the next few years regardless of who is in the driving seat. No point getting biased and missing out on yet another opportunity.

The Asset Allocator dials down Risk, Should you?

The simplest and the best asset allocation matrix is not one that brings the greatest benefits but one that you can stick through the thick and the thin. In popular parlance, a 60:40 split between Equity and Debt is the best split you can ever have. All you need to do is once a year or once in two years adjust for any changes to bring the ratio back to 60:40 and voila, you are all good.

The thought process is that having 60% exposure to equity will add value in the upside while the 40% exposure to Debt will ensure a steady boat that is not rocked by turbulence the way a 100% equity allocation will.

Unfortunately, the 60:40 split suffers from the fact that while exposure of Equity is limited to 60%, its volatility is much higher making it seem more like a 80:20 or even a 90:10 portfolio. As I showcased in the previous post (The Surging Balanced Funds – The Good, Bad and the Ugly), Balance funds which implement the idea of such a split have hurdles that aren’t easily to overlook.

In out and out bull markets, Balance funds massively under-perform the Equity funds (CAGR for last 5 years for the Best Equity fund is 32% while its 20% for the Best Balanced Fund) while in a deep swirling bear market; they aren’t too different from what you could have expected from a Equity fund (Drop from peak in % terms). Hence, while you miss on the upside, you more or less are forced to partake the gifts on the lower end.

I have been on this site posting a split for Equity and Debt based on your Risk Profile / Time Horizon (Greater the time available, more aggressive you can afford to be) for quite some time now. This is a contrarian way of approaching investing with risk constantly being removed as markets creep higher without accompanying growth in the companies that represent the market while adding Risk when rest of the market is panicking.

The contrarian attitude of the model cannot be showcased better than what happened in May 2016. At the end of May, the Model started to cut exposure to Equity. But my own indicators were suggesting that rather than dial down exposure, we should add to it since we seemed to be ready for a bull run in the offing (Start of a New Bull Market?)

Yesterday, the model once again dialed down Risk to the lowest since May 2015 when I started posting the model. Yet, just a couple of week back, my own reading of the market seemed to suggest that we may be in for a Melt up rather than a Meltdown as many were suggesting (Fear of Meltdowns and Power of Meltup’s).

This is bound to be confusing since if a strong move higher is coming, now is the worst time to cut down on risk. As much as its horrible to see portfolio’s decline day on day, it’s even tougher mentally to stay tuned to a lower risk profile when every Tom, Dick and Harry seems to be reaping the rewards of the market.

The way the Asset Allocator has been build is not to try and predict future returns but rather try to remove risk as the same gets build up. Currently, based on the inputs the model uses, its indicating that Risk is at a very high level.

On the other hand, the reality is that markets can remain oversold or overbought for more period of time than what we are prepared for. The question that crops-up is, should be really dial down exposure when there is no sign of turbulence on the horizon.

The way I love to build portfolio is to split it into Permanent or Core Holding and Opportunity based Holding. The permanent holding can be mutual funds (both Equity and ELSS) which you are comfortable holding through the up and down and are not looking at it as savings for any objective that isn’t at least 10 years away.

The Opportunity based Holding on the other hand can be based on either Momentum or Value. For my personal portfolio, I have chosen Momentum while for family portfolio’s I manage; I have tried to create a mix of Value and Momentum.

On the value front, I am loaded up on sectors like Pharma and IT. Yes, these aren’t the sector that are to be touched with a barge pole, but for me, by having a exposure to these sectors I hope to have a lower portfolio risk even though the asset allocation maybe well over what is recommended at the current juncture.

Momentum on the other hand is plain and simple. I stay long in stocks that are showing strong momentum and churn the portfolio once a month to weed out the ones that are showing signs of weakness (real weakness or relative weakness).

While the Risk is way higher, the model has an exit clause which when triggered will allow me to cut exposure from 100 to Zero. The risk then is all about how much damage the portfolio will sustain before risk is dialled down to Zero.

The Asset Allocation model I post is not a recommendation but to be used as a input on the current state of the market. While you may feel confident about the future, remember that the path isn’t as smooth as we think it will be.

The key to the best allocation mix is to think deep about how much of a pain (marked to market loss or draw-down from peak) you can absorb and still sleep well at night. Whatever number you can think of, reduce it by 50% for dream and reality can be way different in how we react to the event.

Personally, my own current asset allocation mix is 40:60 (Equity:Debt) and this is a ratio I am willing to maintain for the foreseeable future. What level you should maintain depends on a host of factors that are unique to you and no automated calculator can come up with a mix that is optimal to you.

The Surging Balanced Funds – The Good, Bad and the Ugly

The choices we make are based on choices that we would rather make but are denied – passively or actively.

Most investors would want nothing better than a simple investment products that can provide them the comfort of long term returns that can match inflation. But there is no simple magic wand that can provide the mental comfort that reality requires.

Fear is the starting point for many a investment but once you over-come that, you have Greed that shall let you take decisions that you wouldn’t have taken just a few years ago.

