On Selecting An Equity Fund Manager

I picked this from an online investment forum.  It’s a response given by someone to a question asking how can one identify fund managers who will generate “reasonably consistent alpha”.  I have lightly edited it for clarity.

I don't know if there is any surefire way to pick successful fund managers and I don’t claim to have such a process.  But I have the belief that I can identify good fund managers. Whether that belief is well-placed or misplaced- that's the big question.

I have been an equity fund investor for almost 28 years and over those years, there have been 18 individual fund managers with whom I have invested through both bull and bear markets. In terms of what I am aware of and remember of their ability to generate alpha, 15 have been good, 2 were just about okay, and one was a failure. Personally I find that rate of success to be frightening and I suspect that I have been very lucky. But despite deep introspection, I haven't been able to convince myself to change my belief. What will happen in the future is anybody's guess.

Obviously, when I started investing there was little or no process in the way I selected fund managers. It was only after 4-5 years of investing that anything resembling a process emerged and that evolved over the years. For the last 17 years, that process has remained roughly the same with no need to make any major changes. I don't know how good that process will be going forward or how useful it would be to someone else but since you have asked, I'm sharing it with you.

Firstly, I believe that the fund house is more important than fund manager and my rule is that the fund house where I put my money should meet my standards of fairness, honesty, predictability and customer friendliness and should be run by people who inspire confidence within me.

When it comes to fund managers, my first rule is that I will entrust money only to someone whom I have met or have seen and heard (in a meeting or on video). The second rule is that the person should have experience of a severe bear market, preferably with the same fund house that he or she is currently with. The third filter is that the fund manager should have a fair degree of humility.  I avoid fund managers who behave like sales people and I avoid fund managers who make confident predictions.

Beyond this, I apply a variation of Munger's four criteria to determine the competence of the fund manager: knowledge, patience, discipline and objectivity. Since I am not an expert, I can only look for indications of knowledge. Similarly, I may only be able to see clues of patience, discipline and objectivity.

Lastly, I go by my instinct. It does not substitute the above criteria but it has the power to veto the above criteria and reject a prospective fund manager.

Empower Yourself With MF Utility Online

This post is primarily for the benefit of two groups of mutual fund investors: a.those who presently do online transactions via fund house websites and b.those who would like to commence doing online transactions.  For those who may not know, MF Utility Online (MFU) is the industry-sponsored transaction website that enables investors to make mutual fund transactions across multiple fund houses.  I regard it as a powerful tool that empowers mutual fund investors.  In this post, I’ll attempt to make my case. 

Before I do so, a couple of things.  Firstly, it would be best to note that, at this point, MFU is a transaction website, and little more.  Over time, it may become a lot more, but for now, that’s all it is.  Secondly, it is one of many websites/ apps that are available to mutual fund investors to do online transactions.  I am not trying to suggest that MFU is necessarily better than the rest.  Each website/ app likely has its own reasons to be considered.  The purpose behind singling out MFU in this post is that I personally see it as a worthy example to illustrate the benefits of transacting via such websites/ apps.  That it is a AMFI-led initiative, and is free, makes it arguably the easiest acceptable choice for someone seeking out a transaction website/ app for the first time.  It is also a good benchmark against which any transaction website/ app should be measured.

These, then, are some reasons for one to choose MFU over/ in addition to individual fund house websites for doing transactions.

One-stop convenience
MFU offers the convenience of buying and selling units across schemes from 28 fund houses (at the time of writing).  You can transact across both regular and direct plans.  You can initiate SIPs, SWPs, and STPs.  For all folios created via MFU, if you need to make changes to your profile, MFU spares you the hassle of having to do so individually, with each fund house.  As for your pre-existing folios with the participating fund houses, these get automatically mapped to your account, enabling you to buy and sell units under those folios.

Efficiency-enhancing features
MFU enables you to execute multiple transactions, across different fund houses, at one go.  In addition, it offers other features that are not available on many fund house websites.  For instance, you can  schedule transactions to be executed on a specific future date, or to be executed regularly at a defined frequency.  You can also save a set of transactions for indefinite future use.  These can be conveniently executed whenever you want to, and as many times as you want to.

Diversification against website downtime
What if you want to log in to a fund house website but it doesn’t allow you to?  In case you find that hard to believe, I can assure you that it has been known to happen.  I have faced this a few times, across at least three different fund houses.  What made matters worse is that even though this was the fault of the respective fund houses, the error messages that popped up, unfairly blamed me for entering a wrong username or password.  As a result, I tried logging in repeatedly, before eventually giving up.  At times such as these, it helps to have access to an alternative transaction portal.  Speaking for myself, ever since I signed up for MFU, I have stopped transacting via fund house websites.

Many fund house websites are not user-friendly
Leave aside the aesthetics, most fund house websites violate basic navigation principles, making it difficult for users to find information.  On top of that, a number of them ruin the transaction experience through pointless clutter and needless, irritating pop-ups.  In contrast, MFU has a clean, user-friendly transaction interface.  It may not be perfect but I consider it to be better than that of almost all the fund house websites that I have seen. 

