Portfolio Yoga - Part 20

The Value of a Back-Test and Momentum Investing

I recently saw the reality sitcom “Shark Tanks” {Season 10 is available on Amazon Prime}. As an entrepreneur, this is an amazing show highlighting the tough path of bringing an idea to reality. While I kind of dislike the behavior of the Sharks who act pretty cruel, this being television and if they are really investing real money, they have all the right to ask the tough questions.

The two main deal breakers for those who couldn’t get a deal were

The person has a great idea but is yet to execute or has failed at execution.
He or She is not fully committed to his enterprise (it being either a part time venture or one of the multiple he is trying to run)

The gap between an idea and the ability to execute it so wide that the vast majority of those with ideas are never really able to execute successfully. You may have heard that google wasn’t the first search engine, but did you know that even the famous logic of Google thata set it apart – ranking of page – wasn’t new. It was invented by Robin Li Yanhong who later went onto found Baidu.

In the Shark Tank, of the few ideas that seemed to be vetted among the thousands that come up for a chance to pitch. But even among the few we are able to see, it’s interesting to see how vast the difference is between those who are just ideating or have had a one off viral sales and one who has worked round the clock to ensure consumer connect and is trying to fulfill a requirement.

The second and what has been generally a deal breaker is the commitment of the entrepreneur to his baby. Most if not all are fully committed and often have invested big money of their own savings before coming to pitch to sell an equity stake. The Sharks seem to hate those who are still currently employed elsewhere while trying this out in their free time (there have been exceptions, but since we don’t have data on all those who apply and get rejected, I would assume a vast majority would fall in this category).

When it comes to finance, it’s easy to talk about how great one’s stock picks are or how great one’s strategy is. The spin can be narrative on the company, it’s great products, it’s wonderful management, it’s enormous scope among plenty others or the quantitative spin.

The quantitative spin refers to the ability to showcase back-tests that show how you could have multiplied your money using a particular strategy that has been discovered by the strategy seller. But most such back-test fail when they are implemented in real time with real money.

The reason for the failure lies in the fact that rather than start with a hypothesis that has a strong fundamental backing, most back-tests are based out of testing hundreds or even thousands of rules till one stumbles across the one that seems to meet every characteristic one was looking out for.

For example, take David Leinweber‘s totally brilliant discovery: that butter production in Bangladesh, U.S. cheese production, and sheep population in Bangladesh and the U.S. together “explained” (in a statistical sense) 99% of the annual movements of the S&P 500 between 1983 and 1993. (Link)

Unfortunately post the discovery, the whole correlation fell apart. But that is what data mined back-test is all about.

Back-testing today has been made very easy thanks to the availability of data and processing power that can run through millions of combinations to find the optimal ones with relative ease. A small investor or a trader sitting on a laptop can find good correlations combining multiple strategies using tools such as Amibroker or R.

A good back-test is built on a hypothesis that is of a sound nature. The reason for testing the data of a historical era is to try and understand if certain strategy that sounds interesting and worthwhile to follow has in the past delivered returns of the nature we seek.

While years of history can be tested and plotted in a few minutes, the reality is much different even if history repeated itself as much of back-test assumes.

Assume for instance a strategy that delivered great returns. This despite the fact that it did not reach its all time high for 6 years after a very great run. 6 years of being under-water is something no investor relishes and one that is a huge career risk to a fund manager.

Would you be willing to bet on such a strategy. Remember, this strategy beats the hell out of any other comparable index in the long run, but how long is something that is left undefined. If you are willing to invest, how much of your equity holding would you be willing to allocate?

On smallcase, I am finding more and more advisors launch momentum strategy. This is good for more advisors mean better appreciation and understanding of a strategy. But it comes with a caveat – most of the back-tests are extraordinarily good. That in itself is not a bad thing if the strategy is properly tested but with not much data available publicly to validate the same, it sounds a bit too good to be true.

A second disappointment is the fact that many advisors offer packages that come as low a time frame as a month. This when testing would have shown them that even after 3 years, there is always a probability of the client being in the red.

