Monday, June 29, 2015

SIP in Mutual Funds- Choose well- A case for Index investing(Th

People write in to ask whether it is better to opt for mutual fund route or direct equities route. To me, it is clear that a portfolio of well chosen direct equities will do better than a mutual fund portfolio.
As mutual funds grow larger in size, it becomes difficult for them to beat the benchmark indexes. This is because of our market structure. We do not have many large ‘market capitalisation’ companies. If a fund manager has a Rs.5000 cr portfolio, he would ideally like to put a minimum of Rs.50 to 100 crore in a single stock. So, he would look for companies that have a minimum market cap upwards of Rs.5000 crore, so that a Rs.50 cr investment in a company does not become a very large stake in the company. Here, the invesment of Rs.50 cr becomes a one percent stake in the investee company!

There are only around fifty companies that have a market capitalisation of over Rs.40,000 crores! So, if an FII were to want to put $ 10 million in a single stock, they would like to look at a company of at least a billion dollars in market capitalisation.  So, as investment vehicles become bigger and bigger, there is a compulsion to invest in the biggest companies and most large mutual funds start looking like each other. And they cannot ignore any stock in the index, for fear of not conforming to the herd.

Due to this lack of depth and breadth in the market, a highly focused quality portfolio of five to ten companies can do better than the NIFTY or Sensex. 

However, not all of us can spend time. Apart from this, there is another big handicap when we want to invest in direct equities. For example, if we were to pick a high quality portfolio of ten stocks, we may need a minimum monthly investment of around Rs.50,000 and upwards as a SIP commitment for ten years. Not all can afford this. So, the choice of direct equities through an SIP route, is closed if we cannot write this size of a cheque every month. And we need to have five to ten stocks rather than pick just one or two stocks. A minimum diversification is needed to insulate the shock of a single company investment going under for unforseen reasons or through a structured fraud.

A mutual fund route is good for those whose investment sizes are small to moderate.  Choosing a mutual fund thus becomes more important, though everyone says they have the same benchmark, they seem to invest in similar or same stocks.

A five year return (as of 20th June 2015) on an annualised basis is given below:

1.     MFs that invest in Large Caps- Best return was 15% and the worst was 7.5%;
2.     MFs that invest in Multi Caps- Best was 20% and worst was 9%;
3.     Banking sector funds- The best was 17% and the worst was MINUS 1%.
4.     The NIFTY/Sensex return was around 9%.
5.     The Liquid Funds returned around 8.5% !

This clearly shows that there is a huge disparity in performance between professional money managers who are paid to manage money on a full time basis.  You could trust any one of them, but the returns are not going to be predictable at all. The disparity is surprising given that all of them have expertise in investment management and have equal access to information and research. We do get a lot of statistical tabulations on mutual fund performance and there is no assurance that if someone topped the charts in the past, he will do it in future. There is unpredicability of performance going forward, irrespective of what measures we use.  So, it becomes important to diversify amongts mutual funds, in order to hedge ourselves agains weaknesses of the investment managers. Portfolio diversion does not happen since most mutual funds look like each other in terms of top holdings etc.

Thus, mutual fund investment through SIP routes do not guarantee us market returns. Going by available data, there is a fifty percent chance that the fund we choose may do worse than the market. In such a case, if we want to be sure about being as close to the market returns, the best option is to choose an Exchange Traded Fund (ETF) on the Sensex or NIFTY.

To sum up, if you are not confident about picking stocks, it is best that you stick to the mutual fund route. And if market returns are what we are looking at, it is better to stick to an ETF.  I am not a big fan of sector funds and there is a lot of timing involved in picking those up. Maybe an FMCG sector fund or a MNC sector fund will always do well, but there are no guarantees.

 (This piece appeared in today's Deccan Chronicle)

The Greek Tragedy and the Nikkei ...

The Greek Tragedy unfolding is desperation gone berserk. Keeping the banks closed for a few days to deny the truth. Reminds me of the old days when the Nikkei used to start tanking after it touched a peak of near 40,000 (It is now at near 20,000!, after never having been near thirty or forty).
In those days, the Nikkei 30 Index computation was supposed to be hilarious. At the start of the day, the exchange officials would write down prices of the 30 stocks. The first trade in the stocks had to be at or above that price. And as prices were falling like nine-pins, the exchange authorities resorted to desperate measures.
Each day, they would write an artificially high price. As no trades would happen at that level, the stock/s would remain untraded through the day. The same price would be treated as the closing price for the day and index computed on that number. So, a false sense of the market was created. Finally....
So Greece is now trying that during the shut days of the bank, all will be forgiven and the world will come to a solution on terms suitable to Greece. And banks will reopen as if nothing had happened. Well, even Rip Van Winkle would have winked.

