Commentary | Portfolio Yoga

Past Performance and Future Expectations

All Mutual Funds carry a disclaimer saying

“Past performance of the sponsor / AMC / Mutual Fund does not indicate the future performance of the Scheme(s)”

Yet, in real life everyone including Mutual Funds want you to see the past performance and while they don’t claim anything, the message sent across is that there is correlation between past and the future and that given the great performance of the fund manager in the past, you can assume similar performance in the future as well.

When I recently tweeted about why I wasn’t comfortable with Nifty Quality 30 Index (despite me liking the idea in itself), one of the questions that I was asked was, you should not look at past performance to judge the future. Yes, past has no relation to the future and yet, every adviser and every rating agent looks at the past returns to come up with a list of Top funds to invest into.

If past performance really didn’t matter, we should have seen a more uniform spread of Assets under Management across various fund houses which is not true and hence showcases that we are really driven by the past performance even if we know that there is no way to know for sure whether the future will be as good as the past.

When the future performance is not in line with the past,we get disappointed and search for excuses as to why the fund manager could not replicate the performance of the past. Let me give a real life example.

HDFC Top 200 fund is one of the biggest single funds in the Mutual Fund industry. While investors continue to believe in the fund manager, there has been more than a murmur of voices as its performance. But is the peformance really so bad?

If you take a look at the fund performance over last 5 years, you shall see that it has performed inline with Nifty Total Return Index. So, why the angst and the disappointments that seem to have surrounded the fund?

The answer lies in how it performed over the 5 years previous to that. Rather than talk numbers, let me provide you with a chart where I have divided the data into two equal parts (10 year data) and re-based everything to zero to provide you with a clearer perspective

The first five year (2006 – 2011) was pretty good for the fund as it outperformed significantly against Nifty generating tremendous Alpha. The next 5 years, returns are all in line with its Beta and therein lies the difference.

When investors look at the past and invest, they are essentially hoping that the fund manager will provide similar performance in future and any deviations on the lower side is not taken kindly.

Futher Reading: A paper on why you should not buy funds that have recently out-performed

To really generate Alpha using Mutual Funds (even as they decline in over all terms), you need to be the few who identify and invest with him early and exit when he starts to become a house hold name and that is really a tall ask to say the least.

A free trip to Goa

Unlike new age media sites which use click bait article headings such as the one above to enhance their page views (and hence garner more advertising revenue), this is no click bait article though it on the surface would seem as such.

Instead, if you are a Mutual Fund investor (Large Cap), you are theoretically gifting away a fully paid vacation to Goa for every Million Rupees you have invested. And if you are a big investor, you are gifting away a trip to Maldives every year and if you by any chance or a Very High HNI, you are just giving away a paid vacation to Monte Carlo.

Now, as a reader of many financial sites, you very well know that there is no free lunch and wondering what the catch here is. The thing is, there is no Catch. What I am calculating is simply the difference between the charges of most mutual fund and Nifty Bees.

I see the smirk on your face as you think, but then – I am missing the fact that MF’s out perform ETF’s and whatever savings I achieve will not compensate for that loss.

Indian Mutual Funds have indeed been (on a long term) out-performing Index by a margin (Alpha). But this out-performance has been on a steady decline over the years. The key reason for Alpha was that in earlier years, with a smaller capital to manage, stocks had a good time buying quality stocks that weren’t identified by others and then held on to it as both earnings and its Price Earnings got re-rated.

But with more and more money chasing the limited number of stocks, its tougher to beat the herd if you don’t innovate in how and where you invest. But as the recent episode with a large mutual fund manager showed, buying what is cheap and not liked by others may sound interesting on paper, but if it doesn’t work out as panned, investors are in for a long period of under-performance.

I don’t know how the future will unfold, I don’t know which funds will do great and which funds won’t but what I do know is that as we go forward, bigger the fund, tougher it will find to out perform and here no matter how big a ETF grows to be, it will continue to give me more or less what the Index has delivered.

If I can get a free trip every year just from the savings, why bother about the nitty gritties of constantly tracking the fund and the fund manager and switching from one fund to another in the hope that he will deliver what the former couldn’t.