Back-tests should always be taken with a bag of salt unless you have been able to replicate it yourself. But that is generally not possible due to the proprietary nature of the strategy even though if you were to look at the portfolio’s, more than 80% of them would overlap with each other. As the famous quote from Kungu Panda goes, “There is no secret ingredient”

But beware of strategies that try to do too much – looks great in testing, can be sloppy when it comes to real time. The ideal way to improve your returns always lies with you – allocating right. Tinkering to show better returns is easy, but it always comes with a cost to the end user. More variables, more prone are the results to data mining bias.

Momentum Investing is no different from other factor investing strategies when it comes to recovery periods from draw-downs. They suffer like everyone else, the only advantage being that when they perform, they outclass most others.

Do not venture unless you are committed for the long run for the short run is mostly messy and one that is unlikely to provide favorable results other than in unusual periods such as 2017.

While SEBI Sleeps

When one door closes, another opens is a famous saying. We Indians are famous for “jugaad” which loosely translates to finding a simple work-around or a solution that bends the rules.

SEBI has been tightening rules on who can manage money which has meant that enterprising entrepreneurs with not enough capital but interested in managing others funds have to find a way to overcome that limitation.

A few years back, you could manage a clients portfolio by becoming a SEBI registered Portfolio Manager if you had 50 Lakhs as Networth. The only limitation to what clients you could encourage was that he had to put in a minimum of 5 Lakhs.

The original limit was set in 1993 and was felt that over time the number had become too low. In 2012, SEBI enhanced the limits to 2 Crores and 25 Lakhs respectively. Recently, SEBI enhanced this once again to 5 Crores and 50 Lakhs.

The thing about Networth for a PMS is that this money basically sits in a Debt Fund / Fixed Deposit since it cannot be put to use or even invested in equity for any decline will affect your Networth.

The idea of having a higher networth is to scare away fly by night operators, but given how easy Banks can be duped, I wonder if networth is the right way to eliminate that risk. But SEBI is wise and they know what is best.

A limitation of PMS is that you cannot take leverage, in other words, the total nominal / gross exposure of a client cannot exceed the capital he has provided. So, if he has given 50 Lakhs and you wish to sell Nifty options, you can at best sell 4 lots since selling one more lot will exceed the limit.

You can take leverage if you are an Alternative Investment Fund, but to become such a fund you need to put in 5 Crores of your money and only entertain clients who can come up with a minimum of 1 Crore each.

But what if you wish to trade derivatives for clients and yet not register with SEBI as either a PMS or AIF? Theoretically its not possible, but recently I am seeing various websites openly offering a product where they shall generate returns for you on stocks that you give them as security.

Here is how this works – I have copied the matter from one website though the strategy is the same with 3 others I have seen.

Step 1: A Demat+Trading account is opened under your name, using your KYC documents. We act your broker who has the authority to executes trades in your account, with your permission.

Here is the interesting thing about the Step 1. As a broker, I can only execute trades that are requested by you. If orders are placed online, there is a log that contains the login information showing that the client himself placed the order (as also additional information to showcase from where it was placed) and if offline, most brokers today record the telephonic conversation since this is a requirement of SEBI.

Any permission the client gives to the broker to execute the trades himself is ultra vires. But, hey, who is checking anyways. Lets now go to Step 2

Step 2: Imagine a capital of 5 lac is brought to the table for investment purpose. We will park almost 80 % of this cash (4 Lac approx) into Blue chip equities.

You could have your already existing stock holding, Mutual Funds or even Fixed Deposits transferred to this Demat account of yours.

Take note of 2 Numbers, 5 Lakhs which is the Capital you are supposed to bring in and 4 Lakhs which is invested in Stocks. This means that there is 1 Lakh in Cash. Lets move to the next step

Step 3: The stock holdings and remaining cash is collateralized with the broker. This is a pledging process. Broker in-turn hands it over to Exchange.

Exchange (NSE/BSE) allows you to enter into derivatives trading with the allocated margin.

You must have heard about margin pledging when the Karvy scandal broke up. This is more or less the same. But there is a hiccup. Exchanges earlier used to have no limits on the split between Stock and Cash you provided for margin. But this changed a few years ago.

