Commentary | Portfolio Yoga

Transparency in Mutual Funds

On Friday, SEBI came out with a Circular detailing among other things

The amount of actual commission paid by AMCs/Mutual Funds (MFs) to distributors (in absolute terms) during the half-year period against the concerned investor’s total investments in each MF scheme. The term ‘commission’ here refers to all direct monetary payments and other payments made in the form of gifts / rewards, trips, event sponsorships etc. by AMCs/MFs to distributors.
The scheme’s average Total Expense Ratio (in percentage terms) for the half-year period, of both direct plan and regular plan, for each scheme where the concerned investor has invested in.

This has really set things abuzz among the IFA folks who believe that this spells death for many of them given the fact that now the customer is empowered with the knowledge of what he is paying for the advice he is receiving, he may not really be quite keen on continuation of the service as it stands.

Some time back, SEBI decided to differentiate between an Adviser and a Distributor. An Adviser while could charge a fee could not take advantage of the commission paid by the AMC. The basic idea here was to ensure that by de-linking the adviser’s income to products he sold, a adviser wouldn’t sell products not suitable for the investor. But given the fact that Distributors were given a free run where they could (and a leading site that enables investment in mutual funds) still claims and I quote “The smartest way to invest in Mutual Funds and more – For FREE!, it was a tough issue for any adviser to ask an investor to pay when he could supposedly get the same for free.

To overcome this, many a RIA just placed their distributor code under a different entity making it seem that they provided the advice for Free when it clearly was not happening since many of them did not even enable investors to invest in “Direct” rather than “Regular”.

The biggest concern among IFA’s is that this method (of not making the client know what the IFA is getting paid) was the best since we “Indians” supposedly do not wish to pay for advice. Yes, we would love to get things for free (who doesn’t), but if there is a way to evaluate and showcase why paying for advise maybe worth the investment, a lot of those who weren’t ready will have a change of heart. That doesn’t mean everyone will do, but who said changing opinions is easy.

Syms, an off-price clothing store in New York, says, “An educated consumer is our best customer.” I have friends who are happy to go with a distributor since he provides them with evidence backed data on what funds are good investments and what aren’t. If a distributor is providing value and has nothing to hide (after all, no one expects anyone to do anything for Free), I find no reason as to why should this new disclosure bother him. The only guys who would be stumped are those who were claiming to do a free service while riding piggy back on the commissions.

As to those who claim that without the distributor, Mutual Funds will not be able to penetrate in a big way, I would like to read this short story “The Old Lady of Somanahalli”

True Lies

The other day Jim Rogers claimed that he foresaw a 100% probability of a U.S. Recession – a probability that gives him no room to escape, but then again, this is not the first nor the last time he has predicted the unpredictable. In his book, Clash of The Financial Pundits, Josh Brown writes about one such guy – Joe Granville and its a fascinating story to say the least.

Mutual funds are good generators of wealth in the long run if the markets where they are invested see a good growth. Every country has seen at least one big bull run which provides unprecedented gains to the investors.

As much as Technical Analysis is about basing the future on the way its past has been, its no advocate of blindly trusting that historical patterns will occur in the future as well. As Mark Twain eloquently wrote, History does not repeat itself, but it rhymes.

Some years back, in a moment of euphoria a Goldman Sach’s Analyst decided that the next big growth will come not from advanced countries like America or Europe but from 4 countries – Brazil Russia India and China and so came the acronym, BRIC which later on became BRICS thanks to the addition of South Africa to the list.

Over time, the bricks have been falling off to the extent that the lone man standing now is India. Brazil which showed so much promise has been done by the collapse of commodity prices, Russia in addition to getting hit by commodity prices also got hit due to its incursions in Ukraine, China – country whose stock market literally shook the world markets is someone whose numbers are always under question.

For a while, it was good with the worldwide growth washing away everyone’s sin’s of omission and commission but while investors may have a short term memory, markets remember.

In a recent article, I read about the last 150 years of innovation has been on lines that has never been seen in any other 150 years. So, when we look back on the markets of the last 15 years and think that that next 15 will be similar or even better, how realistic our assumptions really are?