Steer clear of questionable processes
Recently, I met an investor who wanted to redeem some old mutual fund investments.  Before that, though, he had to first change the bank account into which the money would be transferred.  The reason was that this investment had been made several years ago, and the bank account linked to that had since been closed.  As per the process set forth by the fund house, any request for change in bank account required an investor to present a cancelled cheque of the earlier account, failing which a letter from the bank had to be provided.  The investor didn’t have any cheques of the earlier account, and he was no longer in the same city as the bank.  Instead, on the suggestion of someone, he signed up for online access via MFU by merely offering proof of his current bank account.  He then executed the redemption via MFU, thus bypassing the (shoddy?) process of that fund house.

To get started on MFU, you need to first get a Common Account Number (CAN).  You could click here to know how to go about getting it.  Once you get a CAN, you can apply for online access by sending them an email from your registered email address.  For more information, you could click here.

In case you’d like to explore other mutual fund transaction websites/ apps, I’ve put together a checklist of things to consider in making a choice.

The Complex Nature Of Risk

Here’s a question.  Which of these investment choices would you consider to be more risky: equity funds or debt funds? 

It may appear to be a no-brainer that equity funds are riskier than debt funds.  That’s because to many of us, risk in an investment is about losing some or all of the money that we invest, and there is a greater chance of that happening in an equity fund than in a debt fund.  We could draw a similar conclusion if we were to go by the so-called “riskometer” that every mutual fund scheme document carries, under which schemes are classified by the extent to which an investor’s principal is at risk.  Typically, debt funds are shown as having low to moderate risk whereas equity funds are shown as having moderately-high to high risk.  Yet the reality is that risk is too complex to be assessed in this way.  Having a thorough understanding of risk can help us make better investment decisions.  And while this is a subject that is large enough to fill a book (indeed, many books have been written on risk), in this post, I’ve made an attempt to briefly present some key points.

Risk is best seen in context
To go back to the question at the start, my answer to it would be: “It depends.”  If our investment tenure is, say, a year, then the chances of losing money on an equity fund are much, much higher than the chances of losing money on a debt fund.  However, if our investment tenure is ten years, going by past data, the chances of losing money on either an equity fund or a debt fund are pretty slim.  In fact, over a period of ten years, it is very likely that someone who invests only into equity funds will accumulate more money than someone who invests only in debt funds.

Risk isn’t always about losing money
Doubtless, the risk of losing money is a very real one, most notably in the short term.  In the long term, though, the dominant risks in investing are not being able to beat inflation, or not being able to adequately fund our long term goals.  What if, thanks to inflation, ten years from now, our investments are not worth what they are today?  What if we don’t have enough money at the time of retirement to enjoy a comfortable lifestyle?  By being focussed only on not losing money, there is the danger of being caught unaware by long term risks such as these.  And that’s not all.  There is another risk that we need to be wary of: that of not getting back our money back when we need it.  Among mutual fund investors, this can particularly impact those who invest in closed end schemes, and try to exit before the maturity of the scheme.

Risk comparisons are difficult to make
While debt funds carry a lesser short term risk of losing money compared to equity funds, they carry a much higher long term risk of underperforming the rate of inflation.  So can we really make a fair comparison between debt funds and equity funds, as to their overall riskiness, so to speak?  Fact is, we can’t.  The way out is to assess the extent to which each risk matters to us.  Based on that we can decide how much of each investment option we should have. 

Our strategy can increase or decrease risk
Consider, for a moment, the risks in driving  a car.  To some extent, these are linked to the way that the car is built (how strong or weak is its body, what safety features it has or lacks etc.).  However, a lot would depend on how we drive the car.  For instance, driving the car rashly, without wearing a seat belt, increases the risks involved.  The same applies to investing.  To take an example, the risks in investing in equity funds are greatly magnified if we invest for short term gains, and without a care for market valuations.  On the other hand, investing for the long term, and by staggering our investments (instead of investing at one go) reduces the risks involved. 

Risk management begins with knowledge
If you think about it, risks are but obstacles in the path of getting optimal returns.  We cannot avoid them, but we can overcome them.  To do so, we first need to know their nature.  While the earlier points offer clues to the broad nature of risk, one way to understand the finer aspects is by looking at past performance data.  By that I mean looking at how various investment options have performed, and how various strategies have performed, in an attempt to find the answer to the question: realistically speaking, what’s the worst that can happen?  In this context, there is a quote attributed to former investment manager, Edmond Warner OBE, that is worth mentioning: “History never repeats itself exactly, but you owe it to yourself to be acquainted with the bear markets of yesteryear. At least if history does then repeat itself you can't say that you weren't warned.”

The Truth About Compounding

If you’ve ever flipped through mutual fund literature on SIPs, the chances are that you would have come across references to “the power of compounding” as one of the benefits of investing in SIPs.  If you’ve ever had the experience of listening to mutual fund salespeople and/or financial advisors talk about the virtues of SIPs, you would have likely heard them use this catchphrase as well.  For added impact, some of them may have quoted Albert Einstein as having called compound interest the “eighth wonder of the world”.

