What strategies do equity fund managers use to outperform the benchmark indices? Read my article published in Gujarati Mid-day today ...
http://epaper.gujaratimidday.com//epaperpdf/gmd/07032016/07032016-md-gm-16.pdf
The English translation is as under:
How does an
equity fund manager generate better returns than the index? This is a question
many might have but few seem to ask. The first thing we need to understand,
though obvious, is that the objective is to beat the index performance.
With this
objective, the fund manager has to have a portfolio that is not exactly
replicating the index portfolio. This means, the stocks in the fund portfolio
may be different from the index. However, since the fund may be benchmarking
against a particular index it tries to beat, the fund manager has to invest in
stocks from a similar universe as the index.
A large-cap
fund, benchmarking against Nifty must invest only in large-cap stocks. It cannot
buy mid-cap (or small-cap) stocks only with an objective of beating the index.
There are two
primary strategies that a fund manager may employ in order to outperform the
index.
1.
Stock selection: This involves selecting stocks
that are likely to perform better than the index over long term and / or
avoiding stocks that are likely to underperform the index. The basis for such
selection largely is the fundamental strengths of the company. As a variant of
the same, the fund managers may employ sector rotation strategy. Mostly, the
stocks are selected for long-term holding (though, not always).
2.
Market timing: The fund managers try to predict
short-term price movements of the entire markets and accordingly increase /
decrease their exposures into the market as a whole.
One such
variation includes buying “value” stocks or “growth” stocks. A value stock is
one whose market price is too low compared to the estimated value that the fund
manager puts on it. The question is: how can such a thing be possible in a
market that has access to all the relevant information? The reality is: It
happens. However, the fund manager must be doubly sure as a stock trading at
discount to its value means that either the fund manager knows something that
the market does not or vice versa. The risk here being, “What if the market is
right?” On the other hand, if the fund manager happens to be right, there could
be lots of money to be made. Some of the legendary investors, e.g. Warren
Buffett and Sir John Templeton are known to be value investors. A growth stock
is one where the company is exhibiting a very high profit growth. Such
companies are favourites of the markets. The market players love such stocks
and want to own these. Such attraction means these stocks may be trading in the
market at way above their intrinsic value. The risk here is (1) buying the
stock too costly, or (2) slow down of the expected growth. However, some of the
small and mid-sized companies become big when they continue to grow at high
rates for long periods of time. There have been many examples of such stocks in
our own markets. Many fund managers in India do not want to be bucketed in
anyone of these two styles. They call themselves “style agnostic”. They claim
that they would pick up a stock if their analysis suggests that it is a good
buy, irrespective of whether it is growth stock or value stock. Academics term
this style as “blend” – a mix of value or growth. A sub-style of value
investing may be known as dividend yield strategy, in which the fund managers
try to pick up stocks, with the main criteria being high and sustainable
dividend yields. (Dividend yield is calculated as the dividend in Rupees
divided by current market price).
Another
variation of the “stock selection” strategy could be to identify a sector of
the economy or an industry or a group of industries and own stocks of companies
within these sectors. While in the value or growth style, the fund manager
starts identifying the companies based on their individual businesses, in this
method, they start with identification of sectors and then they search for companies
within these sectors. The purists avoid such strategies. The risk here is that
not all companies in a sector may be good and one may end up buying low quality
stocks simply because the sector is hot.
The market
timing is a very different strategy. The market timers, as we mentioned
earlier, increase or decrease their exposure to the entire market based on the
expected short-term price movements. If the fund manager expects the prices to
move up, he would load up the portfolio with stocks. However, if the view is
negative, the stock exposure may be reduced and accordingly the portfolio would
carry large amount of cash or debt securities. Their idea is to stay away from
equity markets if a fall is expected and come back just before a rally starts.
This sounds very nice in theory, but is extremely difficulty (almost
impossible) to do practically.
While the fund
managers may be using both strategies, they primarily use stock selection or
it’s variations. Many actually claim that they cannot time the markets and that
they employ stock selection strategy, by selecting good stocks and avoiding bad
stocks.
Whatever their
belief and strategy, the objective is to beat the benchmark index.
-
Amit
Trivedi
The author
runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from
Financial Market Cycles We Repeatedly Forget”. The views expressed are his
personal opinions.
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