Commentary | Portfolio Yoga

The Framing Effect

Framing Bias is a congnitive bias. From Wikipedia;

“The framing effect is an example of cognitive bias, in which people react to a particular choice in different ways depending on how it is presented; e.g. as a loss or as a gain. People tend to avoid risk when a positive frame is presented but seek risks when a negative frame is presented.”

Consider this example, posed by Dr. Daniel Kahneman, Nobel Prize-winning author of Thinking Fast and Slow:

1. Would you accept a gamble that offers a 10-percent chance to win $95 and a 90-percent chance to lose $5?

2. Or, would you rather pay $5 for a lottery ticket with a 10-percent chance to win $100 and a 90-percent chance of winning nothing?

Think before you choose either. Have you decided? No Peeking. So, comfortable with and believe you have made the made the right choice?

The answer is both are the same, but research says most people when presented with the above options and who think themselves as rational decision makers would opt for Choice 2. Why?

Because of the way the question has been framed you feel that buying a lottery ticket for just $5 is way better than a 90% chance to lose the $5.

The other day I wrote on why I believe that Individual Traders / Investors are better off not trading in Individual Stock Futures and in a way (which I really didn’t intend to) was framing it in a way that people felt that there was a way higher risk than what they perceived.

Before we get further, let first understand what stock futures are and why more people end up loosing than what a simple coin toss odds will foretell.

From time immemorial, people have taken on debt to try and achieve their goals earlier than what it would if one needed to save the whole amount. Think of a housing loan for instance. How many home buyers can afford to buy a home if they were required to put up 100% of the amount vs the current concept of putting up a small initial deposit and pay the rest with interest as time passes by.

If no one is allowed to take debt for buying their own house, the housing market will crash for the simple reason that disciplined saving is way tougher compared to the discipline of paying off the EMI since otherwise you may tend to loser ownership of that house and its not just the financial loss that will pain you but the ignominy of being seen as a failure by those who know you.

Now, lets come back to Stock Futures and how similar it is to the Housing Loan.

Lets assume that you believe that government will focus on Infrastructure and hence Infra companies that have been bogged down could see better days. Lets assume based on the above rationale, you choose J P Associates as the company you want to invest into.

Lets assume you currently have around 2.5 Lakhs that you want to risk in the market. The rational thing to do would be to spit that into 10 or 20 equal measures and invest each such measure into a individual stock. That would mean that you could buy 2170 shares of JP Associates if you invest 10% of your capital into that company (25,000) or 1085 shares if you were to allocate 5% of your money into the said company.

Lets for sake of understanding assume that you have done a lot of research and that research tells you that JP Associates will bloom in the future and given that its all time high is 339, if you are right, this stock could go way way higher.

Given this scenario, would you opt for buying 2170 shares or 1085 shares or would you think on lines of, given how much I know why not take a loan and pump in more money since the rewards will then multiply by the leverage factor.

Lets for a moment get back to the housing example. Two friends analyze the housing market and feel that its ripe for a big up move and they should take advantage of the coming boom. Person A saves a lot of money and finally buys a house without taking a loan for 50 Lakhs. Person B saves a small amount (10% of the value of the house) and takes a loan for the rest 90% and buys a house for 1 Crore.

With housing prices booming, lets assume that property prices acquired by both Person A and Person B have appreciated by 100%.

For Person A, its a pure doubling money. He had invested 50 Lakhs and sees a profit of 50 Lakhs. He is happy until he turns around and sees that Person B who put in 10 Lakhs is now seeing a profit of 1 Crore, 10x the investment. Given that both had done the same analysis, do you think that person A will really be happy with the outcome he is seeing now?

Lets get back to our JP Associates case. You feel that this being one sure bet, maybe you should bet it all – 2.5 Lakhs and wait for it to move up as your Analysis tells you it will. 2.5 Lakhs will get you 21,000 Shares. At this time comes in the Spider who tells you that why stop at 21K, when the same 2.5 Lakhs can get you exposure to 68,000 shares.

In earlier days (and even these days) brokers offer what is called margin finance where you buy stocks while putting up only a part of the investment. If you are right, your returns explode and who thinks that things can go wrong – always be Optimistic is what he have learnt in Life.