Fact is, there is no record of Einstein ever having praised compound interest (see here and here).  Nonetheless, compounding is, without a doubt, a powerful force that one should take advantage of.  But to do so, one has to have a clear, conceptual understanding.  For instance, one should know that contrary to what many fund houses and advisors say, doing a SIP, in itself, does not assure us benefits from “the power of compounding”.  This post is for those of us who would like to get to the truth about compounding.

Compound interest is the interest that you earn, not just on the amount that you invest, but also on that interest.  As an example, consider a bank deposit (or any other fixed income instrument) in which the interest is automatically reinvested and paid on maturity.   In such a deposit, on maturity, along with your principal, you get interest on your principal, as well as interest on the interest that is reinvested.  It is this interest on interest that is the additional benefit of compounding.  The question: is this really worth such a fuss? 

Depending on the rate of interest and the tenure of the deposit, the interest on interest can make up a significant part of the overall interest.  In fact, it may well make up the majority share of the overall interest that you receive on maturity.  Here are some numbers that illustrate this.

The table below shows the share of interest on interest of the overall interest from a hypothetical recurring deposit in which one makes a fixed annual payment and receive an annual interest of 8% pa that is reinvested.

Rate: 8% pa	Share of Overall Interest
Tenure of Deposit	Interest on Principal	Interest on Interest
5 years	90%	10%
10 years	78%	22%
15 years	67%	33%
20 years	57%	43%
30 years	40%	60%

This table below shows the share of interest on interest of the overall interest from a hypothetical recurring deposit in which one makes a fixed annual payment and receive an annual interest of 12% pa that is reinvested.

Rate: 12% pa	Share of Overall Interest
Tenure of Deposit	Interest on Principal	Interest on Interest
5 years	85%	15%
10 years	68%	32%
15 years	54%	46%
20 years	42%	58%
30 years	23%	77%

In the real world, it may be unlikely to get a quality deposit that pays 12% pa, or even one that has a tenure 20 or 30 years.  So do these numbers have any practical relevance?  And what about mutual funds? Since they don’t pay fixed interest, are these numbers of any use to mutual fund investors?

The concept of compounding is not just restricted to interest.  It also applies to dividends, and even gains.  And if you substitute the tenure of deposit with the number of years of investing that you have left (until retirement), and the rate of interest with the rate of return that you expect to earn on your overall portfolio, a clearer picture of the real-life implications will emerge.  So let’s say that you have 30 years of investing left and you expect to earn 8% pa on your investments.  That would mean that roughly 60% of your potential gains will be on account of compounding.  And if you earn 12% pa on your investments, then, roughly speaking, compounding will account for a whopping 77% of your gains!  Now, that is what the power of compounding is all about.

Bear in mind, these calculations are approximations to facilitate understanding.  More importantly, these hold good only if you reinvest your interest/ dividends/ gains.  If you choose to take dividends and spend that money then you will lose out on the gains on account of compounding.  In effect, this means that to tap into the power of compounding, we should avoid the temptation to encash dividends/ gains and spend that money.  This would apply to all investors, regardless of whether they do a SIP or a one-off investment. 

I must also point out that just as gains are compounded, so are losses.  In other words, for all its power, compounding is not a cure for poor investment choices. 

Beware of “Consistent Performance”

We frequently hear fund houses, advisors, even the media talk about certain mutual fund schemes as having given “consistent returns” or having shown “consistent performance”.   In its rankings of schemes, CRISIL has a category called “Consistent Performers”.  But what exactly does being “consistent” mean?  Can scheme returns or performance really be described as “consistent”?

I have come to believe that most people who use the word “consistent” in the context of a mutual fund scheme’s returns or performance, actually misuse the word.  What makes matters worse is that this is a word that is easy to misunderstand.  Thus, through a combination of misuse and misunderstanding, many of those who promote schemes with such a claim are able to convey an impression of good performance even when none exists. 

Till some years ago, I used to ascribe most such claims to ignorance.  But the dubious and widespread nature of these claims has now made me suspicious of any scheme whose returns or performance is dubbed as “consistent”.  An industry insider whom I know, is fond of saying that “it is the best word to use when you don’t have good performance to show.”  In this post, I make the case to be wary of any claims of “consistent” performance or returns, and to not accept such claims at face value.

For returns or performance to be called “consistent” these have to be, to quote the Merriam-Webster’s dictionary, “marked by harmony, regularity, or steady continuity :  free from variation or contradiction” (emphasis mine).  Thus, to make a claim of “consistent returns,” the returns should be identical, day after day or month after month or year after year etc.  Is there any mutual fund scheme that can make such a claim?

Performance is different from returns, and the term “consistent performance” gives a lot more latitude.  But even so, in itself, it is a vague description.  For one, it needs to be clarified as to how performance is measured (e.g. returns relative to a benchmark index, quartile ranking etc.)  For another, it needs to be clarified as to how consistency is measured (e.g. it could be day after day, or month after month, or year after year etc.)  The total period over which consistency is measured also needs to be clarified i.e. over how many days/ months/ years. Simply describing a scheme as being a “consistent performer,” therefore, is misleading.

But if all of this is sounding too theoretical, let me offer you a couple of real-life instances of misleading communication that I recently observed.