My idea of critiquing investment methods / strategies is not to say that they aren’t worthwhile but to provide you with a perspective of things from a different view point. Anyone and everyone makes money (some by hard work, some by luck, some others by Inheritance) for money is the key essence to survive (forget thrive). But unlike say our grand father or his father before, we want to do a lot more – more travel, more entertainment, more outings with family. And then who doesn’t want a bigger home, better education for his kids among other wishes.

But life is costly and there aren’t short cuts to success. If you were to look at the Fortune 500, you shall see the list of men who risked big and survived. You shall not see a Vijay Mallya there since while he did risk big, the bets didn’t pay off and instead have taken their pound of flesh in terms of loss of existing wealth.

The reason investors are generally skeptical of equities is because of their inability to understand the risk component. Understanding that is the key to getting a better than average return. Everyone aspires for average returns, but for the average to be average, some will be above the average and some will be below the average. Where do you prefer to be?

Mutual Funds /Equity / Bonds / Cash all have their place in one’s portfolio provided you understand their pro’s and con’s before getting sold on what may or may not be ideal for you. To conclude, let me quote this from Howard Marks, a guy who has delivered returns which are closer to equity but by using bonds.

“If riskier investments could be counted on to produce higher returns, they wouldn’t be riskier. Misplaced reliance on the benefits of risk bearing has led investors to some very unpleasant surprises.”

Finance and the Treachery within

Of all the Industries, the one that is loathed despite its laudable achievements is the world of finance. If not for the inventions in finance, most of us would still be bartering stuff around and hoping that you have what I need and you need what I have.

While inventions in other industries are lauded, in the world of finance, invention in recent years has made one wonder as to whose good these instruments of finance really are.

At its simplest level, finance is all about money changing hands from one who has more than he wants (for now) to one who wants more than he has (for now). Every business is build on its ability to finance its investment from one source or the other.

Directly or Indirectly, most of us are participants of every nature of business there is. While investing in Equities or Bonds is a direct way, when you lend your money to the bank and they lend to a business, its a indirect way wherein your money is channeled to the business with the risk being spread across.

Mutual funds are one way of participating in the business with the main logic being that the fund manager knows better than others. But does he really know any better?

Every month, reports go out on what funds bought and sold and the list is large enough to wonder as to why fund managers need to trade so much even as they hold in disdain any form of short term trading / investing. HDFC Equity Fund for example (picked up at Random) has a turnover ratio of 34% which means that the whole portfolio is literally turned over every 3 years and yet, we have fund managers who shout from the roof tops the advantages of holding for the very long term.

Since 2000 if not earlier, there has been reports of how monkey’s have been able to beat professional money managers (at least the vast majority of them). While there is no monkey out there with ability to pick the best stocks, the reason behind their success lies in the fact that markets being random, everyone has a chance at hitting the jackpot once in a while.

Some time back, the book 100 to 1 in the Stock Market: A Distinguished Security Analyst Tells How to Make More of Your Investment Opportunities by Thomas William Phelps started to make waves in the financial circles. I myself have not been able to read it though thanks to the world of Blogs, was able to get detailed reviews of it.

The thing is that no one, not me, not you, not the hot fund manager right now or the wise wizard next door has a clue about which business will click and provide tremendous gains over the next 10 / 20 / 30 years and which won’t. This means that one really cannot buy a few selective number of stocks and hope for the best.

In fact, right from Warren Buffet to the value investor down the road prefer to reduce risk of the portfolio by diversifying the same. Mutual fund advisers advise one to invest into not just 1 fund but 4 – 5 funds to reap the benefits. But if you were to total up the stocks, you may very well find that you own nearly 70 – 80% of market capitalization ranked stocks.

Much of the financial world is made of monkey’s who offer to provide the service of sharing their cake. As you would know the story by now, its the monkey who stood to gain from the cat’s misfortune. There is literature after literature, all backed by data going back decades and even centuries about investing in a simple index fund being way better than in any mutual fund. But we are told that India is different and Indian fund managers are really able to generate Alpha – something that even Warren Buffet is finding difficult to achieve these days.