From Zerodha’s Margin FAQ;

Exchanges stipulate that for overnight F&O positions, 50% of the margin needs to compulsorily come in cash and the remaining 50% can be in terms of collateral margin. If you don’t have enough cash, your account will be in debit balance and there will be an delayed payment (interest) charges charge of 0.05% per day applicable on the debit amount. So, if you take positions that requires a margin of Rs 1 lakh, you will need at least Rs 50,000 in cash irrespective of how much collateral margin you have. Assuming you don’t have this Rs 50,000, whatever you are short by will be the debit balance for the day, and delayed payment (interest) charges will be applicable for that amount. You can check this link to know more on how the delayed payment (interest) charges will be computed.

So, the client, that is you pay the broker an interest since you have provided 4 Lakhs as Stock and 1 Lakh as Cash vs 2.5 Lakhs. While this advisor asks for 20% Cash, another advisor asks for 30% Cash, both lower than what is regulated. Maybe they have a share in the interest charged, I don’t know. Let’s move on,

For the next step, I shall provide what another advisor’s presentation claims their approach is.

Money management helps us decide which strategy should have how much weightage of fund allocation and total fund to be deployed at any point of time in market.

Our risk is reduced as at any point in time we have multiple strategies running on a continuous basis, hence we are able to manage volatility while maximizing return and minimizing the risk. Diversified strategies helps permitted draw down to be adhered to strictly.

Our expertise lies in realizing and implementing which strategy has a better payoff possibility at that point of time in markets. We trade only in Nifty Options and hence completely eliminating news and event based volatilities of individual stocks.

Active dynamic management is deployed on all trades, tracking money flow tools on hourly basis, gives us fast indications about the change in trend dynamics of the markets.

Our Highly experienced teams tracks option premium charts and identifies trend reversal on them. Once money flow and charts indicate a trend reversal, unwinding of one strategy and loading another or booking loss on some positions plays an integral part of Exit strategy.

Option Strategies were coupled with the Money flow and technical analysis tools to reach at a product which had a potential to manage risk with a 7% drawdown.

In simple words, they shall use a strategy to sell options. While most claim to be Delta Neutral, the fact is that Delta Neutral doesn’t generate 18% returns (post all their expenses) which to me suggests that some if not all the time they expose themselves to market trends. In other words, they indulge in active trading / speculation.

Here is a performance chart showcasing a smoothness that even Debt funds don’t have these days. It’s as if like the old Hero Honda Ad, all you need to do is “Fill it, Shut it, Forget it”

The chart below starts in 2008 when Volatility went through the roof but not surprisngly this strategy had a great time even then.

Trading on others accounts with or without their knowledge is as old as the hills. These days, most option experts who trade for others post screenshots which showcase the long list of clients they manage.

They are able to do this by getting themselves registered as an Authorized Person at SEBI with a broker of their choice. This allows them to deal on behalf of all their clients in a single platform without the need to open multiple windows or login individually to each client’s account.

Of course, all this is not legal, but its impressive as how openly its flouted with no fear of any repercussion. All these even as SEBI eliminates those who wish to go by the legal route by adding more hurdles and hence limiting choices for clients when it comes to investing.

My view – if you wish to preserve your capital stay away from such schemes. Its similar to a Russian roulette. All it takes is one bad day to wipe out not just the profits but also your entire savings.

Hardest thing about Investing

A year back, the famous Anonymous Twitter Guru @contrarianEPS posted a list of stocks he randomly picked due to their high price to earnings ratio and called it a ticking time bomb that shall either blow up or shall undergo a time correction.

My own thought was that even though these stocks were expensive, I felt they could out-perform Nifty 50, the Index that is today the goal of every fund manager to beat.

https://twitter.com/Prashanth_Krish/status/1070718652125712384

A year is a short time in investing, but for now the randomly chosen high valuation stocks have beaten the large cap index which itself is seen as an anomaly given that more than 70% of stocks even today trade below their 200 day average.

When the dot com bubble took place, an investor / fund manager had two choices. Play the trend without giving much weight to the fact that the valuations seemed to be ridiculous even for a novice in finance or try and play with the hope that when the music finally ended, you were not caught holding the wrong set of stocks.

Warren Buffett decided to sit out of the game. With internet stocks making new highs literally every day, he underperformed big time. Media saw him as someone who had lost his grip on investing and how he was missing out on the next biggest trend. Of course, Warren had the last laugh.

Stanley Druckenmiller made his name when he was hired to run the Quantum Fund by George Soros. Druckenmiller is one of the best performing hedge fund managers of all time. Yet, when it came to the Dot com bubble, he stumbled and stumbled bad enough to get himself out of Quantum funds.