I love movies and some movie dialogues have such a impact that it never bores me to watch it again and again. One such which in the context of his post would be from one of my all time favorite movies – V for Vendetta

I was reminded of this speech when thinking of why there has been a swell of money that is flowing into Balanced Funds. While I can understand Equity Inflows and Debt Inflows, why the sudden surge into Balanced is a question that has been not answered.

For long, Fixed Deposits in Banks / NBFC’s (for those who were willing to take a bit more risk for a bit more reward) were the key places to invest. Stock markets have been there for Decades and we even had a Quasi Mutual Fund that invested in Equity but gave returns and volatility similar to Debt for Decades [US-64 scheme of Unit Trust of India].

With Interest rates on Deposits falling to low’s not seen in a long time, investors are caught between the Devil and the Deep sea. Rising costs, which seem to have very little correlation with the inflation numbers released by the government.

Debt funds make sense for those who are paying taxes on their Interest, but for those who don’t, there is little to differ in returns. This squeeze kind of forces investors who won’t want to take risks to start taking risks many are unprepared for.

Enter, Hybrid Mutual Funds aka Balanced Funds

Balanced funds themselves have been here for long and yet for a long time it was like the unwanted child. Equity lovers didn’t love that it held Debt and those looking at Debt did not want the volatility that came with the Equity exposure of Balanced.

Balanced is a wrong way to define the current genre of funds in the first place. When we use the word balanced, the thought is that its equally weighted towards Debt and Equity. But look at the portfolio of any Balanced Fund and you shall see that most have a Equity Exposure of 70% while Debt and Cash completes the rest.

The reason for that peculiar spread comes down to the Tax advantage gained from having equity at minimum of 65% which makes the fund qualify as a Equity fund. This means, Zero Tax on Long Term Gains and no Dividend Distribution Tax on Dividends.

If a fund had a ratio of 50 : 50, it would be qualified as a Debt fund wherein Short Term gains (Sale within 3 years of Acquisition) is added to one’s Income and hence treated similar to a Fixed Deposit. Post 3 years, it gets a little better since you qualify for Long Term wherein Tax is levied at 20% with Indexation benefits.

To this, add the fact that Debt funds have very little commission payable to advisers versus Balanced where the commission is similar to Equity Funds. Added to this potent mix are funds which are willing to pay Regular Dividends making it seems like there is little or no risk in going for Balanced versus Debt Funds.

With markets on a roll, all the above factors have meant a strong inflow into Balanced Funds. The chart below plots monthly inflow into Balanced Funds (in Rupees Crore).

Balanced funds are good in terms of the investor getting a bit of exposure to Debt along with Equity. But the sale narrative is that these are good funds and comparable to Fixed Deposits with the additional advantage of higher returns thanks to Equity exposure.

“Only when the tide goes out do you discover who’s been swimming naked.” – Warren Buffett

The disadvantage of Balanced funds comes to the fore if and when the markets crack. While we may or may not see a fall similar to the one seen in 2008, its important to see how the funds held up during the 2008 crisis with a much lower Asset Under Management to get a better understanding of the Risks that a Investor is assuming.

Look at the draw-downs from the peak they had suffered by October 2008. 50% seems par for the course at a time when Nifty was down 60%. So much so for calling themselves Balanced. More importantly, at the end of 2007, Balanced Funds together had assets under management of just 20K Crores versus nearly 190K for Equity.

Today, Balanced funds account for 135K Crores versus 588K Crores in Equity Funds. The ratio has gone from close to 10% to 23%. This growth is good if the investor is looking at risk and returns that are closer to equity funds. But if the investor is looking at this as a Regular Income Scheme, will he be in for a surprise.

A new category of Balanced Funds that have hit the market lately are Dynamic Balanced Funds or Asset Allocation Funds. These funds too hold more than 65% in Equities to qualify as Equity funds but differ in Net Exposure to Equity by holding Short positions (using Futures) thus reducing their Exposure from long positions. In other words, these are comparable to Long-Short funds.

Take the Motilal Oswal Focussed Dynamic Fund for example. Their Long Exposure in stocks is equal to 79.50% as of September 2017. But using Short Futures, they are able to set off 34.75% of the above exposure giving them a Net exposure of just 44.75%.

But since shorts require margins which are kept in Cash, their exposure to Debt comes to just 10%. While the advantage is that the fund can based on its MOVI index (created using a amalgamation of Nifty Price to Earnings Ratio, Nifty Book Value and Nifty 50 Dividend Yield) add or decrease exposure to markets, its low Debt exposure means that any gains will need to accrue from markets.

Balanced funds are good if you want to divest yourself of the responsibility to allocate assets between Debt and Equities to the fund. But if you ratio doesn’t match the ratio used by the fund, you shall end up having a unhappy experience even though the fund would have performed as it should have.

If you are going through a Advisor route, its his responsibility to ensure that your Net allocation to Equity and Debt matches your needs and risk taking abilities. Asset Allocation is much easier and cheaper if you can model it outside.