Importance of Defense

Offense is what we like, Defense is what saves us and in between the two lies the gulf of survival and failure. If you are a Cricket fan, you would have at the very least kept score of what is happening at the IPL. At the start of the tournament, one of the strongest contenders have been Royal Challengers, Bangalore given their incredible batting line up. Yet, year after year, they have failed to convert that into winning that coveted trophy. This year too, they are in a spot with them having to beat the opposition in every match from now on to remain in contention for the qualifiers.

So, what is Cricket doing in a finance blog you may wonder. Well, the reason RCB has failed to notch up the victories this time around for instance has not been due to lack of application in the offense (Batting) department. Its due to fact that their defense has been so weak that even big scores have been chased (hopefully today’s record setting score is something that is bit tougher to chase).

As a investor, we all love for our investments to grow strongly, but in bad times, do we have enough defense to enable us to meet our objectives? Equities is the preferred choice for those wanting to beat inflation by a margin but is that the right choice for one and all??

Lets go back a few years and look at the path that may have been traveled by a US Resident. After the crash of 2000, economy started to bounce back strongly though for a large percentage of population, the gains that accrued through their real estate investments was much more higher. So, a typical guy not only had a good / great paying job, but his investments both in Equities and Real Estate were providing him a nice return on his capital. Towards the end of 2007, he would have seen that housing rates were on the downturn but given the strong markets and the fact that he had a good job would mean that he hopefully can wait it out.

A year later, the perfect storm had hit mainland US and though he himself had not done any hara-kiri and despite not having done any major wrongs, he found himself with a portfolio that was down 50%, a house whose value was less than what he owed to the bank and worse, he had no job since the decline in markets affected the company he worked which in-turn laid him off.

We Indian’s have been lucky not to have experienced such a episode in recent years, but as we become more and more integrated globally, we can easily get hit by the Butterfly effect. Or you can also have a string of bad luck that leaves you gasping for breadth. Its at those times that the real value of your investments gain prominence.

When you invest in markets, your gains are all relative in nature. As long as the markets are good, the probability is that your returns will be good too which reminds me of the following quote

“A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.” – Anonymous

As a investor / trader you should ideally aim for absolute returns but I am not sure how many even understand the difference between Relative returns and Absolute returns. While Mutual fund advisors laugh about those investing in Fixed Deposits, do note that a FD is a absolute return instrument and one that is highly liquid.

In times of distress, Cash is King. Real Estate tends to be pretty ill-liquid not to mention dependent on market forces (unless you are willing to sell at a discount) while Equity can get blasted with you value of portfolio down to a number which you wouldn’t have dreamed off when you first started investing.

If you are not a trader with ability to take advantage of both the bull side as well as the bear side, your next best bet will be to have a portion of assets in debt which can come to your aid when you need it the most.

As Warren Buffet says

I have pledged — to you, the rating agencies and myself – to always run Berkshire with more ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.

Tough times don’t last, but it pays to be prepared well in advance for all and any eventuality. Maintaining a good asset allocation mix is the first step in that direction.

Liquidity, Spread and ETF

While the Asset under Management Exchange Traded funds are a tiny sum compared to the amount Mutual funds have been able to mobilize, they are slowly but surely growing despite it being a product that neither the producer takes interest in selling nor the distributor (stock broker in this instance).

Unlike a Mutual fund where funds charge a trailing commission (non direct) of upto ( and a few even above) 300 basis points per year, most ETF’s have a expense ratio of 50 basis points or less. When it comes to returns, they being passive investments currently hog the middle band when compared with Mutual funds of the same class.

But the biggest issue facing ETF’s to me is the issue of Liquidity and Spreads. Rather than try to explain the meaning, let me post a picture of the definition (plus a tongue in cheek remark) from the book, The Devil’s Financial Dictionary by Jason Zweig

A key way to understand liquidity is by comparing a asset such as Stock / Mutual Fund / ETF vs a asset such as Land. Selling a piece of paper is way easy than selling a piece of land. No wonder that holding period of stocks are low while holding period of land is pretty high.

