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.

Balanced funds may be riskier than you think

Balanced funds are widely understood to be funds that invest across equity shares and debt instruments, but with a slight tilt towards equity shares.  In India, to attract investors with tax benefits, over the years, that tilt has increased.  As things stand today, it would be unlikely for a balanced fund to hold, on an average, less than 65% of its portfolio in equity shares.

For a number of people, balanced funds represent a sweet spot between debt funds and equity funds- “the best of both worlds,” so I am often told.  Most advertisements, articles, and literature seem to encourage that view.  In the eyes of most people that I speak to, in a bull run, these funds are expected to do nearly as well as equity funds, while in a bear phase these are expected to protect the downside risk better than those funds.  While these are generalizations which theoretically appear sound, in this post I’d like to delve into some specific issues related to the risk in these funds.  In case you’re an investor in one of these funds, wondering whether to continue holding these, or you are someone who is considering investing in one of these, this post may help you make a more informed decision.

Don’t go by the name: There is at least one fund with ‘Balanced’ in the name, that is described by its fund house as being an equity fund (and not a balanced fund).  There are also funds that are described by their respective fund houses as being balanced funds, something that you wouldn’t know from their name.  The only sure way to know is by going through the investment objective.  Another way could be to go by the fund categorization of Value Research (Hybrid – Equity-oriented).

All balanced funds are in the ‘brown’ category:  Effective July 2013, fund houses are required to group their funds into three categories, distinguished by color, based upon the level of risk to one’s principal.  While the effectiveness of this coding itself is a matter of debate, as far as I have been able to make out, all balanced funds, along with all equity funds have been lumped together as high risk investments (brown color).  One could infer that within the framework of this coding, there is no significant difference between balanced funds and equity funds.

It is possible for a balanced fund to fall more than an equity fund: The rise or fall in a fund’s NAV depends upon the rise or fall in the prices of the underlying investments.  A balanced fund’s equity investments, as a percentage of the portfolio, will usually be less than that of an equity fund’s.  However, it is possible that the fall in value of those investments be more than those of an equity fund.  In the bear phase of 2008-09, going by data from Value Research, the worst performing balanced fund fell by over 74% from its peak.  To put that number into context, this fund underperformed 98% of the equity funds (including sector funds).

The equity allocation may be more than you think: Based on my conversations with investors, I gather a perception that a balanced fund would usually have 60%-70% of its portfolio in equity shares.  Based upon data from Value Research, as on 30 June, 2014, 12 of the 15 largest funds in the category, ‘Hybrid Equity-oriented,’ had equity investments in excess of 70% of their portfolio (most were closer to, or above the 75% mark).  One of the funds had over 81% of the portfolio in equity investments (its objective allows it to go up to 100%).

There is risk in debt, as well: Going again by data from Value Research (as on 30 June, 2014), if interest rates were to rise by 0.5%, the value of the debt instruments in the portfolios of some of the largest balanced funds could go down by close to 3%.

There is nothing wrong with taking risk so long as we are clear about the nature of risk and consciously make our choices.  Personally, I avoid most hybrid funds.  Most of these have investment objectives that are too vague for my comfort.  Further, investing in these means agreeing with whatever allocation the fund manager chooses to have between equity and debt, and also the choice of strategy and instruments in each of these investment categories.  As I see it, investing in separate funds for each investment category gives me a lot more clarity and flexibility. 

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.

The real benefits of a Systematic Investment Plan

Let me start by sharing what a prominent investment portal has to say about the benefits of opting for a Systematic Investment Plan (SIP).

“Systematic Investing in a Mutual Fund is the answer to preventing the pitfalls of equity investment and still enjoying the high returns. This SIP Calculator will show you how small investments made at regular intervals can yield much better returns over a long period of time.”

I recommend treading with caution while relying on such supposed advice. 

Systematic Investment Plans are a key part of the efforts made by fund houses to attract investors towards equity funds.  A number of financial advisors and investment portals also encourage investments through SIPs.  However, as I see it, a lot of the stuff out there necessitates reading between the lines, and filtering fact from fiction.  The quote at the start of this post is just one example of this.  Opting for a SIP can, indeed, be beneficial, but not in the way that this portal would have us believe.

For those of us who rely on the regular income from our profession to build wealth, a SIP is a convenient and effective way to invest regularly.  In an earlier post, I had mentioned that the wealth that we build is influenced by the amount that we save, the timeliness of our investments and the quality of our investment choices.  In my previous post, I had built on this to make a case for saving more and investing regularly.  This is a useful framework to understand the importance of a SIP.  It is a means to channelize, in a timely fashion, the amount we choose to save, into the funds that we choose. 

In other words, we are responsible for our investment choices and the amount that we invest; a SIP has no role to play in that. Furthermore, merely opting for a SIP cannot compensate for poor investment choices, or for a lack of thrift.  It is up to us to decide how much to save and how to allocate this between equity funds and debt funds.  A SIP ensures that we will not delay investing and will, thus, use time to our advantage.  Therein lies its importance.

SIPs can also be beneficial for those of us in a dilemma when deciding to invest a large sum of money into equity funds (or anything that is susceptible to frequent, steep price fluctuations).  Such dilemmas exist because of the uncertainty attached to the price- Is the current price a good price to invest at?  Or is it better to wait for the price to fall?  In effect, we have three choices:

1. Invest this at one go, now
2. Invest this at one go, on a later date
3. Invest this in smaller tranches, over a period of time

There is no basis for anyone to say for sure, as to which of these choices will result in the best returns.  We will only know in hindsight which course of action would have been the best.  Some of us may be inclined to take a call on the price movement and, hence, go with the first or the second option.  Those of us who would like to hedge out bets would opt for the third choice.  A SIP (or a Systematic Transfer Plan) is a convenient way to exercise this third choice.   It may or may not yield better returns as compared to the first two choices, but in all likelihood, it will enable us to sleep more peacefully.

Life and Investing

Beyond the often-cited need for returns or safety of our money, there is a bigger purpose to investing in our lives.  The clarity to see investing in the context of life can help us make better investment decisions.  This post offers a perspective on this for those of us who are working and haven’t yet retired.

Most of us start our working lives with no wealth, dependent on the earnings from our profession.  As we move through life, most of us build wealth through what we save from the earnings from our profession, and invest.  Years later, when we retire from our profession or choose to take things easy, the wealth that we have built by then, will likely be the primary source of our income. 

Even so, some of us will retire out of necessity (brought about by age or an inability to earn income from our profession), while some of us will do so out of choice, on our own terms.  Whether we will, indeed, be able to be live life on our own terms, will depend on the amount of wealth we are able to acquire, relative to our need for passively generating income from it. If asked to choose between retiring out of necessity and retiring on our own terms, each one of us would prefer the latter. Logically, therefore, the acquisition of the wealth to be able to do so, should be an important (if not the most important) purpose for investing.

Equally logically, we need to understand what it would take to accomplish this goal.  No doubt, the quality of the investment choices that we make throughout our life will contribute to the wealth we build.  In addition, I’d like to submit two factors, related to investing, that will also play a crucial role: one, the amount that we save and invest, and the other, the timeliness of our investments (i.e. our ability to not delay investing).

In my experience, far too many of us focus our attention on the quality of investment choices, losing sight of these two factors.  While all three work best together, and not in isolation of each other, I believe there is a case to say that these two factors are individually more important than quality of our investment choices.  I hope to touch upon this in more detail in a future post.  For now, I’d like to offer the following thoughts:

For a number of people, savings are regarded as what is left over from one’s income, after factoring expenses.  In other words, for such people, paying for today’s expenses is more important than planning for future expenses.  I recommend flipping this around.  I believe that the wealth that we need to meet our future aspirations should determine our investment choices and the amount that we save, and not vice versa.  So long as our aspirations are reasonable, and we start investing early in life, it shouldn’t be difficult to find the right balance between our savings and our expenses.  Thrift and regular investing can also reduce the need for riskier investments, so to say.