In an interview in 2015, he described his biggest mistake

Well, I made a lot of mistakes, but I made one real doozy. So, this is kind of a funny story, at least it is 15 years later because the pain has subsided a little. But in 1999 after Yahoo and America Online had already gone up like tenfold, I got the bright idea at Soros to short internet stocks. And I put 200 million in them in about February and by mid-march the 200 million short I had lost $600 million, gotten completely beat up and was down like 15 percent on the year. And I was very proud of the fact that I never had a down year, and I thought well, I’m finished.

So, the next thing that happens is I can’t remember whether I went to Silicon Valley or I talked to some 22-year-old with Asperger’s. But whoever it was, they convinced me about this new tech boom that was going to take place. So I went and hired a couple of gun slingers because we only knew about IBM and Hewlett-Packard. I needed Ventas and Verisign. I wanted the six. So, we hired this guy and we end up on the year — we had been down 15 and we ended up like 35 percent on the year. And the Nasdaq’s gone up 400 percent.

So, I’ll never forget it. January of 2000 I go into Soros’s office and I say I’m selling all the tech stocks, selling everything. This is crazy. [unint.] at 104 times earnings. This is nuts. Just kind of as I explained earlier, we’re going to step aside, wait for the next fat pitch. I didn’t fire the two gun slingers. They didn’t have enough money to really hurt the fund, but they started making 3 percent a day and I’m out. It is driving me nuts. I mean their little account is like up 50 percent on the year. I think Quantum was up seven. It’s just sitting there.

So like around March I could feel it coming. I just – I had to play. I couldn’t help myself. And three times during the same week I pick up a – don’t do it. Don’t do it. Anyway, I pick up the phone finally. I think I missed the top by an hour. I bought $6 billion worth of tech stocks, and in six weeks I had left Soros and I had lost $3 billion in that one play. You asked me what I learned. I didn’t learn anything. I already knew that I wasn’t supposed to do that. I was just an emotional basket case and couldn’t help myself. So, maybe I learned not to do it again. But I already knew that.

One of my observations and one that data has repeatedly shown to be true is that most investors are unable to stick to a strategy and philosophy that they believe in. Rather, they desire to be seen doing what everyone else is doing for there is always the fear of missing out.

In 2017, Pink Papers, Blogs and Television all showcased the same thing – how great it was to be in small cap stocks. A small cap fund manager who generated 67% returns was seen everywhere extolling the advantage of picking good business with bad managements. 2 Years later he is nowhere to be seen having been replaced by another fund manager who has generated 26% returns year to date.

The hardest thing about investing is not about picking the right stocks or the strategy but to be able to stick when things aren’t flowing in your favor. All forms of investing carries the risk of under-performance at some point of time or other for otherwise, it will be a holy grail into which all money will get invested.

Just take a look at the chart below.

A sector that performed great in one year rarely turned out to the winner the next year as well. But other than a couple of sectors, every sector had more good years than bad. But only those who stayed will have enjoyed the benefit while those who tried to chase (and chasing blindly isn’t Momentum Investing) would have seen a lot of grief.

As Warren Buffett says, it’s important to stay within one’s circle of competence if one wishes to be a successful investor. Of course, that assumes you have a Edge for without an Edge, no amount of staying anywhere will get you the success you believe you deserve.

Rotation of Factors – Keeping up with Sharmaji ka Beta

Factor Investing hasn’t made much inroads in the Indian financial markets even though we keep talking about Value, Quality and some times Momentum. Along with Volatility and Size, the key styles of factors among the many are all the rage in the United States with assets under management exceeding 900 Billion Dollars.

2017 was a year when Size factor was the rage with small cap stocks outperforming large cap stocks. While size premium does exist, the premium doesn’t come free and instead is compensation for risks that exists in the small-cap world such as liquidity and corporate governance.

2018 was a year when the Size factor mean reverted. Small cap stocks fell out of favor and large cap stocks gained credence with Nifty 50, the market cap weighted index being the front runner among broader indices.

2019 has been a year when the Quality factor has been in the limelight and thanks to the narratives that have been written about how great companies will keep generating returns better than the market.