The solution to every problem and goal you have in mind is now easily achievable by doing a Systematic Investment Plan we are told. No amount of words or data seems to change the beliefs of the non believers, so let me try and tackle the issue in another way.

What are the Primary reasons for Investors to invest using SIP. Based on my discussions, I could come up with the following

Unlike in the past, we are told that youngsters these days don’t save much even as they draw mouth watering salaries. Unless some part is taken off and invested, they may not have much by the time retirement comes calling. Also since they are butter fingered when it comes to money, they cannot accumulate money to buy when markets are cheap.
Most investors have no clue about investing and aren’t prepared to make efforts to learn the same. Hence investing directly in stocks is too risky for them since they cannot understand the difference between say a Jet Airways and a Kingfisher.
By investing every month regardless of valuation (which they cannot perceive anyway), they can hope to benefit by long term averaging (in fact, the other word for SIP is Dollar Cost Averaging).

So, any alternative to Systematic Investing has to be one where no grey matter is strained and its simple enough for execution.

One of the ways to generate wealth on the stock markets is to buy Good companies and hope that they continue to grow for decades to come. Easier said than done as evidence has shown that even companies that are part of Indices can come to naught.

Buying the blue-chip of today may provide you with a decent return but nothing extraordinary while if you can buy a stock before market start to believe in it, you may have a real wealth generator out there. Its similar to investing say in Kohli before he started notching up his Centuries. His price (even say in case of Sponsorship) would have been way lower than what after market recognized his abilities.

But identifying such companies is not easy – not even for fund managers who prefer to buy the safe stock than risk (and rightly so) on companies that may emerge to be the next big thing. Most mutual fund portfolio’s are hence full of stocks that are similar in nature (and hence more the funds, more the over lapping).

What if instead of putting X amount of money per month into a scheme you invested the same into a random stock. A stock that was chosen by anything but skill, how do you think that would play out?

Well, I tested out the same. Using a survivor free database, I selected stocks every month randomly and assumed to have bought the stock for the money I was investing (10K per month). Every month all I did was throw a dart and buy the stock it picked.

The negative of the strategies would be

You will have a lot of bad apples. After all, not every company will thrive on the long run.
Your demat statement will run into pages after a few years as you keep adding more and more companies over time.

The positives of the strategy are

Since you invest only a small sum every month, the maximum risk would be losing one month of investment. On the other hand, if you can over time get even a single 100 bagger, it would ensure that 99 other bad apples are taken care of
Cost is small for executing this strategy. These days with brokerage firms offering Zero brokerage for Cash Delivery, the net cost would be way smaller than any other comparable investment (even Vanguard is beaten).

So, how did my test turn out?

I selected 120 stocks from Jan – 2005 to Dec 2014 and invested 10,000 into them. I did not add for Dividends which over time can turn out to be a good enough amount and one that will take care of the costs (Demat / Exchange costs) and more.

So, how did it turn out? A 10K investment per month for 120 months meant a principal investment of 12,00,000. At the closing prices of Friday, the current sum would have been 74,13,875.35 and since the investment was monthly, our XIRR return comes to 29.40%.

Of course, this is just one streak of many (given the randomness) and you may actually end up either better or worse than the above number. The intention of this post is to provide you a view on how you can build a large kitty without having to wonder if you have picked up the right fund manager and if the fund manager is making the right bets.

Much of the finance industry is about making grandiose statement without providing the data to back them up. They say that if you SIP for say 10 years, you returns would be great, but is there is no possibility of having a loss after 10 years? Not even 1%, Zilch? Really??

Hundreds of thousands of Crores change hands from investors to those with the ability to market themselves as being the savior of your savings with no one being the wiser. As a adage goes, “The fool and his money are soon parted”.

When the financial crisis hit in 2007 / 08. thousands of investors lost money, many bankrupted. As to those who sold them such products in the first place? Well, most of them are well off and many are in a better position than during those turbulent times.

