Seven Years On

Call it the Seven Year Itch, if you like.  I was curious to see how equity schemes and hybrid schemes had performed since the peak of the 2007-08 bull run, seven years ago.  In this post, I present some observations that I found interesting.  Just to be clear: I’m not intending to pass judgment on any fund.  My intention is to offer food for thought around investing in equity schemes and hybrid schemes.  As I have stressed in earlier posts, there are compelling reasons to invest into some of these schemes but at the same time, it’s important to be aware of the risks.

Here, then, are my observations.  The scheme data has been taken from Value Research and does not consider loads.

• A hypothetical investment in the NSE-50 Total Return Index on 8 Jan 2008 would have grown over these 7 years by 4.87% p.a.  In contrast, a cumulative, 7 year deposit with State Bank of India would have given a return of 8.77% p.a., before taxes.
• There are, in all, 224 actively managed equity schemes today, that were in existence at that point as well. 
• The returns across these 224 schemes have ranged from 23% p.a. to –10% p.a. 
• 162 of these (i.e. 72%) have shown a lesser return than that of the bank deposit (before considering taxes). 
• 80 of these (i.e. 36%) have shown a lesser return than that of the NSE-50. 
• 8 of the top 10 schemes, and 9 of the bottom 10 schemes are sectoral/ thematic schemes. 
• Amongst domestic, diversified equity funds, the returns have ranged from 16% p.a. to –4% p.a.
• Despite the upsurge in the markets in the last 1 year, 22 schemes have shown negative returns over the 7 year period.  In fact, 19 of these 22 schemes gave returns in excess of 40% in the last 1 year.
• 17 of these 224 schemes are currently rated as 5 star funds by Value Research.  The returns across these schemes have ranged from 15% p.a. to 3% p.a. 
• There are 25 ‘balanced’ schemes today (Value Research category: hybrid-equity), that were in existence seven years ago. 
  • The returns across these schemes have ranged from 14% to –7% p.a.
  • 14 of these schemes (i.e. 56%) have given a lesser return than that of the bank deposit (before considering taxes).  
• There are 54 ‘MIP’ schemes today (Value Research categories: hybrid debt-oriented aggressive, and hybrid debt-oriented conservative), that were in existence seven years ago. 
  • The returns in these categories ranged from 12% to 2% p.a. 
  • 38 of these schemes (i.e. 70%) have given a lesser return than that of the bank deposit (before considering taxes). 
  • The scheme with the lowest returns happens to be currently rated as a 5 star fund in its category.

In part, these observations highlight the risks associated with investing in equity funds at the peak of the markets, something I talked about at length in an earlier post.  In part, these make the case for diversification, something I spotlighted in another post.  Some observations even highlight the limitations of Star Ratings, something I touched upon elsewhere.  But there is no denying that the performance of a number of funds is questionable and if the answers are not convincing, there is no reason for investors in these schemes to continue holding those investments. 

By my calculations, there seems to be in excess of Rs.32,000 crore invested in equity schemes that have given lesser returns than the NSE-50 over these 7 years.  While it would unfair for me to draw any sweeping inferences, I hope those investments are there for the right reasons.

Can you really make money by investing at a peak?

Statistics suggest that most Indian investors in equity funds make most of their investments in bull markets.  As someone put it, “Rather than buy low and sell high, most investors attempt to buy high and sell higher.”  So, what are the chances of making money by doing so? 

Obviously, it depends on how much money one is looking at making, and over what time frame.  While I don’t have a crystal ball or any other means to know what the future may hold, in this post, I propose to examine some historical evidence.

In a way, I had skimmed the fringes of this in an earlier post, where I attempted to make the case for equity funds serving a certain purpose.  To do so, I had looked at the NSE-50 Total Return Index and had examined the outcomes from hypothetical investments made in this index each day between 11 Feb, 2000 and 5 Nov, 2010 (both dates representing market peaks).  This period covered 2682 trading days.  The trailing P/E ratio ranged between 10.68 and 28.47, with a median of 18.10.

In this post, I propose to use the same data and examine the instances of making varying levels of returns by investing on 211 peak days i.e. days on which the index was at, or near, a peak in terms of price as well as valuations (these days were amongst the top 20% in terms of the trailing P/E ratio and also represented either a new price high or were not more than 10% below the last price high).

The performance has been analyzed up to 19 Sep, 2014.  It would be pertinent to point out that of the total 2682 days, there were 281 days on which, if an investment were to be made, would not have completed 5 years on or before 19 Sep, 2014.  Of the shortlisted 211 days, there were 48 such days.

Here, then, are some of the observations:

Across the 2682 days, investments made on 1283 days could have, on completion of 3 years, resulted in an appreciation of 15% p.a. or more.  Of the 211 peak days, there were only 21 days when an investment could have seen similar results.