The Momentum factor did well by participating in the small cap rally of 2017, got whacked a bit in 2018 due to the lag factor impacting its ability to get / stay out of stocks that had peaked and were on the way down while doing better than many other strategies this year.

The thing I want to showcase is that there is nothing that is constant and will out-perform the markets year on year. As regular readers know, I am a strong believer in Momentum factor with all my equity allocation being invested in the Momentum Portfolio. The portfolio peaked in January of 2018 and is even today down 16% from the peak even though the compounded growth rate from inception is in the range of 15.85%.

This long period of under-performance isn’t surprising and for me has been a welcome move for it allowed me to deploy a significant amount of capital and be ready and invested when the factor moves back to the limelight. While this could happen in 2020 or even in 2021, the tests I have done and the literature that surrounds factor investing and its value add provides me the belief that in the long run I can handsomely benefit.

Buying quality stocks such as HDFC AMC or HDFC Life at valuations that make no sense today isn’t wrong as long as you are willing to stick with the same strategy over time. The expectation of returns may need to be moderated by looking at the longer term returns of the strategy vs the returns delivered in recent times, but its unlikely they will under-perform heavily in the long term.

What is risky is when people buy momentum stocks and cloak that with a growth or value narrative. A good story sells yet it also sets a trap for the investor who is unable or rather unwilling to exit when the story ends and the stock enters a phase of long term bearishness.

The best time to invest in a factor is not when everyone is talking about it, positively or negatively but when none is willing to talk about it. Currently that would be the Value strategy with cheap stocks becoming cheaper by the day thanks to lack of interest that has compounded many stocks lack of strong growth.

Markets keep mean reverting on the long term which means what is what is not working today has a greater possibility of being back in the limelight a few years down the lane while one that currently shines takes a backseat.

The biggest advantage of factors such as Low Volatility or Momentum is that the stocks that come up in their buy list can belong to any of the factors. This in a way automatically provides for factor rotation. But if you aren’t confident of being able to move across factors, stick with the one you can stick for the long term regardless of short term performances for there will always be something that is doing better than the one you are holding.

Protecting Client Funds and Securities from Unscrupulous Brokers

Brokers have never been seen as Saints but the Karvy episode once again opens up an age old question, How trustworthy is your broker, especially when these days many of us have a major part of our networth in Stocks and Funds.

One interesting comment came from Nithin Kamath, CEO of Zerodha

https://twitter.com/Nithin0dha/status/1201720166003822592

Most brokerage houses are private entities save for a couple that are listed such as ICICI Securities, 5Paisa, Geojit, India Bulls among a few others. The vast majority are private entities that are unlisted and hence investors are clueless as to their financial strength. Then again in case of Karvy, I suspect that the financial strength is pretty good in the broking company while the problems themselves lay elsewhere.

From the time we have had stock brokers, they have had the unique ability to hold both the funds of clients and the securities which most of the time are multiple times their own networths. There is always the enticement to use the same for their end.

Back in the days of physical settlement, clients opted for the broker to retain the shares especially those bought for speculative reasons than carry them back to their house and return when the sale was done. Today, SEBI rules prohibit brokers from holding onto client securities for any length of period once the settlement is complete and the stocks have been funded, but as the Karvy episode has shown, that hasn’t stopped the mis-use from happening.

A Chain is As Strong As The Weakest Link and so is the case here as well. SEBI has tried to safeguard clients by framing strict rules as well as using technology to ensure that the client knows what is happening at his account. The weak point though is that the broker even today has access to both funds and securities of clients.

Clients make payment to the broker for securities bought and the stocks that are paid by him is delivered by NSE to the broker who then transfers to the client. Since most brokers also are Depository Participants and clients need to have accounts with them to function, this means that even when the stocks have been transferred to the respective client accounts, its still not totally safe for the broker always has access – legal and illegal.

One way to prevent misuse by brokers as well as reducing overall risks is to separate the function of broking from both collection of funds as well as delivery of securities. What we need are independent custodians who shall make the payments for securities bought by clients as well as be the depository participant who holds the shares bought by the client. This is currently done by Custodians for PMS clients and should be easy to accomplish at scale for others as well.

The way it will work is something like this. Anyone wishing to transact in the stock market opens up an account with a custodian. This account is then linked to the broker of his choice.

Every morning, the broker will sync with the custodian to know the amount and securities available with the client so as to grant him exposure for that day’s trades.