As I repeatedly emphasize, every one is after you money and its up-to you to safeguard the same. If you fail, you cannot have anyone to blame but yourself.

Being Right or Making Money

First off, the Title is a Rip off of a very interesting book by Ned Davis that I read and recommend you read it if you are interested in looking at market in different ways. Of course, not all the charts that are provided in the book can be easily re-created, but at the very least it will give you a idea on what to look at.

Yesterday, Bloomberg carried a report on Khmelnitsky, an analyst at Veritas Investment Research Corp being the only Analyst to issue a Sell call even as hedge funds piled in. While he now turns out to be right, in the interim, the stock had doubled (from time of his Sell call). In fact, its still yet to reach the price where he called “Buyer’s Beware”. Chart from Bloomberg below (article link)

On Social Media / Television, Analysts keep calling for either a strong fall or a strong rise (new Low or new High in their lingo) even as much of the time, market seems to do the opposite of what they are calling for. But markets being markets, they do get it right at some point of time. The question as in case of VRX above is, does getting it right after being very wrong for a large period of time makes enough amends?

As one very well knows, Being Right is easy, making money, well that is a problem that sometimes seems absolutely insurmountable. But to make money, one needs to be right in the first place and right in the right time frame. There is no point in being right but being unable to make money due to the pains that the position caused first.

Investing / Trading is all about timing and positioning (size). If you get the timing wrong, you will end up taking substantial losses (Notional or Real) whereas if you get positioning wrong, you either end with too small a profit to bother about or too large a loss to be never able to trade again.

The reason Systematic Investment Planning (SIP) is most preferred is because rather than doing the hard work (of both timing and sizing), one hopes that over a long time, everything will average down and provide a better return than what one time lump-sum can provide (a thesis that can be easily tested).

Yet, its surprising that the very same people who argue for SIP argue against a Exchange Traded Fund claiming that since some funds (remember, Survivor Bias makes the whole testing meaningless) have given true alpha and hence in the Indian context Mutual Funds are better than Exchange Traded Funds. If timing is not possible, how can you really hope to pick up the right funds (average return of funds are generally lower than their bench-mark which means that there are a lot of funds that under-perform) all the time?

But I am digressing, this post is not for or against SIP. This post is about whether it makes sense to even follow Analysts / Fund Managers who claim to be right. Today morning for example, a famous PMS fund manager posted about how he hoped investors took advantage of his bullish tweets and invested in the market. But guess what, I scrolled through the gentleman’s twitter feed and he has tried to call markets bottom at every major level.

His target for Nifty (since Jan 2015) is 10,000 and I am sure he will be right. But how many have the ability to withstand the pain that came in between. Stocks, fancied or not have had a hell of a time in recent months with even marque names taking a substantial beating.

To me, timing is crucial – its easy in hindsight to say that, all you needed to do was sit tight, but sitting tight is not the answer most of the time unless you want to be like the average investor. But a average investor has no clue and does no home work, so why should your returns mirror his?

The future is unknown. Yes, we can make speculative / probability based guesses about it, but truth be told, no one has a clue of how it will unfold. The investors who have done big for themselves didn’t make it by taking small risks that will not hurt them if they got their Analysis wrong. Concentration was the key – it made some guys while broke many others.

As a parent, would you ask your ward to give his best (and hopefully come on top) or say, you know what – do as much as the average kid on the street. Why bother with hard work as Edgar Bergen says — ‘Hard work never killed anybody, but why take a chance?

Power & Responsibility

Of the major Superheroes – Batman, Spiderman and Superman, to me, Spiderman deserves a special place for unlike Batman, he is no Billionaire with a R&D team to conk out his villains nor has the Superpowers that Superman has. He is just a ordinary guy who gets ability to jump buildings. Maybe his humility also comes from his Uncle who provides with one of the great quotes ever

“With great power comes great responsibility”

Of course, that is not original and if you are a sticker for the truth, this link should help you find the source of similar sounding statements from history (Quote Source).