But for JP Associates, you don’t need a kind broker to help you. The exchange itself will provide a medium where you can borrow. All it asks you is that you fulfill the margin requirement as well as the day to day, Marked to Market difference.

If you are not exposed to Futures and Options, you may think which irrational fool will take that path, but then again all you need to do is visit a broker’s place and see for yourself how the herd behavior will influence one to take more risks that he should if had analyzed the whole scenario much more carefully.

So, now that we are convinced that JP Associates will move higher, way way higher and we aren’t satisfied with just a small token quantity, we convince ourselves that nothing will go wrong and jump into buying a single contract of JP Associates.

We are now proud owners (not in real sense) of 68,000 shares of JP Associates which means that every time it goes up by One Rupee, we are seeing a profit of 68,000 and since our capital is 2.5 Lakhs, we are up by a awesome 27% of our capital (remember, a Fixed Deposit gives you 7.5% for giving it money for a year). Man, we can start dreaming.

A couple of days later, comes a news item that a certain bank is proceeding with confiscating certain assets of JP Associates and the stock promptly goes down like a brick. Theoretically that shouldn’t cause a problem, after all we have put in 2.5 Lakhs right and even though the stock is down 10% from our entry, its just a loss of 68,000 and big as it may sound, we still have 1.80 Lakhs available.

In 2007 when housing prices started to fall in the United States, those who have taken loans to buy their houses found that many banks had started to ask for them to make up the difference (since most housing loans were to the extent of 100% of the property value). But having invested everything they had, how the hell were they to come up with more money. By 2008, prices had fallen so much that even those who had paid back a lot found that their house value was lower than they still owed to the Bank. With job losses, many were forced to relinquish their homes, something they had paid a lot for (in monthly installments) while getting back nothing.

Back to our JP Associates trade. While we think we still have money, we are actually in negative equity since NSE demands that you plonk up 2 Lakhs as Margin for every contract you wish to hold. Given that we had 2.5 Lakhs to start with, with the loss of 68,000, you are now having a debit balance of 18,000.

Depending upon your broker, you will either see him closing out your position without even giving a chance for you to replenish the amount or shall call you up and ask you to immediately replenish or else position will be cut. Either way, you will need to put in more money to hold that position.

But if we had invested the whole capital we had, where else can we bring fresh capital from? I have seen clients Beg or Borrow from others in the hope of maintaining the said position. In fact, years earlier, I myself had come to face a very similar situation and its in those situation you not only realize who your real friends are but realize how stupid you have been with your money.

But that is for later, what comes first is the requirement of more capital. If you can bring it in the time they provide, your position will be saved, else, its closed and regardless of how JP Associates moves from here, you will have nothing to lose or gain.

So, when I said 95% of clients on the longer term end up loosing, its not because they were stupid but because most of them were financially unprepared. When you use Leverage, its a double edged sword and yet people believe that only one edge is what matters to them without focusing on the dangers brought by the other edge that could cut your neck in no time.

Stock futures are a good product if you can use them wisely (more on that in another post) but if you are using it as a quick way to becoming rich, Good Luck. The 5% who are out there eating up the losses of the rest 95% losses (remember, futures is a Zero sum game) know for sure that Luck can only last so long. Some point or the other, you will throw in the towel after having seen your capital being decapitated several times.

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so. – Mark Twain

The Ultimate Strategy

The holy grail of returns would be if you could get equity like returns while having bond like volatility. While in theory such possibilities do exist, the question that arises is whether its feasible / practicable in execution where reality meets fantasy.

Motilal Oswal Mutual Fund has indeed launched one such fund aptly named – Motilal Oswal MOSt Focused Dynamic Equity Fund. In the words of Aashish Somaiyaa, CEO, Motilal Oswal AMC;

Now, as a systematic trader, my ears perk up when people talk about how great a system has been in back-test. Having build and buried thousands of systems that look great in back-test but fail miserably when it comes to the real world, there is a very high risk of the out performance being more of a mirage that seems to be out there but never can be reached.

To ascertain how long has the system been back-tested and how long its running in real time, I asked him details of the same and here is the reply;

The back-test period encompasses both bull markets and bear markets making at the very least it having some kind of validation about having shown its out performance when times were good as well as when times were bad.

But does that provide any sense of understanding given that any and every data mined strategy will pass the back-test with flying colors?

A better way to test would be to run the data through some statistical testing and see if it really is as good as it claims to be.