The first instance relates to one of the largest fund houses by AUM.  In a recent marketing communication, they implied that one of their debt schemes had given better returns than any PSU bank deposit over any 3 year period over the scheme’s 14 year existence.  They highlighted it as “consistent outperformance”.  Prima facie it met the requirement of being adequately clarified, and free from contradiction.  But there was one other problem: the claim appeared too good to be true.

Not surprisingly, when I looked closely, I realized that the data they were using to make the claim, represented just 6 years of the 14 years that the scheme had been in existence.  And when this was subtly pointed out to them, they opted to unabashedly continue with the assertion but without mentioning that the scheme had been around for 14 years.

The second instance relates to an exchange that I had earlier this week with a certain mutual fund salesperson.  He was trying to convince me of the merits of investing in one of the equity funds managed by his fund house.  As readers of this blog would know, I select schemes based on qualitative factors rather than performance.  Regardless, this gentleman was keen to draw my attention to the actual returns of the scheme.  The thrust of his pitch was that if I looked closely enough, I would see that this scheme had delivered “consistent performance” over the years.  As I mentioned earlier, any such claim sets alarm bells ringing for me.  And when someone emphatically pushes such a claim in my direction, as this person was attempting to do, I tend to react strongly.  Luckily for this person, I was in a good mood that day.

So when he made his remarks about “consistent performance,” I responded by saying, “Forgive my ignorance but how do you measure performance?”

He replied, “It has consistently beaten its benchmark index.”

“So you’re saying that it has beaten the index year after year, right?”

“Over the last 1 year, 3 years and 5 years.” 

Any claim of consistency based on trailing returns can be safely assumed to be a deception.  On any other day, I would have halted this person in his tracks and compelled him to consider that either he didn’t know the definition of “consistent” or else he was lying.  For good measure, I might have even pulled out a dictionary and read out the definition aloud.  But that day, as I said earlier, I was in a good mood.  I took a few minutes to check something on my laptop, before replying. 

“Well, it seems that this scheme gave less returns than the index in 4 of the last 7 calendar years.”

He appeared adamant.  “But it has beaten the benchmark over the last 1 year, 3 years and 5 years.”

“So it has.  But that’s because of end-point bias,” I said politely. 

He did not seem to be aware of that term.  Worse, he chose to hide his ignorance by holding his ground.

“That may be, but the performance is still consistent.”

This is where I lost it.

“If it has given better returns than that index in only 3 of the last 7 calendar years, then how the f**k can you call it ‘consistent’?”

The forcefulness of my response put him on the defensive, and he chose to retreat.

“I’ll need to check and get back to you.”

I don’t expect to hear from him anytime soon.

How important is a fund’s return?

There are some who may dismiss this as a pointless question with an obvious answer.  But if you are willing to read this with an open mind, it might just be worth your while.  Some of the thoughts presented here have been shared in the past, across different posts.  In this post, I’m attempting to connect these together to suggest an answer to the question in the title.

Do past returns really matter?

Most of us, when deciding on a scheme to invest into, look at its past returns.  Whether we admit it or not, most of us believe that a scheme’s past returns (relative to its peers) are a reliable indicator of its future relative returns. In other words, we believe that if Fund A has given a better return than Fund B in the past, it is likely to give a better return in the future as well.

Frankly, I have not seen any data that would compellingly support such a view.  On the contrary, based on the data that I have examined, I question such a belief.  As evidence, I’ve given below some observations from a study that I recently updated.  In this, I looked at the relative returns of domestic, diversified equity schemes over four market phases, listed below.

• 8 January, 2008 to 9 March, 2009 (Falling)
• 9 March, 2009 to 5 November, 2010 (Rising)
• 5 November, 2010 to 20 December, 2011 (Falling)

• 20 December, 2011 to 29 January, 2015 (Rising)

The study covered 141 schemes that had been around across all these four phases.  Based on their return in each phase, I grouped these schemes into quartiles.  These are a few of my findings:

• 33 of the 35 schemes in the top quartile in 2008-09 were not in the top quartile in 2009-10.  Of these, 26 dropped to the third or fourth quartile.
• 29 of the 35 schemes in the top quartile in 2009-10 were not in the top quartile in 2010-11.  Of these, 19 dropped to the third or fourth quartile.
• 30 of the 35 schemes in the top quartile in 2010-11 were not in the top quartile in 2011-15.  Of these, 19 dropped to the third or fourth quartile.
• Not a single scheme managed to be in the top quartile across all four phases.  Only 7 schemes consistently ended up in one of the top two quartiles in each of the four phases.

To me, what emerges from this is that the past ranking of a scheme is not a reliable indicator of what its future ranking will be.  In case you’d like to take a look at the data supporting these findings, please send me an email. 

Do future returns matter?

Once we invest in a scheme, it should be correct to believe that the scheme’s returns will impact our returns, right?  Well, yes and no.  If we make a single investment, then yes.  If we make multiple investments, then maybe not.  Let me illustrate.

Let’s say that 10 years ago, someone decided to start SIPs of an equal amount in the growth options of these schemes:

• Reliance Regular Savings Fund-Equity Option (RRSF)
• SBI Magnum Midcap Fund (SBIMMF)

Over these 10 years, RRSF ended up giving a higher return than SBIMMF.  However, the investor would made more money in SBIMMF than in RRSF.  The table below shows the difference.