In the world of Finance, Experts / Fund Managers who come on Television and provide their views for one and all can be considered the super heroes for many a investor / trader. But do they exercise caution when asked to provide views / predictions on the future of a stock / market?

Fund Managers are generally bullish on markets and stocks for one, they understand the probabilities better in the sense that there is a much higher probability that markets can say double from here than halve from here (Current Nifty level being around 7K). But more than that, its always better to sell Greed when you are looking for funds from clients than spread Fear (more so if you are say a Long only PMS manager).

But this probability is not true at all times since when markets get into bubble territory, 50% fall is something we have seen happen. Dow Jones for instance has seen a 80% crack from its peak and while those times may not repeat, there is nothing like “will not happen” in markets.

A fan blog site which was pumping up all and sundry when mid & small caps were hitting the sky suddenly seems to have started believing that fund managers are clueless since their stocks have fallen a lot during the current bear market.

While Nifty is currently down 23% from its peak, a lot of stocks are way down. Here is the distribution chart of the same

60% of stocks that are trading on the National Stock Exchange of India are down 40% or more from their peaks (4.5 years look back). A substantial number would still be well above what they were a couple of years ago, but this fall is nothing to be laughed at.

I am not much of a fan of guys who sell subscription services since they carry / assume no risks and its all down to how they market themselves. Fund managers on the other hand have quite a skin in the game. Their performance numbers maybe tough to access (especially Hedge Fund Returns) but end of the day, they are answerable to their investors and bad news can spread fast as history clearly has shown us.

I was browsing through the twitter time line of one such fund manager who has not a single bearish / caution tweet right from beginning of 2015. Right from Jan 2015, his target for Nifty (even as he advises that unless you are of the time pass variety, you should be looking past Nifty) has been > 10K. I am sure, some day in the future, that 10K will arrive and he will claim to have “told you so”. But by then, a wave of investors who follow him since Television channels now sport him as “Market Guru” would have disappeared never to come back to the pits.

Thanks to experience of burning hands, I am aware of the risks of following such junkies, but when I entered the markets, this was the only way I knew how to buy / identify stocks. Even today, when people enter markets, it takes a few years before they start differentiating the good from the bad and the ugly. What I really hope is that people who come on television provide a bit more balanced view for as a Idiom says “What goes around, comes around”.

Pall-bearer of bad news

“Shooting the messenger” is a metaphoric phrase used to describe the act of blaming the bearer of bad news and while theoretically we all love to be told the truth, the reality is that we fear the truth that does not appear appetizing to our view of the world.

Every week (in fact, every day), most newspapers carry a column where a “Astrologist” predicts the future for the zodiac signs. If you were to read through them, you will find that none have a bad day ever. At worst, one needs to be cautionary in a otherwise life of good things that keep coming.

While am no believer in Astrology, the fact is that if the column predicted something really bad, the probability is that you will stop reading the said column and while at it, may actually change the news paper. Which newspaper editor would want that anyways 😉

The world of finance is one such where we would love to be lied to than accept the reality. We know that Insurance is not a investment, but love the fact that some one is offering a product where you get the amount invested back and heck, even get a Bonus above it while all the time being secured.

ULIP’s got sold big time not just because it gave the agents big commission but also because investors felt that they were getting more buck for the rupee without understanding either the risks of the product or how much of a conflict of interest there was for everyone other than the Buyer of the said product.

Finance is one field where there is tremendous amount of historical data that can help one make the right choices and yet, more investors fall for “True Lies” than be willing to hear the real truth and the real truth is that there is no “Free Money”.

Recently I was privy to a friend’s portfolio which contains Insurance (Endowment / Money Back / ULIP) policies dominating to the extend of 70% of his non business / non real estate networth. But was he upset about buying policies given that the returns hasn’t been great ? Hell, No. On the contrary, he was and is still happy with his Insurance broker for enabling him to invest in those policies and while he knows that the agent gets a commission, has no clue about how much it is and its impact on his returns.