While deciding our investment choices, we should diversify against the risk of our profession.  This risk is highest for employees having significant holdings of shares of the company they work for, or entrepreneurs keeping most of their wealth as capital in their business.  What if, something were to happen to the company one works for?  What if, something were to happen to one's business?  Limiting one’s exposure to one's business or the shares of the company that one works for, helps protect against this risk.

Looking at investing in the context of life is a key part of what is known as, ‘financial planning.’  Financial planners understand their client’s financial aspirations and then draw up a roadmap to translate these into reality.  Most even handhold the client on the way towards achieving these aspirations.  Chances are that your trusted financial advisor would be adept in the art and arithmetic of financial planning.  If not, you might like to ask around or check out the website of the Financial Planning Standards Board India.  They have the option to search through the list of financial planners registered with them.

Diversification

Diversification is the strategy of spreading one’s money across multiple investment options. In its simplest form, it involves dividing one’s money across as many different kinds of investments as possible; in its more sophisticated form, it involves assessing which investment categories to have one’s money into, and to what extent (also referred to, as ‘asset allocation’).  Diversification makes one’s portfolio less dependent on the performance of a single investment or category of investments.  It can also minimize the impact of unpleasant surprises that may affect any single investment or category of investments.

In my opinion, the single most important reason to invest in mutual funds is the speed and convenience with which an individual can actually build a diversified mix of investments. In this post, I would like to share my thoughts on some questions related to diversification that I am often asked.

“If I invest in a safe place such as a PPF or a bank deposit, do I still need to diversify my investments?”

For a number of people, the term, ‘risk,’ implies the potential loss of capital, and ‘safe’ investments are those that implicitly or explicitly guarantee against that. Fact is, risks come in a variety of forms, and all investments, including those that we might consider as ‘safe,’ carry some kind of risk. For instance, most ‘safe’ investments carry the risk of not beating inflation.  By diversifying across investment categories, we can use the strengths of  one investment category to offset the risks of another.  To illustrate, equity investments can offset the risk of not beating inflation, that debt instruments carry.  Debt instruments, in turn, provide a cushion against the risk of price fluctuations, that equity investments carry.

Additionally, there are some risks that could affect any investment or investment category but may not necessarily impact all investments or investment categories at the same time.  For instance, there is the risk of an unexpected and inconvenient delay in getting back one’s money. (Just in case you find this difficult to relate to, you might like to visit online consumer grievance sites and check out the complaints related to withdrawal of investments, including those made with government-owned institutions.)  Diversification helps minimize the impact of such a risk.

“Is there any point to diversifying across multiple equity funds if they all hold shares of the same or similar companies in their portfolios?”

True, our gains from a fund are linked to the gains from the underlying investments. More specifically, other than in index funds, our gains are linked to the gains that the fund manager derives from the underlying investments. Two funds may have the shares of the same companies in their portfolios, yet the specific reasons for the respective fund managers to hold these could be very different. These fund managers may have different price targets to accumulate, and different price targets to sell.

Thus, there is merit in diversifying across funds with similar portfolios if the fund managers are different, and they employ different strategies.

“Wouldn’t an equal diversification across multiple equity funds result in average returns?”

While an equal diversification will result in average returns relative to other equity funds, my experience, and the evidence that I have examined, lead me to believe that it is likely to result in above-average returns relative to other investors.  Let me explain.

As suggested in an earlier post, I believe it is difficult, if not impossible, to know which funds will do well, relative to others.  Yet, as I also hinted, our brains are wired in such a way that most of us cannot resist the impulse to predict winners, so to say, and invest in them.  Once we do so, a number of us try to improve the odds by frequently switching funds.  This adds costs and usually reduces returns.  Last, but not the least, when prices fall, a number of us panic and get out and stay out, and miss the inevitable rise in prices, as and when that happens.  All of this results in returns that, more often than not, are less than what could have been achieved by simple diversification.  My analysis also suggests that if one were to do a basic, qualitative screening of the funds to diversify across, the results would be far more in favor of diversification.