Period: 1 May 2006 to 30 Apr 2016	Scheme Return (p.a.)	Investor Return (p.a.)
RRSF	13.8%	13.4%
SBIMMF	11.3%	18.0%

Scheme returns and investor returns have been calculated using the tools at Advisorkhoj and assume a monthly SIP on the first business day of each month.  Loads are not considered. 

Let me try and give these numbers a bit more context.  The growth in the NAV of RRSF over this period was 36% more than the growth in the NAV of SBIMMF.  Yet, the gain to the investor from investing in SBIMMF was 57% more than the gain from investing in RRSF.  I look at this as proof that investing in a scheme that gives better returns, in no way, guarantees that we will get better returns.  Indeed, the returns to us can be far less than what we may imagine.

The role of returns in building wealth

I remember a thought shared by a stock broker in my early days in the business.  I paraphrase: “You may earn a 100% in a year but if all you invested is Rs.100, all you will have at the end of the year is Rs.200.  By no stretch of imagination will you be wealthy just by seeking high returns.”

I have regarded that as a useful comment on how wealth is built.  To refine it a bit, the wealth that we build is most influenced by the amount that we save and invest, and the timeliness of our investments (i.e. our ability to invest regularly, without delay).  We can, and must supplement these with good investment choices.  However, we need to realize that there are practical limits to the rate of return that we can earn from our investments on a sustained basis.  And if the points made earlier are anything to go by, we have limited control over the return that we will end up getting.

Putting all of this together, I would like to suggest that a scheme’s returns are not as consequential as most of us might believe.  But I’ll let you be the final judge of that.  And along with what I have, so far, shared in this post, I’d like to offer you a parting thought that puts a whole different spin on the question in the title.

Most good things in life come at a price.  Generally speaking, the more important something is to us, the higher is the price that we are willing to pay.  Conversely, the higher the price that we are willing to pay for something, the more important it can be considered to be to us.  Thus, the importance of a scheme’s returns to us can well be judged by the price we would be willing to pay or, more accurately, the compromises that we are willing (or not willing) to make.  Let me explain with a personal example.

I have taken a stance to not invest my money with HDFC mutual fund.  To be clear, I have great respect for their Chief Investment Officer as an equity fund manager.  I have no reason to doubt his ability to generate better returns than most of his peers.  On the flip side, I have regarded their disclosures around expense ratios as inconsistent and opaque.  Nonetheless, a few years ago, I went ahead and invested a small portion of my portfolio with them.  I was clear that I was making a compromise.  But then, a series of service issues started popping up which left an extremely bitter taste in my mouth.  To put it bluntly, I felt like I was being yanked around.  After a bit of deliberation, I came to the conclusion that this fund house did not deserve my business, and pulled out my investments.  In other words, this time around, I refused to compromise.

Yes, I am a small investor, and my stance may not affect them.  Some of my well-wishers have argued that I have had more to lose than them by depriving myself of good returns.  Fact is, that doesn’t bother me.  For my part, I am clear on where I draw the line on making a compromise, and my actions reflect that.  And that’s really the question we have to ask ourselves.  Would you be willing to chase the promise of ‘good returns’ at any cost?  Or would you want to draw the line somewhere?  And, if so, where would you draw it?

From High to Low

As readers of this blog may be aware, I am a sucker for statistics.  I frequently go digging into historical data.  But it isn’t something that I do for entertainment.  Every now and then, looking into data, I find something that sharpens or enhances my understanding of the nature of risk.  It is with the intention of sharing some of that, that I present below the results of my latest effort, which looks at the returns of some equity schemes over a 16 year period.  In such studies, it is often the case that some schemes end up with far more impressive returns than others- that is but to be expected.  While there may be a case to raise eyebrows and ask questions, I wouldn’t suggest passing judgment on any scheme without further investigation.  As I have maintained in the past, there is more to performance than what returns may convey. As I have also previously mentioned, one should be careful about drawing any inferences from such observations other than on the merits of diversification. 

Almost a month ago, on Feb 11, the BSE Sensex hit a new low, relative to its last high.  It may well fall further but at the time of writing, that has not (yet) happened.  Its closing value on Feb 11, was over 22% below the last closing high on 29 Jan 2015.  As far as I can make out, this was the 11th time since its inception that the Sensex has fallen 20% or more from a previous high.  The first time this happened, it fell just over 20% before rebounding.  On the subsequent nine occasions, the fall to the bottom has ranged from 27% to 61%.  On five of these occasions, the fall was in excess of 40%.

Feb 11 also happened to be the anniversary of an earlier high.  In 2000, the Sensex peaked on this date.  The identical date brought back the memory of something that I had heard many years ago, from a certain advisor.  He had said something to the effect that the acid test of the long-term performance of an equity scheme was the return that it generated from a market peak to a market bottom.  In that light, I thought it might be interesting (even if premature) to check out the returns of equity schemes over these 16 years.  I am aware of the vagueness of the term, “long-term” and the mixed feelings that people have about its use.  But I doubt if anyone would question the validity of a period of 16 years being “long-term.”  Using data from Value Research, ICRA Online and Moneycontrol, I give below some of my observations.  Do note that the scheme returns do not consider loads.