Most people I interact with already have strong opinions that are unlikely to be changed no matter what evidence I can come up to discredit the same. Of course, its not surprising since that behavior is known as the “Backfire effect” where dis-confirming evidence strengthens than weaken one’s belief. The only common factor I have experienced is that I have been avoided – why bother with the guy who tries to show us the Mirror or so the thought I assume it is.

Just like you can find very few Sell reports when it comes to Stock Recommendations, so too are advisers who try to provide you with a alternative view that is not palatable to one’s own views. Rather than dismiss it off-hand , the least you can do is take a serious look into the data with a open mind since mistakes in the world of finance can turn out to be very expensive on the long run.

Responsibility, duties and Commission

There is a old saying that says “never ask a barber if he thinks you need a haircut”since its in his financial interest that you not only get a haircut but maybe a head massage as well. A Real Estate agent (even one appointed by you for your best interest) would try to close the deal even if waiting a bit more time would have given you a better deal since his interest lies in his ability to collect his commission once the deal was signed. In fact, in the book Freakonomics – A Rogue Economist, the Author digs into public information to show how when it comes to selling their own houses, Real Estate agents manage to get a better deal that what they could get for their clients.

Where-ever there is fees, there is bound to be a conflict of interest, especially when such fees accrue only if the transaction is through. As a stock broker, I tried to dissuade my clients from trading intra-day showcasing large amount of evidence that the probability of them making money on a consistent basis was lower than what they tend to believe. But all I got for that nice gesture was attrition of the said clients to other brokers who told them what they wanted to believe.

In India, Mutual Fund distributors as a lot earn hundreds (a couple of thousands perhaps) of crores per year (info available publicly) for selling funds to their clients. Biggest earners are banks since a Bank is a place where we place our trust (after all, we are trusting them with our hard earned money, right?) and would not be in a position to understand whether the relationship manager has our interest in his mind or his monthly target.

If you aren’t sure if its his interest in mind or yours, all you need to do the next time you are approached with a irresistible proposal is ask him if you could invest “Direct”. The answer will be all you need to know about his conflict on interest and hence the bias.

The other day, I came across a database which provided data on how much of their commission was from funds that was sold by their own Asset Management Company. A leading public sector bank had 100% of its Income selling funds that was from their own AMC. Do you really think the bank clients got the right information on what funds were available to invest?

Sometime back, I was discussing with a friend of mine as to whether it made sense to start a enterprise where we sold mutual funds for a fee (not the trailing commission). My friend dismissed the idea right away saying that Indian’s love to get things free (or supposedly free) and this idea would go nowhere (other than maybe emptying our pockets of what we had). I do hope he was wrong and since there has been new launches of financial websites offering similar services (Invezda for one) does give me hope that maybe, just maybe he was wrong.

If I recommend something (and it maybe as small as buying a book), I have a inherent fiduciary duty to ensure that I am not selling something that is not worthwhile for you. When Mutual fund distributors say that any day is a good day to start investing, they are looking at you as a piece of meat rather than hoping that your growth will provide them with earnings over a longer period of time.

Of course, it would be unfair to tar the whole segment since there will be a lot many who have your interest at heart and will not lie to you just to make sure the deal goes through. The only way to differentiate them would be for you to ask the right questions (and hopefully know the answers as well) to really know whose interest he really has in mind. Even better would be going to a fee based advisor since his Income will not be dependent on whether you invest or not.

A year back, my father who had gone to the bank to make a Fixed Deposit (Tax Saving) was sold a ULIP which guaranteed him a 4% return (when FD rates were nearly 9%). Guess what, my father was actually happy with the deal (of course, he had no clue that final yield was measly 4%). Thanks to me raising a stink on Twitter, the reversal was affected and my father went and made a fixed deposit with a different bank. But if not for me, he would have felt that the seller was looking at his benefit when it reality he was most probably just trying to complete his monthly quota.

Do remember that there is no “FREE MONEY” anywhere. Once you completely accept that, you will know what questions to ask and understand what the underlying risk and rewards are. Once again, let me emphasize, its your money everyone is after and its for you to ensure that you take the maximum possible care of it.

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