If a client buys securities, at the end of the day the broker sends a bill to the custodian who shall then make the payment not to the broker but to the exchange itself.

Securities purchased by the client will be delivered by the exchange to the Custodian who then transfers the same to the respective client account. The reverse works in case of Sale of Securities – the Custodian delivers them to the Exchange and receives the funds from the exchange itself. In other words, through the entire process the funds and securities are safe from the broker.

What this also accomplishes is the ability for a client to shift broker without having to open a new Demat account and shift securities. In other words, the trading account becomes easy to port.

By dividing the role, this will ensure that the broker’s earnings are dictated by only the brokerage he can charge to his clients and not be able to use / misuse clients funds or securities for his own benefit.

This is not a new proposal either as it seems SEBI has in the past discussed the same. While lobbying may have prevented this from being executed, the Karvy episode should hopefully swing the trend back in favor of such a move and one that shall ensure that clients funds and securities are never at risk.

If the government wishes that citizens move from savings in non financial assets to financial assets, its important to develop systems that can generate trust and one that cannot be easily misused by all and sundry.

Active vs Passive debate rolls on

Aarti Krishnan of Prime Investor posted today an article titled “What are the Risks in Index Funds”.

Basically she boils it down to

They do not protect you from market volatility
They may have concentrated portfolios
They don’t shield you from business or governance risks
They do not guarantee superior returns

I believe that the above reasons aren’t in themselves reasons that make Index funds Risky in any way compared to the alternatives (Active Mutual Funds). My views on the points raised and my thoughts on what is the better approach.

They do not protect you from market volatility

While there are various ways to measure volatility, for me the choice is to look at maximum draw-down. Draw-down is the percentage change the instrument has suffered from the time it hit its peak.

For example, Nifty 50 hit a high of 6357 in January 2008. By March of next year, it was down to 2600 levels. In other words the Index had declined by nearly 60%. If you had invested in a passive fund or ETF, this is the draw-down you would have seen since the fund mimics the Index, nothing more nothing less.

On the other hand, Active Mutual funds have a fund manager to look after the portfolio and hence your interests. It’s the very reason you pay 2.5% yearly. They wouldn’t have done so badly, right?

Here is the chart depicting the draw-down faced by various mutual funds. Do note that some of these funds weren’t large cap at that time.

Large Cap Mutual Fund draw-down from Peak

As you can see, Mutual Fund’s did not shine themselves too well. But that is excusable as long as they deliver alpha – or gain more than the Index gains itself you may say which is true. As long as a fund manager delivers a higher return than the Index after fees, his fee is none of the concern unless you believe that you can do better than him.

The following table from S&P shows 6 out of 10 funds have failed to beat the Index. This presents an issue – Can you select the better fund 10 years ahead of time. In the last three years, just one or two funds out of 10 have outperformed.

Maybe this can reverse, Maybe it won’t. But purely based on Data, Active funds carry the same risks as passive while not really delivering big, at least when it comes to Large Cap Funds.

They may have concentrated portfolios

Since Indices are free float market weighted, sectors that are the current favorite have a higher degree of concentration than the one’s that have fallen out of favor. With the current favorite being financials, it no wonder that it dominates the Index. But this has always been the case. If you remember in 2007, Index weight was dominated by Infrastructure & Ambani companies.

Concentrated Portfolio in itself isn’t wrong. The key is to have conviction in the stock and bet on the same. A diversified portfolio is good when conviction in the stocks is low and one reason my own Momentum Portfolio has a 30 stock portfolio.

If you look at the portfolio’s of most funds and compare them to the benchmark index, you can see very little differentiation out there. Its as if they are closet index funds with a pinch of active.

They don’t shield you from business or governance risks

Indices that are fundamental agnostic do once in a way add a stock that carries significant risks. But that risk is carried by even active funds. When Manpasand fells on questions of Corporate Governance, more than a few funds were found to be holding the same. Everyone makes mistakes, Active or not, you cannot avoid such risks completely.

They do not guarantee superior returns

I think this point was the focus of the article going the replies in response to a tweet. Index funds actually underperform the Index to the extent of their fees and slippages. But with fees for ETF’s (different from Index funds) as low as 0.07%, one wonders should one be concerned.