• Currently, there appear to be 49 actively managed, diversified, domestic equity schemes that were in existence in Feb 2000. 
• The return on these schemes over these 16 years ranged from 18.7% pa to 5.2% pa.
• The CAGR of the BSE Sensex Total Return Index (TRI) over this period was 10.6% pa.
• The return on 14 of these schemes was less than the CAGR of the BSE Sensex TRI. At least 4 of these were once positioned as flagship schemes, so to say, of their respective fund houses. 
• Amongst schemes that are currently rated with 5-stars by Value Research, the lowest return was 9.7% pa.
• Amongst schemes that are currently rated with 1-star by Value Research, the highest return was 18.5% pa.
• The preceding 13 months (i.e. preceding Feb 11 2000) was a period of extraordinary returns for equity schemes.  One scheme, it appears, had delivered a higher absolute return over the preceding 13 months than it did over this entire 16 year period. Its absolute return over the preceding 13 months was 326% while over the entire 16 year period, it was 297%.
• At least 4 other schemes delivered an absolute return over the preceding 13 months that was over 50% of what they did over this entire 16 year period.
• At the time, there was only one index scheme, which continues to be in existence.  This scheme tracks the NSE-50.  As against a CAGR of 10.6% pa for the NSE-50 TRI, the return on this scheme was 8.3% pa.

Whose Word Can You Trust?

Recently I came across a video of a highly respected fund manager in which he offered personal finance advice to investors in general.  One of the things he spoke about was asset allocation.  On checking around, I gathered that a number of people had found what he had said to be worthwhile.  It wasn’t clear as to how widely the video had been watched online, but on one portal there were five times more ‘likes’ than ‘dislikes.’  Here’s the problem: the fund manager’s views on asset allocation were flawed and misleading.

There is a certain personal finance blog that is written by a gentleman who apparently has no professional experience as a financial advisor.  To be fair, he is better versed in matters of personal finance than an average investor.  But that’s probably the best that I can say of him.  I have read posts in which he has distorted facts, made false claims, and expressed views that are flawed and downright ridiculous.  Despite all of this, his is one of the most popular personal finance blogs in India and a number of readers appear to blindly trust anything that he has to say.

These are not isolated instances.  There are countless personal finance blogs written by people who have no grounding or experience in that subject.  And I frequently come across experts waxing eloquent beyond their ken.  Sadly, far too many of us are falling for the questionable advice being dished out by these individuals.

So how can we distinguish an expert from a non-expert?  How can we know when to trust an expert?

The plain truth is that there is no foolproof way.  If you think about it, only an expert can truly know if someone else is also an expert.  The rest of us have to make a presumption about an individual being an expert.  At best, we may have, what some call, a justified belief of a person’s expertise.  I give below some thoughts on how we might build such a belief.

Understand the area of expertise: Thanks to the business channels on television, for a number of us, there is an enduring image of an “investment expert”:  someone who can explain why the stock markets moved the way they did on a given day, predict how they are likely to perform in the next few days, and advise on the suitability of buying or selling a given stock.  This is a highly dubious stereotype.  For one, it is debatable as to whether short term forecasting can be an area of expertise.  For another, there is a lot more to investing than just analyzing stocks.  In fact, the landscape of investing is too vast for anyone to be an expert across all its aspects.  Fund managers and analysts, while competent in matters of researching securities and analyzing the macro environment, are hardly qualified to advise on matters of personal finance.  Financial planners and mutual fund advisors, while better placed to advise their clients on asset allocation and selection of mutual fund schemes, are rarely equipped to analyze stocks.  Knowing an expert’s area of expertise helps in noticing when he/she strays from it.

Look for indicators of expertise: To some extent, one’s academic credentials and certifications can be an indicator of his/ her expertise.  Personally, I regard professional experience and testimonials from known or proven experts as better indicators.  But more than that, I look for clues in what a person is saying.  Are there any factual inaccuracies?  Is there a clear logic in what is being said?  Are all points consistent with each other? 

Watch out for conflict of interest: Good intentions are by no means a substitute for expertise but questionable motives can dent the credibility of an expert.  A number of fund houses are known to insert subtle (and not-so-subtle) promotional messages in their so-called investor education programs.  And there are a number of bloggers who focus more on their ad revenues and search engine rankings rather than the quality of their content.

Listen to your instincts: Each one of us has an in-built warning system.  Mine makes me uncomfortable with individuals who trumpet their credentials.  I am also wary of those who make assertions without sufficient evidence.  And I tread particularly cautiously when such assertions are made with a high degree of confidence.

Ask Questions:  If still in doubt, do ask questions.  For more on this, check out this post.

In case you’d like to dig deeper, check out this piece that summarizes and expands upon some of the best research on the subject of assessing expertise and trusting experts.

Where Mutual Funds Add Value

This is not a post based on my thoughts.  It reflects those of Colaco & Aranha, a Mangalore-based financial advisory firm.  It is a firm that I greatly admire and respect.  For quite some time now, I have considered giving readers of this blog a slice of their wisdom: something that I have personally benefitted from.  As the firm completed 30 years in business this week, it struck me as a good opportunity to do so.

In particular, I would like to share a video of a presentation by Mr. Gerard Colaco, partner at the firm, about the areas where he sees mutual funds adding value.  But before stepping into the video, it may help to have a quick look at some of the firm’s beliefs (a few of which come up in the presentation as well):

• Never expect an investment adviser to take a greater interest in your money then you yourself have a duty to take.
• The ideal client-adviser relationship is one of partnership, not dependency. An investment adviser must make investor education an essential part of his practice. The better informed, interested and participative the client, the better will the expertise of the adviser be exploited.
• All investment must form part of a plan. It is never too late to plan. Having a plan without the money to invest is better than having money to invest without a plan.
• Investment principles are universal but investment plans are unique, because each individual is unique with unique circumstances, needs and temperament.
• Financial responsibility is far more important than financial literacy, just as common sense is far more important than cleverness.

This, then, is the link to the presentation.  It has a running time of about 2 hours.  This presentation was made a few years ago.  Since then, there have been regulatory changes, and changes in tax laws, but most of what is said continues to remain very relevant.  This video is courtesy of Simplus Financial Consultancy Private Limited, an associate of Colaco & Aranha.

Fund Volatility and SIP Returns

A few readers of my previous post have said that I was wrong in suggesting that all funds are equally suitable for a SIP.  According to them, if an investor who is proposing to start a SIP, had to choose between two funds, he/she would be better off choosing the fund that is likely to be more volatile (i.e. the fund that is likely to see greater fluctuations in its NAV). 

This is not the first time that I have heard this argument.  Over the years, I have heard many advisors voice a similar view.  Unfortunately, this is a flawed perspective that is, paradoxically, the result of intelligent thinking.  In this post, I propose to clear the air on this.  But since this may not be easy to explain or even follow, let me first cut to the chase, and state my position:

a.       There is no conclusive or compelling evidence that supports this argument.

b.      Pursuing such a strategy can potentially have disastrous consequences if one is forced to redeem one’s investment in a bear phase.

If you’d like some elaboration on this, do read on.

Let me start by questioning the mathematical validity of the volatility argument, if I may call it that.  Imagine, if you can, two equity funds that, over a certain period, start with an identical NAV, and end with an identical NAV.  Let’s further assume that, over this period, these funds have an identical average NAV.  This may be a hypothetical scenario but it is one that immensely favors the volatility argument.  If the argument truly has merit, then in such a scenario, an investor opting for a SIP in both funds, should always gain more in the more volatile of the two funds.  Yet the fact is that even in such a favorable scenario, there is no certainty that that will happen.

For those who prefer empirical evidence, I’d like to present some data on three of the oldest equity schemes in the country.  The table below gives the data for the period from April 2012 through March 2015.  All the data has been taken from the fund factsheets.

Apr 2012 - Mar 2015	Fund A	Fund B	Fund C
Standard Deviation*	14.2	16.5	15.8
Fund Return (p.a.)	18.6%	17.1%	34.9%
SIP Return (p.a.)	24.9%	25.2%	35.2%

*Standard Deviation (SD) is a measure of volatility. The higher the SD, the more volatile a fund.

Over this period, Fund B was more volatile than Fund A, and despite its lower return, an investor opting for a SIP would have gained more in this fund than in Fund A.  One may say that this data supports the volatility argument.  However, when we compare Fund B with Fund C, the picture appears to be somewhat different.  Fund B was also more volatile than Fund C but an investor opting for a SIP would have gained less in this fund than in Fund C.  One may think that this was because of the much higher return of Fund C over the period.  But before drawing any conclusions, let’s look at the data for the preceding 3 year period.

Apr 2009 - Mar 2012	Fund A	Fund B	Fund C
Standard Deviation	22.5	27.9	28.3
Fund Return (p.a.)	27.9%	26.7%	34.6%
SIP Return (p.a.)	8.8%	4.5%	9.3%

 

This period was marked by a significantly higher level of volatility across all funds.  Yet when you look at Funds A & B, despite a much higher return over this period (compared to Apr 2012 – Mar 2015), an investor who opted for a SIP in these funds over this period would have gained much less than a similar investor in these funds over the subsequent 3 year period.  Fund C had almost the same return across both periods but here, too, an investor who opted for a SIP over this period would have gained much less than a similar investor in this fund over the subsequent 3 year period.  Clearly, the volatility argument does not hold good.

You may also note that during this period, Fund C was more volatile than Fund B.  However, in the subsequent period, Fund B was more volatile than Fund C.  Thus, even if volatility were to matter, to whatever extent, historical volatility of a fund (absolute or relative) can be no indicator of future volatility.  Just to be clear, the investment objectives of these funds did not change over these years.  In fact, these are among the most consistently well-managed funds in the industry.

Let me now flip back another three years to a period that highlights some of the risks of investing in highly volatile funds.