Spread on the other hand is the cost that will accrue to you to do the deed. Once again, unless markets are in turmoil, you should be able to sell your stock without suffering large slippage. In case of Mutual Funds, its the headache of the fund manager since he is obliged to give you the NAV regardless of how liquid his portfolio is.

ETF’s in many ways behave like stocks since unless you are a big investor, you will ideally be buying and selling it in the stock exchange rather than dealing with the fund house behind the ETF. But how liquid are ETF’s in the first place?

Following is a list of 12 ETF’s that track Nifty 50 and were traded today, a day of pretty low volatility and no panic by either the buyer or seller.

In the table, check out the dates. Do you notice that not all dates are that of 11th May 2016? LIC ETF did not trade a single unit today while Edelweiss ETF has not traded for 2 days now (database I am using is updated till y’day, but if you were to check today’s trading data, you shall see that no trades took place today either).

So, how does it impact you as a investor?

Rather than assume the worst (exiting say the Edelweiss ETF – Nifty 50), lets assume you wanted to Buy SBI-ETF Nifty 50 which thanks to investment by EPFO has a sizable AUM of 6,400 Crores. On the NSE, you shall find the spread as shown in the pic

As you can see, there is real limited liquidity despite it being just 1 / 100 of Nifty (Nifty Bees for instance is 1 / 10 while Edel is 1 / 1). In fact, if you wanted say 500 units, you will need to buy at 81 and for 1000, you may have to buy at 83.

You may think that like in stocks, a rupee or two should hardly make a difference. But you couldn’t be more wrong for every Rupee in this ETF equals 100 points in Nifty. In other words, if you were to buy at 81, you are essentially buying Nifty at 8100 (vs Spot Price close of 7900 and NAV of 7948 (79.48). In other words, just to get in, you may have to pay a premium that is more than what its worth.

And this on a calm day like today. Just think of wanting to exit when the markets are in turmoil with Nifty having fallen > 3% (lets not even bother with bigger numbers). I guess, you can think of how much a impact such a move will make in terms of your returns.

Liquidity begets Liquidity and the same couldn’t be more truer in the above case. I personally use only Nifty Bees and despite it being the most liquid of the choices we have, you can still have a pretty big slippage if you want to buy or sell in a volatile market.

The advantages of ETF are many, but let it not blind you to the risks they carry. Liquidity is the biggest risk as a ETF investor and the spread can seriously affect your returns even if you are using this not for trading but for investing.

Do note that I have no affiliation with any ETF / Mutual Fund house. Above views is just for sake of helping you make the right decisions by providing you with the right perspective of how to look at things.

Bees Saal Baad

Twenty years is a long enough time frame to understand and validate processes and theories, but does that also mean that the next Twenty years will be similar in nature and stature to the 20 years past? We Technical Analysts believe that “History tends to repeat itself”. But even the strongest votary of such a idea will laugh if you ask him whether markets will provide returns of a similar nature as it has done in the past (especially when we are looking at years / decades).

In Yesterday’s Business Standard, Chandan Kishore Kant writes about how if you had invested Rs 1,000 per month as SIP for 20 years, these schemes (listed in the article) would have turned the Rs 2.4 lakh into Rs 55 lakh. And he is right in the sense that if you were able to identify these schemes when they originated and were able to predict that they will Survive, you may have ended up with gains of the nature that is usually associated with Real Estate investing.

But then again, these are the Top schemes from that period and doesn’t include funds whose returns has not been upto the mark, forget about those funds that have changed hands and now no longer sport its original name (and in many cases, its original criterion). Hindsight as they say is 20/20.

A new newsletter seller yesterday posted about the humongous gains made by some stocks in the Nifty 50 universe over the last 5 years. But how many were there in the Index 5 years ago goes unanswered precisely because many of the top gainers got included very recently.

Marketing in its purest form is selling ice to a Eskimo. Some use total lies, some half truths, some do use the real data but massage the same to make it seem way better than it really is. Either way, they want to close out the sale and are happy to tell what you want them to tell.