Does all the above info mean that it makes no sense to go active and instead one should buy the cheapest ETF or Index traded fund?

I disagree. Mutual Funds have their use case, but it’s more of an active strategy than a passive one of just Buy and Hold for a lifetime. If your use case if Buy and Forget, I think there is more benefit buying a Multi Cap fund than buying an Index which buys the top 100 stocks of today.

When we invest in funds, we are betting on the fund philosophy / fund manager. That being the case, why should you limit him to buying only from the top 100 stocks or stocks ranked from 100 to 250 for instance.

Multicap funds allow the fund manager to take a call on where he feels value is there in the current market scenario and bet on those segment regardless whether its from the large cap or small cap.

Another style of funds that is worth being in active vs passive is from the Small Cap and Thematic funds. But here too some amount of timing is required unless you can stomach draw-downs of 70%+ that few funds saw in 2008 / 09 for instance and one that took years to reclaim.

The biggest risk of Index investing is that Indices can go flat for a long time. India has limited data. I hence calculated the % of time, your investment could have yielded negative returns even post holding for 10 years. For the S&P 500 where data goes back to 1950, that comes to 8% of the time. Not high, but something that you should bear in mind.

The best use case for ETF’s that track Indices is to have a tactical allocation strategy. Be long when the trend is in favor of you and be out when its not. Right now the trend in large cap is hot and strong and a good time to be invested. But there will come a time when its out of favor and it makes no sense to go through the pain.

SEBI sounds the death knell for boutique PMS.

In India, you can manage other people’s money in three ways – Mutual Funds, Alternative Investment Funds and Portfolio Management Service. While much of the world has only two options, Mutual Fund and Hedge Fund, PMS in India was a hybrid way for small fund managers to provide a way to manage the funds of each client in accordance with the needs of the client.

Of course, most PMS doesn’t really operate in that way. Rather every client regardless of his risk appetite is sold the same portfolio of stocks. In other words, PMS have become more like a Mutual Fund and one that suffers from tax disadvantage as well.

Few months back, SEBI constituted a Working Group to review the SEBI (Portfolio Managers) Regulations. The SEBI board yesterday met and approved the suggestions. Key changes are

Networth of the PMS firm is now raised to 5 Crores vs 2 Crores earlier
Clients now have to invest a minimum of 50 Lakhs vs 25 Lakhs earlier.
Custodian is now compulsory for all PMS. Earlier, you could have managed upto 500 Crores without the need for a Custodian
The fund manager now has to have a professional qualification in finance, law, accountancy or business management

In recent years, PMS’s have taken off with total assets under management crossing 140K Crores with more than 350 PMS in operation. The new changes, especially with regard to the minimum amount is bound to have an impact on the growth going forward.

The intention for all changes by SEBI is to safeguard the interest of investors. But the recommendations that are now applicable will reduce competition and actually hurt the interests of the clients.

In the United States, you can start your own mutual fund relatively easy. The cost of starting a mutual fund ranges from around 20 Lakhs to 80 Lakhs. In India, you need a networth of 50 Crores to start a Mutual Fund.

While the regulations for PMS aren’t as stringent compared to say stock brokers, we haven’t seen any PMS running away with clients money. On the other hand, you have multiple brokers who have vanished with crores of client money.

To avoid small investors from getting burnt in derivatives, SEBI has from the start taken a stand that the minimum size of the contract will be high. This was recently enhanced to an even higher level. But dig a bit deeper and you shall find that this has led to more clients losing more money than being saved.

Another rule that is now applicable and makes no sense is the requirement for a professional degree. Once again, there is no correlation to show that just because I have a professional degree in law, can I also be a great fund manager. But the higher powers seem to believe that.

A CFA certification in my opinion has a far greater value than a Management Degree since the focus is totally on understanding companies, their Balance Sheet and the ability to spot frauds and inconsistencies. Moreover, being international in reach, it ensures that the fund manager follows the best global practices.

The current move while not totally surprising is a retrogressive one. There are various ways in which SEBI could have safeguarded investor interests while at the same time provided for more choices. Sadly, once again we have missed that boat.

Links: Issuance of SEBI (Portfolio Managers) Regulations, 2019

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They do not protect you from market volatility

They may have concentrated portfolios

They don’t shield you from business or governance risks

They do not guarantee superior returns

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