Overall, there were 1366 days on which an investment, if made, could have, on completion of 5 years, seen an appreciation of 15% p.a. or more.  There wasn’t a single peak day, investing on which this would have been possible.

What if, instead of a buy-and-hold strategy, one were to have actively monitored one’s portfolio and cashed in the gains?

An annualized return of 15% p.a. over 3 years equals a total return of 52.1%.  An annualized return of 15% p.a. over 5 years equals a total return of 101.1%.  Of the 211 days, there were 41 days, investing on which, one could have seen a cumulative appreciation of 52.1% in 3 years or less.  These included 21 days, investing on which, one could have seen a cumulative appreciation of 101.1% in 5 years or less.  

The tables below give a more detailed set of observations pertaining to investments made on the 211 peak days.

Targeted  Return	Instances of achieving targeted return by holding for exactly
	1 year	3 years	5 years
30% p.a.	19	1	0
20% p.a.	20	21	0
15% p.a.	26	21	0
10% p.a.	32	33	9

 

Targeted Cumulative Return	Instances of achieving targeted return in a period of
	5 years or less	3 years or less	1 year or less
10%	184	115	92
20%	144	68	48
30%	133	55	34
40%	101	45	24
50%	49	41	20
60%	40	24	0
70%	24	24	0
80%	22	21	0
90%	21	21	0
100%	21	21	0
120%	21	14	0
150%	21	0	0
200%	21	0	0
250%	12	0	0

In case you have difficulty relating to cumulative returns, here are some quick indicators:

A cumulative return of 100% is approximately equal to a compounded return of 15% p.a. over 5 years, or 26% p.a. over 3 years.

A cumulative return of 150% is approximately equal to a compounded return of 20% p.a. over 5 years, or 36% p.a. over 3 years.

A cumulative return of 200% is approximately equal to a compounded return of 25% p.a. over 5 years, or 44% p.a. over 3 years.

A cumulative return of 250% is approximately equal to a compounded return of 28% p.a. over 5 years, or 52% p.a. over 3 years.

One final observation: there were dates on which, investments made and held,  would not have achieved a modest targeted return even over periods beyond 5 years.  For instance, investments made on certain dates in Oct, 2007 and Nov, 2007 would not have seen an appreciation of 8% p.a. at any point over the last six-odd years.  As of 19 Sep, 2014, these investments, if made and held, would have registered an annualized return between 6% p.a.-7% p.a.

Based on these observations, I am inclined to conclude that investing at, or close to, market peaks is fraught with considerable uncertainty.  While it may have been possible to generate returns as high as 50% in a period of a year or less, or in excess of 25% p.a. over a period of 5 years, such opportunities would have been very, very few.  The evidence suggests that there were far greater instances of, at best, generating single digit returns over the short term, and annualized single digit returns over the long term.

If at all one still chooses to make investments at similar peaks, I would recommend investing in a staggered manner, such as through a Systematic Investment Plan.  Further, I would suggest one set modest return expectations, actively monitor the returns and cash in and/or average out, as and when opportunities present themselves.

The new usefulness of equity funds

This isn’t for everyone, so unless you are confident that you understand the risks involved and are willing to live with a potentially unfavourable outcome, don’t attempt this on your portfolio without consulting a good investment advisor.

Till recently, for investors in the higher tax brackets, with an investment horizon of between 1 and 3 years, debt funds were arguably the most attractive investment option, in terms of potential return that could be earned, relative to the risk.  In the wake of the taxation changes announced in the recent budget, these funds are now, more or less, as attractive (or unattractive) as any other debt instrument.  The taxes that such investors would now have to pay in these funds could well be up to three times (or even more) what one would have paid based on the earlier tax laws.  This would also be the case for investors who have already made investments in debt funds and need to withdraw some or all of those investments, some time after the completion of 1 year (from the date of investment) but before the completion of 3 years from that date.

For all such investors, who are uncomfortable with the additional tax now needed to be paid, I would like to propose the case for a greater allocation to equity oriented funds.  A note of caution: Equity funds are not a natural substitute for debt funds or any debt instrument.  These require far greater risk management as compared to debt funds, and it would help to bear that in mind while evaluating this.

The background: According to the new budget proposals, gains from exiting a debt fund before completion of 3 years will now be taxed at one’s normal tax rate.  Gains from exiting an equity oriented fund after completion of 1 year continue to be tax-free.  At the time of writing, a deposit with State Bank of India for a period of between 1 and 3 years, is assuring an annualized return of 9.31% p.a.  If taxes were to be taken at 30%,  then this roughly translates into a post-tax return of 6.52% p.a.  One could say that an equity oriented fund needs to produce returns in excess of this number for it to be a more worthwhile investment.