Being not Rich, I never thought I could watch the Berkshire Hathway Annual general meeting that now attracts fans from all around the world making it the world’s most attended annual general meeting of any company. But thanks to technology, I finally was able to watch Buffett and Munger live without moving out of my comfortable couch.

Berkshire in its annual report every year provides data on how their performance (Book Value) has been when compared to S&P 500. Returns since Inception was way past what the S&P 500 (TRI) delivered. But then again, how many investors knew about Warren Buffett let alone invest in his company way back in the late 60’s and 70’s?

In the Annual General Meeting Q&A session, I heard many of their shareholders talk and unless I dozed off, I cannot remember too many a investor say he was invested pre-1998. Why 1998 you may ask and to answer that, I shall direct you to the following picture

As you can see, despite everything, returns from owning BRK over the last 18 years has been as good as what could have been gained from owing S&P 500 itself. But that is only half the picture. Lets take a look at a larger picture, shall we?

As you can see, anyone who invested in 1998 seeing the past 18 year returns as the proof of the pudding will be left sorely disappointed.

I believe investors who look at fund returns of the previous 20 years and assume similar returns over the next twenty too may be in for a surprise. In the 1990’s, investing in stock markets, let alone in Mutual funds were a real unknown. But today, with growing knowledge and corpus, funds will find it tougher and tougher to keep beating the markets as they did in the bygone years.

Alpha has already been on a steady decline though its still well in the positive territory. But like in US where Mutual funds have not been able to match the Index returns, let alone beat them black and blue, so will be the case (if and that’s a big IF, Index is property constructed) in India as well.

Size is really the enemy of good returns. Buffett has never been able to repeat the performance he showed when he was doing his partnership’s, the first few years of Peter Lynch were way above awesome, same is the case with many well known hedge funds of today.

But picking the next big manager requires dollops of Luck not to mention ability for you to invest a sizable sum so that the returns are really worthwhile (compared to your overall networth).

As Technical Analysts, we trade based on our anticipation (based on history) of how the move unfolds much like the mutual fund investor. But where we differ is that when it’s not going according to our anticipation, we cut our losses and search for new pastures. Do you?

Be the Devil’s Advocate

Back in the school days, we had a debate team and as much as I thought I loved to be part of it, never had the guts to raise my hand and ask for being on the team. My friends who were on the team maybe knew as much as me or maybe even lesser, but the fact that they weren’t afraid to be judged (and debating all about getting judged – how much you know, how much you can defend and how much you can convince) while I was happy to be the guy who never faced that ignominy of losing face when facts one believes in are shown to be false.

But Internet in a way provided me the Anonymity to debate and yet not lose face in the way one would in a live debate. 2003 was when I really started expressing my views on markets using Technical Analysis as my telescope.

While internet does provide a level of anonymity, as time passes by and one gains reputation and friends based on reading and respecting each other’s views / works, one starts becoming not the faceless man one once used to be but somehow who is known.

As much as one thinks this reputation doesn’t really mean anything, once again as time goes by, one starts to feel that this is what one has for all the time spent reading, questioning, testing ideas and views of self and others. The more one gets known, the harder it’s to be a devil’s advocate and try to reason out views that is accepted and followed by the majority.

A reason majority of people follow the herd is not because they believe in the idea, but because they do not want to be seen as someone who makes his own road. After all, what if the majority was right (and most of the time, they indeed are), how foolish it would look to not just being an advocate of an idea that didn’t work out.

In the United States, adjusted for Inflation, real estate returns over the Century has been close to Zero. While I have no idea what inflation adjusted returns in India are, purchasing power based return in my opinion is still in the positive zone.

Being a devil’s advocate is risky business for you end up being seen as a guy who doesn’t understand and worse, have an agenda I not accepting the universal advice. Then again, if you read about the Entrepreneurs who made it big, their idea flew in the face of logic at that point of time though as time evolved and they succeeded, their idea now is seen as a master stroke.

In 2012, I wrote a long report on how a simple MA Cross would not beat a Buy and Hold for most Indices and across time frames. This ignited a controversy in the Yahoo group where I posted it culminating with me and my group being ostracized by many who I had earlier taken to as being friends.

But as every dark story has a positive twist, for me, this was the start of understanding the process of testing trading systems much better than I had ever been able to do so earlier. In recent months, I was once again in a controversy when the SIP debate opened up. Once again, while I am not sure I have been able to convince others of how they can do way better than just sipping blindly, I for one have immensely benefitted from the tests I carried out.

In the world of finance, human behavior is everything and that has not changed since the days of the Tulip / South Sea bubble. It’s hence surprising to think that the new age investor is way different and with the help of his advisor will be able to swim through the choppy ocean.

We have had a bull run between 2003 and 2008 and another bull run that started in 2012 and is yet to end. But there is an astonishing amount of difference when it comes to the quality with this run being one of absolute smoothness and rarely giving one the jitters.

As much as India maybe the one eyed King of the Blind, when markets across the world catch a cold, be sure that India will be no safer than any other country and given out dependence on Dollars, may in the short term actually turn out to be even worse than those countries which aren’t as dependent.

It’s in those times your strongest beliefs will get tested and unless you have been prepared, probability is that you will do no different than the crowd which most of the time behave like lemmings as they leap of a cliff (Urban Legend, but hope you get the point).

To get a glimse of whether you shall be really different than others, look back on what you did when markets fell below the 7000 (on Nifty) levels a few months back. Did you sensing markets were cheap, add more to your portfolio than you generally do or did you await even further fall before deciding to venture.

If you have been an investor in SIP, you would have bought at 9000, at 8000 and at 7000 as well. But, should not you buy more as markets became cheaper while buying less (or even horror of horrors, selling) when markets are expensive? If you didn’t do differently in this small fall, do you really think you will be able to take advantage of once in a decade opportunity when it presents itself the next time around?

Strategy is about making choices, trade-offs; it’s about deliberately choosing to be different. Michael Porter

Power is Power

In the second season of HBO’s fantasy television series Game of Thrones, there is a interesting exchange of dialogue about the nature of power between Cersei and Littlefinger. While Lord Petyr Baelish (known as Littlefinger) tries to home in on the fact that Knowledge is Power, Cersei shows that ultimately Power is Power.

I was reminded of the above exchange as I wondered about the impact of Media on the choices we make. The easy availability of a medium such as the web has provided many with the ability to put forth their views which otherwise may have never been heard outside their four walls, when it comes to their ability to influence, they are still nowhere compared to those who are able to get their views expressed in Newspapers or on Television.

But how neutral are the Journalists / Experts who are provided the ability to express their view which is then flashed across to millions of readers / viewers. How many policy makers for instance use the new methods of Twitter / Blogs vs. reading the newspaper or watching the television to get a sense of the opinion of the general public at large?

For years and even today, much of the population believes stock markets are evil and dens of gambling. Any wonder then that the population of investors (Direct / In-direct) is very small despite our stock exchange being one of the oldest in the world (BSE is the oldest stock exchange in Asia).

In his post, “Financial Media & Reader Maturity”, P V Subramanyam who blogs at Subramoney closes of with the quote

What do I do when I read such articles? Nothing. Many of these articles have no take away for me. Generally none.

Its one thing to have a contrary opinion and quite another to say, Ignorance is Bliss. In the recent debate on SIP’s, the one question that was tossed up regularly was, well, what are the other choices anyway.

But when I did provide those choices, those were tossed away as if I had committed some cardinal sin by advocating things that others don’t (buying a random stock every month for instance) believe in.

When NSE got started, there was a hue and cry by the other exchanges who felt short changed but today, when one looks at the history, one cannot but accept that 1994 was the start of a new revolution when it came to increased transparency and better investor protection.

Mutual funds as a whole charge thousands of Crores per year to manage money and those that are higher up the ladder would not want anything to change. But change is one thing that is guaranteed and while some things may take time, Change is guaranteed.

If you are reading this blog, you are one of the very few enlightened investors who believe in understanding finance better than the man on the street. All I can say is, May your Tribe increase. We need more voices and more opinions, not less.

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