Unfortunately the Index is not really a Index as it is bounded and will move between a lower and a upper end making it more like a Stochastic.

But Motilal Oswal in a presentation of April 2016 has the following picture

While the comparison between Inception to April looks tremendously good, do note that much of the data is from the back-test. On the other hand, data from 2 Years on wards is of walk forward and hence more reflective of how good it is.

Below find a correlation chart of 100 period returns of MOVI vs future 100 day returns of Nifty 50.

Since the strategy is contra (Buy when market goes down, Sell when market goes up), do note that we need to focus on when strategy is positively correlated vs Nifty and when its Negative. On the face of it, it seems to do the job though the true picture can only be obtained after a few years of operation by this fund.

The key idea behind the launch seems to be with the idea that since Investors cannot digest large volatility (downside), by having a strategy that sells when markets are expensive and buys when markets are cheap, its volatility will be lower and hence hopefully the investor will stay longer.

In 2010, Motilal Oswal launched a Smart Beta ETF on the Nifty 50. The premise here as defined in the leaflet is as below;

What is MoSt50 basket?
MOSt 50 Basket is a fundamentally weighted basket based on S&P CNX Nifty Index (Nifty). The methodology is conceptualized and developed by Motilal Oswal AMC. MOSt 50 includes all the Nifty 50
stocks but not in the same proportion as Nifty. Weightage of a stock in MOSt 50 basket is determined by using Motilal Oswal AMC’s proprietary pre-defined methodology that assigns weights based on
stock’s fundamentals such as ROE, net worth, share price and retained earnings. This is to ensure that companies with good financial performance and reasonable valuation get higher weightage.

Once again, it was a good concept. After all, if you could buy more quality stocks and less of the bad quality, you theoretically should outperform the Index. The said leaflet also had a chart to showcase its advantage vs Nifty 50

As the chart and the accompanying table shows, the strategy was perfect. While you got the same volatility of the Index, returns were way higher. Since the above chart has both back-test data and walk forward, its tough to notice that it had started to deteriorate. So, how did it perform after being listed vs Nifty Total Returns and Nifty Bees;

As the chart clearly shows, the fund more or less under performed Nifty Bees most of the time and not surprisingly the fund house decided that it was going to follow the regular model from Oct 2014 instead of being fundamentally weighed.

This issue is not just of Indian funds. Take the ETF, First Trust Dorsey Wright Focus 5 ETF for instance. Using a concept of Relative Rotation among sectors that are showing strong momentum, the fund showcased how it has trumped S&P 500 returns

As the table showcases, it yielded strong +ve returns vs the S&P 500. Given that fact that in United States, majority of Mutual Funds under perform the Index, this was a real breakthrough or so the Investors must have felt.

So, once again, how has been the real time performance of the fund vs S&P 500

Once again, there is disappointment in store as forget out performance, for now the fund is not even performing in line with S&P 500. Then again, the time frame is short and who knows how it could perform in future.

Sometime back, NSE introduced a new index Nifty Quality 30. The fact sheet quotes “The ‘Quality’ investment strategy aims to cover companies which have durable business model resulting in sustained margins and returns”.

Once again, the idea is right. High Quality companies can and shall (in theory at least) out perform Low Quality companies and this is proved even in their back-test data.

Does the Nifty Quality 30 whip the asses of Nifty Total Returns. Holy Grail Unveiled, or is it?

Once again, its too short term to make conducive large term forecasts, but Quality 30 seems to be facing some strong headwinds as of now. Will it do better in future? I have no clue though if you believe, you now have the opportunity to invest in the Index through ETF’s such as Edelweiss ETF – Nifty Quality 30.

What is common in all of the three above examples is that the heart is at the right place – how to do better than Index with similar or lower risk. But the result is not as one would expect. Would Motilal Oswal fund be different?

Once again, I have no clue but would rather (as a Investor) wait for data rather than rosy forecasts / back-test data which may or may not be the best way to ascertain which strategy is good and which isn’t.

A known devil is better than an unknown angel.

Travails of a Trend Follower

Over the last few decades, Trend following has really taken off with a lot of believers flooding the streets so as to say. After all, if I were to sell you with charts like the one below, why would you not be convinced about its benefit

But then again, I choose that particular chart out of the 1000’s available because I could use it to show what I wanted to show. Selection Bias / Survivor Bias and what not come into picture the moment I select a single or even multiple instruments from a set of data.

But trend following is tough and this makes one starting to question premises even when we can show from history that what is happening is exactly something that has happened in the past and will happen in the future as well. But, past is the past and the future is unknown. Present is the key and our emotions aren’t really concerned with either the past or the future but the moment on hand.

Yesterday for instance I had a debacle day for me. In the morning my stops got stopped out and I went long. Well before the close though, I once again got stopped out and went back to the original short mode. But markets had not ended and while I did not get any fresh signal markets did move a lot higher than the point that my longs got stopped out and I went short once again.

This is a rarity for my system with system exiting 2 trades in a single day being just 5% of the time, but it hurts and not surprisingly is the costliest (per trade) whipsaws as the chart below will showcase

What is striking in the above chart is that whenever the trend ends fairly soon, you end with negative results that are the primary contributor to the adverse win-loss ratio most trend following systems have. In the above system for example, if you are in the trade for more than 7 days, the probability that you shall still end up in a loss is pretty low. The chart below plots the same

Its amazing to see how not a single trade (out of 365 in above example) could close in +ve if the reversal happened in the first couple of days. Once that hurdle is crossed, the probability keeps going lower until it hits zero and stays there.

Since 1996, Nifty has moved up by around 8000 points. But if you were a trader, you could have gained that 8000 points by being rightly positioned on just 36 days (which is just 0.70% of the total number of trading days). If you were having a trading system that traded daily, if you slept for the first 10 years (1996 – 2006) and applied your theory on just those 36 days, you will have in theory outperformed all 99.3% of the other days (all this being theory, but please bear it with me for a moment).

In other words, you could have been long since 1996 and gained exactly the same points as some one who entered and exited daily on just 36 occasions. Of course, if only we knew about these 36 days in ahead, why would we bother would be the question in your mind and you are absolutely right.

But think on the contrary you were long for all the time and yet were out of the market on those 36 days. What would you be staring at? You would be looking at having the same capital as you did 20 years ago.

Now, lets take a trend following system equity curve. What is the cost of missing a few trades (which inadvertently turn out to be the best trades you could have taken)?

As can be seen above, more the trades you miss, lower the returns. Since the number of trades scrutinized above is around 365, missing 15 trades is missing only 5% of the Signals and yet the returns can be disastrous. You could always argue that maybe the trades you missed weren’t the best but the worst and hence the returns actually are better. But if you could do that in real time, your success rate will be closer to 100% since you can easily over ride all bad trades similar to the way many advisors just remove their bad calls while showcasing their good ones.

So, given this relationship, why do traders still try to skip few trades in the hope that those skipped will be a loser and hence be advantageous. Think of a coin toss. Theoretically odds of a fair coin falling either on its head or tail is 50:50. But if you were to toss the coin n number of times, you can get streaks of heads or tails. But does that change the probability of the next coin toss to something like 40:60? Of course not.

Trend following systems have a average winning of 40 trades vs losers of 60 in a sample of 100. But that doesn’t mean anything since you can have 10 or 12 or even 20 consecutive losers without one single intermittent win. But does that really change the overall ratio? I say Nope. It still remains 40:60 in favor of Losers.

I keep hearing various remarks about how you should know when to ride the system and when to over-ride, how one should not take a trade before a big event (which is actually of a lower risk compared to the risk of the Unknown event we take when we carry positions home everyday), how January is not a good month for longs among various other theories.

When you have a loser after loser, its easy to believe a lot of nonsense that gets sprouted. But as showcased above, data indicates that missing can cause more harm than participating in each and every trade. All we can control is Risk and that is better controlled by modifying our position size than by skipping a few trades.

Should Retail Investors / Traders indulge in Derivatives

Twitter is a place for discussions, collaborations, fights and what not. Today’s post has much to do with one such discussion which more or started when while replying to a friend, I put it out that I was long in Nifty (as we dwelled on how markets may behave on Monday following the carnage (if one could say that) one saw in Dow on Friday).

Vijay Pahwa commented on the tweet and tweeted “Even the best of traders lose money. A layman shd focus on investing in stocks. No trading system can predict mkts!”. Well, for starters he thinks too high of me to place me in the same box as the best of traders. If anything I hope I am above average (especially since I have survived) and not in the bottom of the bracket.

This comment started a new thread on its own and in one such tweet, he tweeted the following

While I don’t know the source of the 95% (am told by various brokers its even higher), I have to agree with at least the first part of the statement. Second part is questionable given that there is so much of Survivor bias in the data we have and one never knows which fund will have lost money regardless of how long one held the same.

A google search provided me with what could be the Worst Mutual Fund “Ameritor Security Trust” which lost money despite being in the market for 50 years. If you think India is different, think again. CRB Mutual Fund was closed after 20 years with investors getting back 64% of what they invested.

Given the evidence, the question that naturally comes is whether a retail investor should ideally dip his toes into the world of derivatives. While I have been a trader for the last many years, if there is something I agree with the naysayers, it would be that most of them have no business to take part in that trade.

But human greed is tough to conquer. When one thinks there is a opportunity in a certain stock, would you just buy what you can afford (Cash Segment) or try to leverage it (using either Futures, Options or Margin Trading – provided by a lot many brokers) to make the best of the situation?

While I trade in Derivatives, I trade only in Nifty and not Individual Stock Futures. But Stock Futures are the more famous cousin in India where it out-trades Index Futures (measured in Turnover) by nearly 3 times. In fact, Stock Futures turnover is higher than even Stock Options turnover showcasing the bias that has meant that liquidity begets liquidity and there is hardly any trades in majority of the stock contracts.

Stock Futures has had a interesting history in the United States. From Investopedia I learn that Stock futures were in fact banned from 1982 until 2000 and though it trades today, the volumes are way lower than what you see in Individual Stock Options.

In India though, Individual Stock Futures has been the rage. Then again, where else on earth would you see a retail trader having access to a contract worth 5.7 Million (MRF, near its peak) without there being a iota of necessity with regard to whether he is even financially fit to buy such a contract. If you thought, that was excessive, you should have seen the contract value of Gaur Gum hit the roof when it climbed an astonishing 2000% in just around 18 months. Since contract is for specific quantity, there is no revision.

For instance, when MCX started offering Gold contracts, the value of 1 Kilo (its normal contract) was around 8 Lakhs. Today, the same contract has a value of 31 Lakhs. With SEBI revising the minimum lot value from 2 Lakhs to 5, a lot of stocks have so absurd a quantity that its enticing to the retail investor to try his luck and see whether he can make it big.

Unlike delivery based investments where you can lose only what you invest, when you deal in futures you can lose a lot more. While risk is limited when you buy options, that is theoretically not comparable since you cannot really bet big on options without taking the risk of having a large part of your capital wiped out. For instance, while there is high risk in stocks, you can bet 10 / 20 or even 40% on a single stock,the probability of you being wiped out (especially if you are buying Index Stocks) is pretty low, in Options, you can get wiped out pretty easily.

Trading attracts the best of the minds since its a constant challenge and winning means that you are literally the member of a high class club with very few long term members. But trading is not even comparable to other endeavors since the risk is asymmetric.

Just as I was about to write this post, I came across this very view by Eric Peters

Trading is tougher than most realize, the odds of success are fairly small and when that window of opportunity opens, very few have any stamina (financial or otherwise) left to take the big calls that would lead to the big gains.

If you were to count the number of advisors who offer you the recipe for success in markets, you quickly realize that this is a market for selling shovels to gold diggers. Brokerage houses survive thanks to Sepculators, more so those who do it in Stock Futures as they have very small holding periods are liable to churn excessively.

While I have no clue as to what might be the optimal number of trades, for me it comes to (based on my system history), 1 trade in a fortnight. As Adam Grimes blogged and I quote,

“On some level, professional trading is boring, and it should be. What we need is structure, routine, and a methodology that points toward repetitive elements of market behavior. What we don’t need is excitement. Be a bricklayer.”

Trading is not for the fainthearted, nor for those looking to make some quick bucks, not for those who cannot afford to spend the time required (its a full time job regardless of how little amount you trade) and definitely not for those who think its a path to glory and riches.

People love the story of Jesse Livermore but forget the fact that he went bankrupt not once but twice. Having had a close encounter myself, its amazing that people think that bounce back is easy. Its not and generally ends with the trader abandoning the markets rather than come back in force.

To conclude, in my opinion, its not Leverage that kills but the inability to understand and handle the risk that finally kills the trader. Leverage in the hands of a able trader is a opportunity, in the hands of a speculator, its a self-destruct button.

If you aren’t a full time trader, stay away from derivatives and at the very least you can enjoy the up’s and down’s of the market for a long time to come (regardless of whether you actually make money or not). There is no such thing as hand-holding out here.

Airtel and the case of Authority Bias

Last Saturday, I received a phone call on my land line (Airtel) with the caller having confirmed he was speaking to the right number, informed me about a change in a scheme I had subscribed to. To give you a background, Airtel offers for its Landline users 2 schemes where in you can make unlimited outgoing calls for paying a certain fee.

For a fee of Rs.99/- per month, you can call unlimited number of local as well as STD numbers

For a fee of Rs.49/- per month, you can call unlimited number of local calls.

I had opted for the later since most calls are local in nature since the fee appeared to be nominal given the number of calls we usually make.

The caller after having confirmed my number proceeded to inform me that due to a TRAI ruling, they were no longer offering the 49/- plan and if I wanted to make unlimited out going calls I need to shift to the 99/- plan. While I was not interested in hiking my already inflated bill, I was curious as to why TRAI of all the people would want Airtel to disband a scheme especially when Reliance Jio is coming up with a similar unlimited (no additional fee either) plan.

Rather than just agree to taking up the 99/- plan, I asked the caller as to more information on which circular by TRAI prohibited this scheme and more details about it. After trying to evade, he finally asked me to call up the help line (121) for more info.

Since my experience with 121 has been more about long wait times, I decided to ask the query on Twitter where I have found them to be more helpful and faster when it came to responding. While it took them 5 days to finally respond, I finally received a phone call from some one in Airtel who informed me that the 49/- plan was very much active and I needn’t worry. He also confirmed that if there were to be such changes in the future, it will be one provided in written format (rather than being vocal).

All well that end’s well, Right? At least in this case, thanks to me asking questions, I did stop them from charging another 50 bucks for a service that I wouldn’t make use of

But lets get back to the Title, Authority Bias. Wikipedia explains it as under;

“Authority bias is the tendency to attribute greater accuracy to the opinion of an authority figure (unrelated to its content) and be more influenced by that opinion.”

If the guy who called me repeated the same to say another 100 or even 1000, how many do you think would stop to question and how many will meekly accept the change. After all, TRAI is the Authority when it comes to Telecom and if they are saying something, it has to be right, Right?

Marketing is all about exploiting our cognitive biases and the guy was just trying out a way to make people pay more without there being a reason to do so. A couple of decades back, I was taken to a very famous ENT Specialist since I had been for long suffering from incessant cold. After examining me, the Doctor said that I needed to be operated and after that I would be free of such cold for Life.

My parents fell for it since the Doctor was very well known and his clinic was lined up with Certificate after Certificate he had received (not sure how many were study related and how many thanking him for being a participant). While they paid up, I endured weeks of pain and for a while, his word was right. I was really free of cold. 6 months later, one fine day the cold started as if it was never gone.

What my parents experienced was Authority Bias, you really cannot question your Doctor since he is the Authority and if he says, its unlikely to be false.

Lets switch to investing since this blog is about investing and avoiding the mistakes therein. If you are a watch financial media, you know about the various experts who come on television expounding their views on markets. Have you ever stopped to ask, Who made them the Expert in the first place? Do they have track records to show how good their analysis has been? Have they won any awards (not that the Award itself would make it right) proving their theories (like for example The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2013
which was awarded to Eugene F. Fama, Lars Peter Hansen and Robert J. Shiller “for their empirical analysis of asset prices”)

Marc Faber for instance is seen as a Expert and appears on Financial Media regularly. But is he really a Expert? Lets check some of his calls (image credit to Ritholtz)

Based on the above pic, would you still treat him as a Expert?

In God we trust; all others bring data – W. Edwards Deming.

Everyone has a opinion and based on simple statistics, 50% of them could turn out to be true. But then again, its only in hindsight that we know which 50% was right – but if you were on the wrong side, its a truth that is too delayed to be of any use.

Recently PSU Banks have been on a roll and yet if you were to search the web, you will ‘n’ number of experts extrolling one to keep away from PSU Banks. They may indeed be right in thought, but markets have shown them to be wrong and I doubt even one of them coming up with a reason as to why PSU Banks are hitting new 52 week highs if there is indeed nothing good in them.

To appear on financial television as a Expert, you don’t need to have proven your expertise. I in fact know guys who have lost big sums of money (other people’s money) and yet get called to provide a view on the future of the market. Its more about having the “right connections” + ability to be coherent in front of the camera + willing to swing for the fences.

Predictions of big moves 6,000 / 12,000 are widely welcomed and even debated without there being a iota of reasoning that is backed by data (that could be tested). Today for instance, I found someone who has predicted that Sensex will rise by 50% over the next two years. I have no clue as to whether he will be right or wrong, but history suggests that 50% move in 2 years is not really normal (based on data [from 1990], the probability comes to just around 36%).

Two years down the lane, no one would even remember if it had gone wrong (if right, be sure that it will be flashed as sign of the Genius he is) but that ain’t the worst part. Assuming he is right, how does one play it given the low odds of it happening. Buy and Hope??

I am no expert but I do know one thing which is that if you can understand the cognitive biases we fall prey often, it will do wonders to your life and investing. For selling bullshit is far tougher to someone who knows to ask the right questions.

Look Ahead Bias and its Impact on Trading Results

As most system traders, my mind is constantly thinking of ideas that I think can help me beat the markets comprehensively without too much of a effort (no day trading types for example). So, today as I was doing what people do in bathrooms (having a bath), I suddenly had this idea for a new test – it wasn’t really new since I had tested parts of the ideas yesterday and this was more of a build on top of the model I had tested.

Given that so many such wonderful ideas end as failure, I knew there was no point in calling out EUREKA and rushing to the system to test it out pronto though I did kind of write down the general thesis of the idea before I forgot about it and went off to meet up with a few friends.

But as soon as I was back, it was to test out the system and man, had I hit the jackpot. The logic was simple and yet it seemed to work very well, in fact too well. Draw-downs were minuscule and the equity curve was pretty smooth. I was so excited that I even wondered for a second about posting this chart out on Twitter (how else do you think we system traders massage our ego’s :D)

System-1 and System-2 are both from same system though System-2 had a additional trend filter which seemed to clean out even better. At that point I was already thinking of how much equity to allocate to this bugger.

The only fly in the ointment happened when I then went ahead with bootstrapping the results. The output (p-value) was not something I anticipated (and regardless of anything else I found later would have killed the system). One thing experience has taught us is that if its too good to be true, its most likely not true.

So, the next step was to recreate in fresh all the steps I took from clean data and was the output a revelation. Here is the chart with both the original equity curve and the new ones (Realty-1, Realty-2)

Realty-1 was still okay though way below the originals while Realty-2 was a disaster. Do note that all of the above is before any slippage / brokerage / STT, etc. Add that and you will question the need to trade.

So, what went wrong?

For starters, the system had two Independent variables wherein decision was taken based on how Variable 1 acted and where Variable 2 was placed. Now, theoretically the idea was that if Variable 1 ended the day positively, I would look whether Variable 2 traded above a certain parameter and then bought Nifty 50 at end of the day.

Now, this meant that I should look at changes in the next day of Nifty 50 of the next day (holding period was of 1 day) and take that change as either my Profit (if it ended the day positively) or as Loss (if it ended in Negative zone). But while coding I had made a small error which meant that rather than take the next day’s figure, it was taking the current day’s figure.

In essence, it looked ahead by taking the returns of the day when the system was triggered rather than the next day. Remember, when the day opens, I have no clue as to how Variable 1 or Variable 2 will close and yet the system conjured that I was already long from previous night and would based on the decision close out my position.

Look ahead bias is one of the frequent biases you shall come across as a system trader for this one bugger makes a bad system look great and a okay system look like you have hit the jackpot. Realty-1 is still nice and may be worth working upon, but for now, sleep was calling.

And rather than Rinse-repeat-Rinse, I shall post the following pic on Look Ahead Bias from the website Quantstart.com

The future is Passive

The big news this week was about the inflow into Vanguard, the world’s largest mutual fund company which attracted $198.4 billion in the first eight months of this year drawing money from Active Mutual Funds and even Exchange Traded Funds as investors poured money into its low cost Index funds.

On the other hand, we in India recently had a SIP day when more than 30,000 investors signed up (in other words, parted with their money) to active funds in the hope that these funds will deliver more than what passive investing will return.

While I am a believer in ETF’s being the future, for now, one cannot dispute the fact that a lot of active funds have generated better returns (historical) than a passive Index. But the question that is rarely asked is

How are Indian Mutual Fund Managers generating Apha even as American Mutual Fund managers have a hard time catching up with the passive returns?
Secondly, the bigger question is, how long this out performance will sustain. Will the next 30 years be similar to the previous 30 years?

Lets first address the first part – the Alpha generating Fund Manager. A lot of funds have indeed generated Alpha over the last ‘n’ number of years but as the recent experience with HDFC showcased, if the fund manager bets wrong (and bets big on it), one would be destined to under-perform for a pretty long period of time. So, basically it boils down to fund managers being able to pick right and sit tight (not that most do as you can see from their churn ratio’s, but that is the basic idea).

The reasons for managers to generate Alpha is many, but one key fact is that the Indian Markets is still dominated by Retail investors. As Aashish P Sommaiyaa, CEO of Motilal Oswal tweeted, the number of Share holders in RIL, RCOM, SBI etc is greater than most MFs investor base.

In United States on the other hand, Institutions dominate the landscape. In markets, its common knowledge that the retail investor (includes us) are the weak hands while Institutions are the strong hands. As long as the ratio is maintained, funds can and will beat the passive indices comfortably.

But competition is brewing in the fund industry itself with more funds being launched and more monies being collected. With there being just around 400 or so stocks that funds invest in, as time goes by, it would be tougher to beat the rest of the pack unless a manager makes some serious bets and then comes a winner.

Take for example, the number of Mid Cap funds over the last 10 years. On ValueResearch I find that there are only 18 funds with a track record of 10 years or longer. But if you come down to 1 year, you find as many as 40 funds in the same Universe. Assets under Management too has exploded significantly while the number of stocks they can invest in hasn’t caught up in a similar way.

This is also showcased by the difference in returns between the best and the worst funds. On a 10 year time frame, the best fund has generated twice the returns of the worst surviving fund. Among funds with 5 year track records, this difference is 2.5X and for those with 1 year track record it spirals to 5x.

But lets get back to United States and the developed markets. Let me quote from an in-depth study by S&P Dow Jones Indices here

“There is a widely held belief that active portfolio management can be most effective in less efficient markets, such as emerging market equities, as these markets can provide managers the opportunity to exploit perceived mispricing. However, this view was not substantiated by our research, as over 70% of active funds underperformed their benchmarks across all observed time horizons.

In the U.S., the performance of equity markets remained solid, albeit weaker than previous years. However, over 84% of U.S. active funds underperformed the S&P 500® over the past one-year period. This poor performance continued over the longer term, as over 98% of active funds trailed the benchmark over the past 10 years.”

Let me put that in perspective. If you had invested in any mutual fund in US in 2006 (when it was still very much a bull market), you had a 2% probability that you will come out a winner in 2016. While I don’t think Indian funds will match such numbers over the next 10 years, its very much a possibility as you extend the time frame.

In 1995, a news paper reported this on the Pager Industry and its future growth prospects

“Just as microchips moved in the 1980s from the computer into washing machines, toasters and telephones, so tiny paging microchips are being developed for lighting, cars, vending machines, and notebook computers. “We’re at the tip of the iceberg of paging applications,” said Jeff Hines, paging analyst at brokers Paine Webber.”

While the paging industry did touch Indian shores, by the time people became aware, the Cell Phone had arrived and made it obsolete. Investors in United States are realizing only now that not all active funds are created equal and most funds find it tough to beat a simple index despite (or is it thanks to) their staggering fees / research.

I have no doubt that the Mutual Fund industry will continue to grow in size since there is plenty of money out there looking for avenues to invest but that doesn’t mean that they will all perform. Some will, most will not and many in between will just perish.

Its hence important that you analyze the facts carefully and take a call based on your reading of the situation and how it can / could develop from hereon. As a saying goes “”The past is history. The future is a mystery. The present is a gift.”

Today, the average investor has access to information that wasn’t there a decade back. The one’s who will thrive in the future are the one’s who make the best of the opportunities that such information / knowledge provides.

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