Investment objectives and Risks of both Equity funds and Debt funds are clear – WYSIWYG , with Balanced though, its neither here nor there.

To Hedge or Not

When markets crack and they do crack all the time, it doesn’t really matter whether your portfolio is made of high quality stocks or low quality, your portfolio will take a hit. The only difference would be in percentage with high quality portfolio’s tumbling way less than low quality portfolios.

Derivatives were introduced to enable long term investors to take a hedge against short term corrections using options. But using options as a tool to protect portfolio from falls such as one we saw on Friday doesn’t come cheap.

Nifty 50 closed at 9965 on Friday. If one wanted to take a hedge, the best way would be to buy a At-The-Money (ATM) Put Option. A Put option, for those who don’t trade Derivatives, makes money when market falls. With October Futures traeding well above the 10K mark, the ATM option to buy would be the 10,000 Put.

Nifty 50 contract size is 75 and with the strike price at 10,000, this means a exposure of 7.5 Lakhs. In other words, if you have a portfolio that is totally correlated to Nifty 50, buying one contract of Nifty 50 should be enough for every 7.5 Lakhs of Portfolio Value.

But portfolios are rarely correlated to Nifty 50. While last week saw Indices dipping by 1.2%, the Median fall witnessed among Large Cap Funds (Direct) was 1.47% with the worst performer being Taurus Starshare Fund which fell 2.72%.

Nifty Midcap 100 Freefloat Index and Nifty Small Cap 100 Freefloat Index fell by 2.9% each. I would assume most investor portfolio’s fell by as much or more. This suggests that buying 1 Lot of Nifty 50 Put may not be actually enough to protect the downside.

The Nifty 50 10,000 Put of October closed at 135. One unit hence shall cost Rs.10,125. In other words, the cost of Insurance for a month will cost 1.35%. Not bad but then again, one needs to remember that most portfolio’s require more than 1 lot for every 7.5 lakhs of portfolio. At 2 lots, the cost now doubles to 2.70% – an amount that will disappear if Nifty closes anywhere above 10,000 on October 26, 2017

A better way to Hedge?

The risk of hedging using options is that by the time the market falls eventually, you may have run out of patience to keep buying puts and seeing them expire worthless.

A simpler and better way is to reduce exposure by way of Asset Allocation. While we all want to maximize when markets are going up, its tough to bear the pain when markets turn the other. This also means that when markets drop, you have cash to deploy rather than be part of the herd that pained by the enormity of the fall is waiting to just off load at any price.

Markets have changed dramatically since 2008. Any one looking into the past and hoping to invest when markets fall like they did in 2008 has been waiting for a very long time even as markets have gone one way up.

The chart above depicts draw-down from 52 wee highs that were seen in Nifty from 1995 to 2008. While we have more deeper corrections pre-2000 than post-2000, we did see some regular deep cuts. From 2003 – 2008, Indices rose 500% though we did have two cuts of 30% or more.

The same chart but now showing the 2009 – 2017 time frame. Not a single reaction of 30%, forget more. Comparing and Contrasting the two charts suggests that what earlier was 30% is now 20%, what was then 20%, now more of 10% and what was 10% now more of 5%.

Of course, this is no suggestion that we may not see a 50% or higher fall in the coming years – there is nothing like never again. But while probability of a fall of 50% or more is low, that is not the case when market tanks 10% or 20% from the peak.

We saw a 10% fall towards the end of 2016, a year which began with markets continuing to drop and finally bottom out 25% below the peak of 2015.

You asset allocation should take into account, the kind of loss you are willing to suffer if market crack 10% and yet have allocation that you can add more at that point as at the point when markets down 20% and later at 30%. I am using round figures though you are free to use any number you feel is place where you should start investing more.

The final objective needs to be that you are at the maximum exposure you are comfortable at the worst possible time. The negative of this strategy is that you will never be at the maximum for most of the times and that is okay if you understand the thought process is more about enabling you to stay through the journey.

To get a better understanding, here is a table that lists the draw-down in Nifty (from 52 Week Highs) using the Percentile method

What the above two data charts point out is the probability of market draw-downs > 40% from Year high of 52 Highs is pretty slim. Yes, we have had instances of market falling 50% or more, but as the above data shows, the amount of time markets spend there is less than 1%. This Analysis was conducted using data from 1990 to 2017. In 27 years, markets spent less than 14 week below such levels.

Waiting for the proverbial shoe to fall generally means that investors add more risk to their portfolio’s when they should actually be reducing and when that results in disappointment, reduce risk when one needs to add.

Reducing draw-down comes with a reduction in returns but what use are returns of the future if we cannot live through a draw-down? Food for thought?

How Risky is Momentum:

What can we summarize from this?

Looking through the Lens of Asset Allocation:

Share this:

Share this:

Share this:

Is this the End

What to do Now

Share this:

Share this:

Enter, Hybrid Mutual Funds aka Balanced Funds

Share this:

A better way to Hedge?

Share this: