Performance of Indian Mutual Funds

It would be an understatement to say that the past 3 years have been interesting for investors. What a roller coaster ride! From 10,573 (3 years ago), the Sensex went to an all-time high of 21,113 on 9-Jan-08, touched a low of 7,697 on 27-Oct-08 and it has gone back up to 13,887. Overall, the Sensex gave 9.5% compounded return in the past 3 years which is not bad because long term capital gains are tax free. On top of it, you would have got from 1% to 2% as dividends per annum which makes the returns more than those available in fixed deposits.

The period is interesting to analyze because such sharp movements are a rule rather than an exception in the equity markets. These are the periods which separate men from the boys. When the market is showing what folks at CNBC call a secular uptrend, the investors who bought, with our without reason, perform better. When the markets are falling, your grandmom with all her savings under her carpet will outperform you.

In the Indian context, the period is even more important. When the Sensex crossed 10000, it became a topic of front page headlines in the national dailies. There was nothing sexier than the Sensex and many investors, who had so far resisted the lure of a forbidden fruit, entered the market. These new investors weren't the ones who should invest in equities in the first place because their definition of long term coincides with that of the Indian tax department…One year! [This is amazing because I can't think of any business whose projects have a gestation period less than one year…except may be the booming Indian business of procreation]

From the shady bylanes of Bharuch to sparkling tech parks in Bangalore, stocks became a topic of discussion. I'm not saying that investing in stocks is bad. After all, if the inhabitants of the country won't participate in their country's march towards prosperity, foreigners will and soon every profitable corporation will be owned by foreign investors. But what these investors need to invest in is the right advice.

In all countries (including India), mutual funds play a big role in channelizing the investments from investors into good businesses. India too has a booming mutual funds industry. They have a mandate to make the investors prosperous and they claim they will… in no time.

The results, however, are saying something else. In the last 3 years, 78.44% equity mutual funds underperformed the 9.5% p.a. return from the Sensex. The median return was 5.28%. In the balanced funds, 78.78% funds underperformed the Sensex and 81.12% debt funds gave returns lower than 10% of what was available from Fixed Deposits during this period[1].

If you invested in mutual funds, you've got to get angry. These MFs charged you 2-3% of the money invested per annum and what a lousy result.But your anger is unjustified. You should have known better. You were screwed the day you bought the mutual fund. The world knows it. Forty years ago, when people collated decades of performance data, they found that more than 70% of fund managers underperformed the indices like S&P 500. This shocking result led to the rise of low cost Index funds and a highly costly Efficient Market Hypothesis (EMH).

The former relied upon a passive investing approach by investing in stocks in the same proportion as the weight of the stock in the benchmark index and thereby reducing the 2-3% fund management costs to close to zero. It was a huge success.The latter, i.e. EMH, theorized the empirical observations. Efficient Market Hypothesis claimed that it's not possible to beat the indices consistently because the markets, always, price the stocks efficiently. Forty years on, the investors like Buffett have proved the theory wrong with a simple common sense approach to investing but that doesn't stop the bogus hypothesis to be in curriculum, in analysis models and in the investing strategies of mutual funds.

There are two things which are very clear about the mutual funds. (1) They charge exorbitant cost ranging from 2-3% of the money for delivering this lousy performance. (2) The very structure of the mutual fund prohibits them from being able to outperform the general market.First, on the cost part. If a fund is delivering 30% per annum compounded and charges 4.5% per annum, you still make 25.5% compounded. The fee is well earned. If the fund makes only 13% and charges 2.5% p.a. for this, you are getting only 10.5% per annum. That's not enough incentive to subject yourself to market risk. You are better off by investing solely in fixed deposits. You are better off by investing in Index funds.

Secondly, the inevitability of underperformance. In 1997, when I had less than 3 years of experience in investing, I read an article by Paul Krugman: ‘No Free Lunch; Seven Habits Of Highly Defective Investors' [2]. These habits, as per him, are

1. Think short term
2. Be greedy
3. Believe in the greater fool
4. Run with the herd
5. Over-generalize
6. Be trendy
7. Play with other people's money

I really liked what he wrote. I realized that mutual funds have all these habits and some more. In my life, I never invested in mutual funds (except making a killing by buying close ended funds quoting at deep discounts close to their maturity date). But I didn't sit quiet either, sucking my thumb, quoting EMH profs., "you know, it's impossible to beat markets". Looking back, I feel happy that I did what I did. (In 2008, Paul Krugman won Nobel Memorial Prize in Economics).

In addition to Krugman's list, the structural problem with mutual funds is that they get the highest amount on inflows when the markets are at their peak and they face huge redemption pressures when the markets are close to bottom. In sector specific funds, they mop highest amount of funds for the sectors that have given huge returns in the past few years and that are overheated. This is recipe for disastrous performance. (That being said, I must note that in India, during last 3 years, all closed ended mutual funds and 21 out of 25 tax saving funds underperformed the Sensex. The more free hand you give to them, the more they underperform).

There is also a problem of incentives. From the point of view of an asset management company, the most successful mutual fund is the one which makes maximum money for them. You are incidental. The size of the fund is the key concern for the fund manager, because the expenses are charged on the invested amount. The mutual fund investors usually rank the mutual funds and invest in those with highest returns. This means that a fund manager has to focus on being among the top ranking during the upmove of the market because that's when the deluge of funds begins. You don't have to care about safety because no investor likes to exit at loss. This makes the whole proposition speculative and that's the reason why the mutual funds under-perform in the long run. In fact a careful look at the data will show that the performance of past few years does not guarantee above average returns in future.

What are the options for investors who don't know enough to invest themselves? Invest in index funds? I can't answer this in affirmative. The indices in India are heavily concentrated into few stocks and they are highly volatile. There is no index like S&P 500, because the quality of companies rapidly degrades as you go towards bottom of the pyramid. That's why you would see that Nifty Junior is even more volatile index.I've a simple advice for new investors. If you have to invest in equities, directly or indirectly, you have to learn few basic things about investing. Devote the next 5 years of your life to learn investing. You don't have to quit your job for it. You don't have to devote more than an hour to it, reading newspapers, business magazines and books. Don't worry about discounted cash flow valuation. Learn how to analyze the strengths and weaknesses of the businesses around you. Observe how powerful HULs brands are. Observe how ITC is investing heavily in FMCG and how long has it taken for the company to break even. Guess what will happen in the next 5 years. Analyze the results. This is what investing in stocks takes because a stock represents part ownership of a business. Your percentage returns in stocks of a company are not different from the majority owner. Then why should people think about stocks differently?

Theoretically, beating a leading index like Sensex isn't difficult. If you allocate your portfolio to same stocks as in Sensex, in same proportion as the weightage of each stock, you can match the returns from market. To beat that, all you have to do is to allocate a little less to a company that you think is below average and allocate that extra money to a company that you think is above average. That simple change will put you ahead of 78% mutual funds. But in reality, it's not that easy. Those very companies whose weight you reduced may outperform the index. That's why you need some bit of business knowledge so be able to make informed changes. Even if you never reach the confidence level to invest on your own, you will be able to at least check the portfolios of your mutual funds and check if they are taking unnecessary risk. Remember, if you don't know about investing, you can never judge whether your fund manager knows anything about investing. In such a case, every rupee you invest is stamped with "In God we trust" like the one US dollar bill.

References

1. Mutual Fund Performance Data
http://spreadsheets.google.com/ccc?key=r4s7pAjvBwOIxKNsSA9yObQ

2. No Free Lunch; Seven Habits Of Highly Defective Investors
PAUL KRUGMAN, Fortune 12/29/1997
http://www.scribd.com/doc/15762047/Seven-Habits-of-Highly-Defective-Investors

Actionable Information

They call him Jesus. He must be a God to win five World Series of Poker bracelets with his live tournament winnings exceeding 7.3 million dollars. You would expect him to be an astute reader of faces who can look at your face and tell if you are holding an ace. But he is very different.

Chris Ferguson(Jesus), is a PHD in computer science(on virtual network algorithms). His game is purely mathematical and strongly based on game theory. That must have made his dad, a game theory professor, a proud father. He is not to leave his mom unimpressed for he can cut bananas, carrots and water melon with playing cards!.

I’m telling you about Chris due one very important difference in his game. All good poker players(counting myself in!) know how to make an intelligent guess on the cards their opponents are holding. They can read situations, thoughts and yes, faces. At the same time, their own face doesn’t give any clue on what’s going on in their mind. They have what you call a poker face. Chris, however, doesn’t like to look at his opponents. He wears a big hat, keeps his head down and watches only the cards and bets.

That’s surprising because one would think he is missing out on an important source of information. But his record speaks for him. He says that at the highest level of poker, no player would give you a reliable tell. (A tell in poker is a subtle but detectable change in a player's behavior or demeanor that gives clues to that player's assessment of his hand. Examples include leaning forward or back, placing chips with more or less force, fidgeting, direction of gaze etc). Most of the times, the opponent is deliberately giving a tell to confuse you. Chris relies solely on mathematics and his game theoretic analysis of the game. What he is essentially saying is that although you can try to guess, the information you get from the tell is not actionable.

Let’s come back to investing.

May 14th 2009. Most exit polls in India are predicting a hung parliament and weeks of uncertainty while political parties cobble together a weak coalition. You know that such a thing will be a sure disaster for the markets reeling under constant flow of bad news on economic front.

You know that the markets have been extremely volatile in recent past and all the gains of past 3 months can be wiped out in few days. What do you about the stocks you are holding? Why not sell now and wait for clear picture to emerge. After all, the markets don’t look that cheap at this juncture as they were few months ago?

Many analysts suggested this course of action. Many investors sold in a hope to buy back later at half the price. I would never think along these lines. The reason is that the information coming out from the exit polls is not actionable.

Figuring out which information is actionable and which is not, is a key part in decision making under uncertainty. Investing in stocks is a problem that involves decision making under uncertainty and investors will do well to understand this concept.

Actionable information means that you have got an information which has (a) reasonably high chance of being true and (b) reasonably high chance of affecting your interest if it turns out to be true. There is a cost involved in taking action in a hurry and that cost plays an important role in deciding what to act upon and what to ignore.

To give you an example, I ignored the news from exit polls completely because

1. The information was unreliable. I’ve seen more exit polls going wrong about the results than those hitting the bulls eye.
2. Even if the information is correct and there is a hung parliament, there is no direct impact on the worth of businesses I’m invested in.

There are many scenarios where the exit poll results, even when they turn out to be true, may not affect me. For example

1. Given the era of political opportunism we live in, there can be unlikely alliances which can result in a majority government.
2. Even if a minority government is in place, it may remain stable until some parties are willing to go to the polls again.
3. Even if government is weak, it may still be good for the economy by letting the free markets decide the right course of action.
4. Even if the economy is hit, my business may not suffer that much.
5. Even if my business is hit in short term, the stock price of my companies may not fall because the investors see the bright long term prospects.

As you can see, there is a long and uncertain casual chain between the hung parliament and my stocks falling in value. At each step there is an uncertainty whether the cause will have the effect you are worried about. This reasoning has a mathematical basis. If a fact p implies another fact q and q implies r and r implies s, then you can deduce that s is true if you know the fact p is true. This information is actionable.

However if the causality is uncertain, you have to put a confidence factor. For example, suppose I’m planning to host an event, outdoors, on an evening in July. My friend who works at Indian Met department tells "You know that in any given day in July, there is 60% chance that it would rain in Bangalore. And in a rainy day, there is 40% chance that it will rain the evening. Are you sure you want to do it outdoors?"

I know that hosting the event indoors will be costlier but I’m scared of rain playing a party pooper. Are my fears justified? Think about it.

I don’t need to tell you about reliability of the Met department. On top of that my friend may not be having correct data or may just be spicing up his advice with data to show of his knowledge. Even if he’s correct, there is only 24% chance that it will rain on the same evening that I plan to host the event.

His information is not actionable given the cost of acting upon it. I’ll ignore the rains.

Coming back to elections. Results are out. We are heading for another stable government. It’s business as usual. I own the same stocks that I have been owning for years. For those, who sold their stocks, there may not be another chance on Monday to catch the same bus again.

The Three Musketeers

You are counting. It's probably 10th time in this hour when you have heard him say “I don't want to lose money”. If it was any other old man you would say "Now shut up and stay away from stocks. If you want to make money, you got to be mentally prepared to lose money. No risk, no gain!"
But then you get to know, this is no ordinary old man. He is Walter Schloss, one of The Superinvestor of Graham-and-Doddsville. He produced a 16% total return after fees during five decades as a stand-alone investment manager, versus 10% for the S&P 500.

And the realization strikes that the only option left is to shut up and listen.


Walter J. Schloss
Presentation at "The Ben Graham Center for Value Investing"
Richard Ivery Schools of Business, Feb 12, 2008
http://video.google.com/videoplay?docid=3897274042353134646

Warren Buffett, doesn't need the weight of his 37billion dollars to impress you. He is not only the richest but his wit and wisdom has turned him into the most respected and most popular investor of our times. In this video, he gives valuable insights into his thinking on investing and life in general.


Warren Buffett addresses students at the University of Florida
October 15th , 1998
http://video.google.com/videoplay?docid=-6231308980849895261

Charlie is simply magnificent. He is master of brevity. He can bulldoze a never ending argument with just one word and he doesn't mind offending you if it can put some sense in your brain. To give you an example, once in a shareholder meeting a guy asked him "what is the dumbest thing you ever did in your life". Charlie looked around the auditorium sizing the viewers and then said "I'm not going to answer it here".
You get the first hand taste of his wit and brevity in his conversation with Tom Tombrello, at Caltech. He acknowledges "In terms of humility, I frequently say that when they passed it out, I didn't get my full share. It was a serious problem when I was young but I cured it partially by becoming very rich"

He doesn't even hesitate to take a swipe on his host, Tom Tombrello, chair of Caltech's Division of Physics, Math and Astronomy. When Charlie says "I'm going to touch on my favorite subject, common sense". Tom interjects "which isn't so common" and pat comes reply "See"…and a roar of laughter





DuBridge Distinguished Lecture: A Conversation with Charlie Munger
March 11th, 2008
http://today.caltech.edu/theater/item?story_id=30623