The case: To understand the odds, I looked at data of the NSE-50 Total Return Index, and tried to examine the outcome from making a hypothetical investment in this index on each day between 11 Feb, 2000 and 5 Nov, 2010 (both dates represent market peaks).  More specifically, I tried to see how long would it have taken such an investment made on each day to deliver an annualized return of 7.00% p.a., after taxes (subject to a minimum absolute return of 7.00%, after taxes).  Tax (on investments held for less than a year) was assumed at 15%.  Here are some of the key observations:

• Of the 2682 trading days in this period, there were 2207 days (82%) on which, if an investment were to have been made, would have resulted in this target return in a period of 1 year or less.   
• There were 1864 days (70%) on which,  if an investment were to have been made, would have resulted in this target return in a period of 180 days or less. 
• There were 621 days (23%) on which,  if an investment were to have been made, would have resulted in this target return in a period of 30 days or less.  
• There were 179 days (7%) on which, if an investment were to have been made, it would have taken over 3 years to achieve this target return.  These include 43 days on which, if an investment were to have been made, this target return would have not yet been achieved (as on 30 June, 2014).  
• The longest wait to achieve this target return would be for an investor who invested on 29 Oct, 2007.  As on 30 June, 2014, he/ she would have waited 6 years and 8 months.  As on that date, the return on his/ her investment would have been 5.06% p.a.
• There were 1754 trading days on which the trailing Price-Earnings (P/E) Ratio of the NSE-50 was below 20.  An investor who invested on any of these days would have had to wait no longer than 2 years and 11 months to achieve the target return.  Of these, there were 1553 days (89%) on which, if an investment were to have been made, would have resulted in this target return in a period of 1 year or less.   

In case you think there is a case for using this information to formulate a strategy, here are some suggestions:

• I believe that the primary motivation for using this information as part of a strategy should be to bring down taxes.  This will help determine how much should be additionally allocated to equity funds.  Any motivations beyond that should be carefully assessed before moving ahead. 
• Judiciously pick the moments when you would want to allocate money to equity funds.  The P/E Ratio can be a good indicator.  In addition, I would also consider how much below the last peak is the index.
• Don’t defer your exit from an equity fund till the time when you need the money.  If, at that time, prices are down, it may have far more adverse consequences than you may realize. 
• Do bear in mind that any gain from exiting an equity fund before the completion of 1 year is not tax-free.

At the time of writing, the P/E Ratio of the NSE-50 stands close to 21, and markets are around their all time high.  Personally, I would use this as an opportunity to exit equity funds to the extent that I can anticipate a need that would otherwise increase my tax liability.

Is this a good time to invest in equity funds?

In my opinion, for anyone contemplating investing into an equity fund, this is as good a time as any to do so, provided one puts in place some kind of a safety net, so to speak. 

While it is true that stock prices have risen significantly in the last several months, and the valuations are not as attractive as, say, a year ago, these facts are now a part of history and cannot be re-written.  But should we wait for a more opportune moment? No matter what anyone may say, only time will tell us how remunerative any decision taken today will be.  Going forward, it is possible that we may look back and wish we had waited a while before investing.  It is equally possible that we may look back and regret not having invested at this point. 

What is probably more important is that we plan with an awareness of the risks that could accompany our investment decision.  I, for one, regard stock markets with the awe and respect that I reserve for forces of nature.  Any attempt that I make to harness their power is done while taking as many precautions as I can, with the knowledge that there is still the possibility of being overwhelmed.  Equity funds give our portfolio the potential for appreciation, yet their price fluctuations can be unnerving for most of us.  Panic in a downturn is a key reason for investors missing out on the benefits from equity investing.  In the event of a steep or sustained fall, most of us will inevitably grapple with discomfort.   Here are some things that we can do to soften the impact:

Know how much to invest: Investing is not an end in itself but a means to an end.  Having well-defined financial goals can help determine the extent of investment that we should have in equity funds, and it is best to keep our investment within that limit.

Plan to stay invested for as long as possible: A number of experts suggest that equity investments should be planned with a minimum time horizon of 5 years.  This is usually attributed to the fact that historically, business/ market cycles (peak to recession and back) have lasted, on an average, for 5 years or so.  I am not an expert on this but I look at this as a reasonable rule of thumb, nothing more.  From the evidence that I have examined, the only somewhat conclusive inference that I can draw is that the longer we hold, the lesser are the chances of unpleasant surprises.

Avoid investing a large amount at one go: If investing a large amount, consider doing so in small tranches rather than at one go.  This helps protect against the soreness that one is likely to feel in the event of a sharp fall in prices shortly after initiating the investment.