Apr 2006 - Mar 2009	Fund A	Fund B	Fund C
Standard Deviation	28.4	31.5	33.2
Fund Return (% p.a.)	-3.1%	-2.7%	-17.5%
SIP Return (% p.a.)	-13.9%	-13.7%	-30.2%

To put these numbers into context, the value of a SIP over this period in Fund A or Fund B would have been almost 20% below the amount invested, by the end of the period.  The value of a similar SIP in Fund C would have been almost 40% below the amount invested.  So much for the volatility argument.

SIP Returns

A number of investment portals offer tools that enable one to calculate the so-called ‘SIP returns’ of mutual fund schemes.  Most fund houses also offer similar calculators for their schemes.  Some offer these calculations in their monthly fact sheets.  But does looking at the SIP return of a fund serve any purpose?  In this post, I will attempt to show that SIP returns are of little use, and that one is better off not using these returns to draw any conclusions.  To keep things simple, I will restrict my thoughts to SIP returns of equity funds.

The SIP return of a fund is not a representation of its performance. It only tells us the return that an investor would have got if he/she had opted for an SIP in that fund, over a particular period.  The SIP return from investing in a fund can be, and indeed often is, very different from the fund’s actual return over the same period.  As an illustration of this, I have given below some data of two of the oldest diversified equity funds in India. (PS: All the SIP calculations in this post assume equal monthly investments made on the first business day of each month from the starting month till the penultimate month.  Loads are not considered in any of the calculations.)

	Fund A	Fund B
NAV- 01 July 2004	70.67	47.73
NAV- 02 July 2007	228.91	142.70
Absolute Fund Return	223.9%	199.0%
Absolute SIP Return	65.4%	75.9%
Fund Return (p.a.)	47.9%	44.0%
SIP Return (p.a.)	35.5%	40.3%

Over the 3 year period mentioned above, investors in both funds who opted for a SIP saw a lesser return than those who put a similar amount at one go, at the start.  You may also notice that while Fund A gave a higher return than Fund B, investors who opted for a SIP in that fund saw a lesser return than those who opted for a SIP in Fund B.

If we now look at the 3 year period that immediately followed, a pretty different picture emerges.

	Fund A	Fund B
NAV- 02 July 2007	228.91	142.70
NAV- 01 July 2010	263.45	195.03
Absolute Fund Return	15.1%	36.7%
Absolute SIP Return	41.7%	35.1%
Fund Return (p.a.)	4.8%	11.0%
SIP Return (p.a.)	24.0%	20.6%

Investors in Fund A who opted for a SIP over this period, saw a better return than those who put a similar amount at one go, at the start.  Investors who opted for a SIP in Fund B saw a lesser return, in absolute terms, than those who made a lump sum investment, at the start.  However, if you consider the time value of money, as reflected in the annualized returns, the SIP investors benefitted more.  In contrast to the previous 3 years, over this period, Fund B gave a higher return than Fund A, but investors who opted for a SIP in that fund saw a lesser return than those who opted for a SIP in Fund A. 

In the examples above, both the fund returns and the SIP returns were positive.  Yet, it is possible for one or both of these to be negative.  The data below, of another diversified equity fund, illustrates the possibility of a fund’s return being negative, and SIP return being positive.

NAV- 01 Jan 2008	40.71
NAV- 01 Jan 2013	33.49
Absolute Fund Return	-17.7%
Absolute SIP Return	24.9%
Fund Return (p.a.)	-3.8%
SIP Return (p.a.)	8.8%

There is also the possibility of a fund’s return being positive, and SIP return being negative, as the data below, of yet another diversified equity fund, shows.

NAV- 01 Dec 2003	29.86
NAV- 02 Mar 2009	51.98
Absolute Fund Return	74.1%
Absolute SIP Return	-2.3%
Fund Return (p.a.)	11.1%
SIP Return (p.a.)	-0.9%

So, what explains these numbers?

While a fund’s return does influence the SIP return, the extent of that influence depends on the pattern of NAV movements over the period.  Odd as it may sound, some patterns cause the SIP return to exceed the fund’s return, while others bring down the SIP return to below the fund’s return.  But knowing the effect that a particular pattern has, doesn’t really help because neither can a fund manager control the pattern of NAV movements for a fund, nor is it possible to predict the future pattern for any fund.

In this backdrop, consider this: even if we believe that a more competent fund manager is likely to generate better fund returns than a less competent one, the pattern of NAV movements may make it possible for a SIP in a poorly performing fund to give a better return than a SIP in a well performing fund.  The only thing resembling any kind of certainty is that the longer we carry on a SIP, the more likely it is for the SIP return to mirror the fund’s return. 

Yet, every now and then I come across supposed advisors who wax eloquent about how some funds are “more suitable for a SIP.” At the start of each year, and occasionally in-between, I also see recommendations pop up for “the best funds for SIPs.”  To anyone who understands the maths of SIP returns, these are flawed notions which consciously or not, capitalize on the misconceptions of investors.  But all of these pale in comparison to a remark that was brought to my attention, that The Economic Times attributed to the CEO of a fund house: “our CIO-equity runs… …the number 1 fund in the country in 10-year SIP (systematic investment plan) returns.”  The statement may be factually correct, but to me, the mention of SIP returns in that sentence is nothing short of deception.

As I see it, SIP returns serve little purpose and are best ignored.