Hot Money and Mutual Funds
Why do people invest in Mutual Funds vs say Directly investing in the stock market?
One reason is that Mutual fund offers a diversification that may not be easy to achieve by a lay investor with limited funds.
A bigger reason, reason number two is that there is hope that the fund manager knows better about companies and their future prospects and will not make ill advised investments that go bust when the sentiment changes.
A question that was bothering me recently was the role played by mutual funds in bubbles. A bubble literally sucks everyone and its only later one realizes the absurd valuations that one was paying for those whereas the same is seen as rational during the course of such a bubble.
In the 2000, as Infotech stocks zoomed breaking barriers upon barriers, I remember quite a few funds getting launched (Sector funds) with focus on investing in the hot info-tech companies. How many were launched and how many are still present till date?
In 2007 we saw a lot of funds launching Infra focused funds since this time Real Estate and Infra were the hot sectors everyone was looking up at. Every time a real estate company acquired land, it notched up gains as it was seen as a major moat (land bank). Once again, how many funds remain active today (a observation made by some one a long time back was how many a Infra had big investments in sectors such as Banking making its comparison with the Infra index totally unreliable).
In recent time, this role has been played by Mid and Small caps as they notched up enormous gains and while the large cap Nifty 50 topped out in quarter ending March 2015, the Mid Cap Index closed at its highest level in December 2015 (lag of 9 months).
A rise in itself doesn’t mean anything since undervalued stocks can rise greatly to catch up with what the market believes as its fair value. So, let me once more present to you the Mid Cap Index Price Earnings ratio which I had posted in my previous post
At the end of 2015, valuations were the highest we have ever seen and came very close to touching the 3rd Standard Deviation. Mid and Small caps are more easily prone to move from under-valued to over-valued due to lack of liquidity and the frenzy making it seem like many of these will transform themselves to become large cap over time.
But liquidity is a two bladed sword. When the swords turns around, it literally can slice through portfolio’s like a hot knife through butter.
The above chart is a Quarterly chart of Nifty Midcap 100 Index. As can be seen, after the rise in 2009 / 10, the Index had more or less flattened out till the next leg started from the quarter starting 1st October 2013. From its close in September 2013 to end of December 2015, the Index rose a incredible 91.50%.
So, how did the Assets under Management of funds change in the period. Here is a pic depicting the same
Above is data compiled using data from AMFI India and selecting funds which had MidCap in their names. AUM above is in Lakhs of Rupees.
From End of September 2013 to End December, Assets under Management increased by 316% while number of funds increased by nearly 50%.
The question now is, how much of this flow of money pushed the valuations of Mid Cap stocks to levels it had never seen earlier. And the bigger question now is, how much of this will stay as historical evidence points out that future returns from times of high valuations are really poor (in a post earlier, I have posted data of future returns you can expect if you invest at different Price Earning ranges (for Nifty)).
Mid and Small Cap funds have given excellent returns over the last year and a half, but the question you need to ask is
Does it make sense to continue to be invested in such funds given the evidence above.
Do note that I may be totally wrong and the Small and Mid Cap rally can continue unabated, all I am offering you (with apologies to Morpheus) is data, nothing more.
Historically most of the theme funds have never been consistent in long term performance (and even existence). So for a small investor its always better to look for a diversified fund with a consistent long term performance (hard to find, esply in recent years when volatility was so high). So now the most important question: Which fund to look into? Any answers…….. happy investing. Play safe. ;P
Agree about the volatility.. How does one create hedge against that? Volatility isnt going to decrease imo, (world events) any thoughts?
Cash is a Asset and you will need to use that as a way to reduce volatility. Selling volatility (again as a hedge) is neither easy nor feasible for small investors
But cash doesn’t make me money.. What about bonds(newbie to bonds too)? Having cash on hand breaks the momentum of achieving it’s goal(growth of capital)
When I say Cash, generally I mean Liquid Bees. Provides interest on day to day while at same time being liquid enough to enable deployment the day you want.
Hedge sounds good in financial theory books and in real world it is vastly misunderstood and confused. Its good if one leaps in financial markets with some bit of volatility in mind (Its not as bad as put by media / financial pundits). Else bank FDs with x% returns and zero volatility is the best.
Hedging is like buying Term Insurance. If your anticipated event doesn’t occur, its a loss. But it can work out if the event you anticipate occurs.
Again, timing is crucial since most of the time, hedges expire worthless
Hi Prashanth,
Has anything changed with the mid cap stocks past 20 days, to indicate rally might not happen again? Given giant companies are comparatively cheaper now, would mid cap be buyable, when cheaper stocks are available? #pondering
I looked at HDFC midcap opportunities fund, I’ve been in it for over 3.5 years now, asked the same question you asked in this article, didn’t close it tho, because I liked the portfolio stocks (most of them).. But you are right, most of the gains got wiped out #fingerscrossed till the next rally to figure out the next step..
Valuations are like Rubber Band – they get stretched and once in a while stretched so bad that it gets cut. So, rather than you ask what has changed in the last 20 days I ask, how much was it stretched and how fast and sharp will be the reversion to the mean.
In normal markets, the fall is not very sharp while in stretched markets, there is a real risk of the rubber band getting cut and everyone wanting to rush to the exit door at the same time.
I honestly have no clue what the future holds, all I am holding is a candle and hoping I am right in what I am seeing.
“Does it make sense to continue to be invested in such funds given the evidence above”- So what’s the way out for an average investor ? To practise market timing based on BSE Midcap Index Average PE ratios and valuations ? Or to maintain an equity-debt asset allocation and ignore all upside and downside until the day his goals come very close ? Because for a large number of investors “blindly SIPping and staying invested ” would work out better for them than trying to second guess the markets. For the few savvy guys who can pump in more money at market lows and redeem a portion at market highs , sure it may work . There is no need for an investor to aspire to more than average returns in the markets. Unless they have very huge corpus creation needs , acheiving market returns should take care of the needs of most investors.In fact , an investor should strive to be above average in every aspect of his life – except in the markets. And as long as our indices are poorly constructed , an investor should just buy and hold broadly diversified equity funds.
I agree that novice investors will find it tough to exit and enter markets as easily as I describe and this is even more difficult when it comes to Mutual funds which is why I believe that ETF’s are a much better tool in terms of asset allocation.
Mid Cap Index lost 40% in 2011 and it could get back to the new highs only in mid 2014. In other words, anyone who invested at peak had to wait a real long time to get back his money. The difference this time though is that valuation as of today is not even at the Peak of 2011, we are higher.
>> There is no need for an investor to aspire to more than average returns in the markets. Unless they have very huge corpus creation needs , acheiving market returns should take care of the needs of most investors
I don’t think its about creating huge corpus as much as to be able to achieve their goals earlier. Markets move in cycles and if we cannot take even the slightest of advantages, we will suffer needless pain that comes when one sees his nest getting smaller and smaller as the market hugs the bearish cycle.
I am not for timing of markets, but at peak valuations, it makes a lot of sense to lighten up the load so as to be able to take fresh risks when another opportunity presents itself.
So what’s peak valuations ? 22 times earnings ? or 28 times earnings ? How do we define the top and bottom ?
For most of the investors, Top is when one is fully invested (thinking sexy returns soon) and Bottom is when one is topless and dont have a penny to invest, mentally and financially. (either lost all money invested or sitting on dead investments),