Sunday, June 7, 2015

Compounding of Money, Rule of 72 and some basics that time forgot

(This piece appears in Deccan Chronicle)

Investing should not get complicated. You either love it or hate it.  Some of us like to spend time understanding stocks. Most of us do not want to know about its existence, but the noise bothers. We all think that either the stock market is one big scam designed to cheat us out of our savings or it is a casino where money doubles faster than we can fold a currency note.

We all need to ‘reformat’ our thinking when it comes to investing. Money is an important part of our existence ( hopefully not the sole purpose ). It is an aid to living and not an end in itself.

Let us understand that big wealth has been created mostly by owning businessess that do well. Very few people have created big wealth from stock markets alone. The fact that we find it dificult to recall more than a handful of names that made it big from investing, tells us all.

Stocks are perhaps the fastest way to growing wealth, IF risk is managed well and you have the right attitude. A bank account may give us, say nine percent annualised return. Stocks may give us around fourteen percent (a random number- assuming six percent inflation and eight percent GDP growth).  You may think that all I am losing is a five percent return for something unknown.

Unfortunately, due to our schooling system, innumeracy is rather high,.  Let me put across a table to you that shows the impact of Compound Interest:

(Value of Rs.1000  at different rates / diff periods)
 5 years
 10 years
 20 years
 30 years

The first row is the rate of return at which a sum of ONE THOUSAND is ‘compounded’.  The next rows are the maturity amounts at the end of different time periods.  Thus, 1338 is the sum at the end of 5 years, at 6% Compounded. It is 5.743 at the end of 30 years,  Similarly, if we can get 12%, the amounts at the end of 5 years is Rs.1,762 or Rs.29,960 at the end of 30 years.  The difference between 6 and 12 is just 6 or it is double the rate. However, Compounding it, at the end of thirty years, 12% is 29,960 and 6% is 5,743.  Over five times!

It shows us the importance of fighting for that one or two percent return, on a longer time period.

This table also gives us another very important lesson. For example, if I were to start investing and get returns from, say age 40, at the end of 20 years, when I am 60, 1000/- would have become 6,727. If I had started just five years earlier, at age 60, I would have had  17,749!  Nearly three times. This is why everyone tells us to ‘start young’. Probably it is repeated so often, we think it is a cliched phrase and ignore it.  

You will become easy with it, once you understand something as simple as a ‘rule of 72”.  For example, you want to know how long it will take for your money to double, at , say 8%.  Simply divide 72 by 8 and the answer, 9, is the number of years it will take. Similarly, if someone promises to double your money in six years, just divide  72 by 6. The resulting number, 12, is the annual rate of interest on your money.  This is a very close approximation and not mathematically precise.  So do not let anyone fool you. Now you can easily work out the consequences of starting late in life, when it comes to savings.

Once you understand your compounding tables, you can decide when you want to save, how much etc. Of course, the table will not tell you about the risks  In fact, use the power of compounding to retire early by saving more in the earliest periods of your earning life. .

The purpose of introducing the above table was to demonstrate what it means to invest in stocks rather than keep money in the bank. I think it is feasible to look at a return of 12 to 14 percent compounded return from stocks, over the very long term. This is a conservative number. And you do not even have to choose which stock or which mutual fund. Buying the index, through a proxy, like the Nifty or Sensex ETF should be good. This will save you from the risk of having to choose a mutual fund scheme that may underperform the index.

Of stock market bubbles etc

(From "The

History repeats frequently when it comes to financial euphoria. If the seemingly obvious lessons from these episodes going back almost 400 years haven't been learned yet, chances are it isn't going to be any different the next time.

Galbraith explains why these bubbles recur so often with what he calls "financial memory" (or the lack thereof). Basically every 20 years the new players involved in the financial system, the so-called smart money**, become convinced "it's different this time" because of some new innovation, financial or otherwise (ie. The Joint Stock Corporation in the 1700's, holding companies in the 1920's, junk bonds in the 1980's, internet stocks in the late 90's, derivatives like CDO, CDS etc more recently). Here are some relevant excerpts from John Kenneth Galbraith's book, A Short History of Financial Euphoria:

"The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 19)

"All [financial] crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment." - John Kenneth Galbraith 
in A Short History of Financial Euphoria (Page 20)

"Let it be emphasized once more, and especially to anyone inclined to a personally rewarding skepticism in these matters: for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 87)

One of the common elements in these episodes is the use of debt to finance speculation.

Historically, the so-called financial innovations from these episodes of euphoria have just been leverage in a different guise.