What do equity fund managers do to beat the index?

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.

Should you invest in stocks directly or through equity mutual funds?

Read my article on whether it makes sense to invest directly in stocks or through equity mutual funds

http://epaper.gujaratimidday.com//epaperpdf/gmd/06072015/06072015-md-gm-12.pdf


The English translation is as under:

“Should I invest in stocks directly or through equity mutual funds? Which of the two can generate better returns?” A participant asked in one of my investment seminars. This is not the first time that one has faced this question. This question keeps cropping up periodically.

There are quite a few investors who think they can easily generate higher returns than most mutual fund managers. Many also quote some of their successful stock picks. Such examples could be quite attractive, and seductive sometimes. The result being, some individuals start thinking that beating other investors is quite easy. When one sees someone making money (or hears about such a story), the above question is raised.

What should one do? The question is straight forward, and so is the answer.

One has to go back and understand what a mutual fund really is. A mutual fund is an investment vehicle offered by an asset management company. An investor investing in a mutual fund is outsourcing the activities related to investment management to a professional fund management and administration team. This professional fund management team takes up certain tasks on behalf of the investor, e.g. analyzing and identifying for investment opportunities, managing the inflows and outflows in the fund, taking care of investment administrative activities, valuation of the portfolio and calculation of the NAV, etc.

If an investor has to do all these activities, one would need three things, viz. (1) skills and abilities to manage money, (2) time required for various activities including investment research and administration, and (3) liking for all these activities. In the absence of one out of the first two, the performance could turn out to be disastrous.

Investment management is a full time job and requires one to devote time towards study of balance sheets of companies to understand the businesses one is buying. It is surprising that so many investors buy stocks of companies without knowing the business of a company. Let us understand that one becomes part owner of a company by buying stocks. The owner of a company is entitled to profits of the company in proportion of the shareholding. If one is looking at becoming shareholder of a company with this understanding, it is important to buy stocks of companies that can remain profitable for long. In order to understand whether a company would be profitable or not for long, there is only one way – study the business of the company.

During one such discussion, one gentleman looking for buying stocks asked, “How many people know how to read a balance sheet of a company?” His question is right. However, there is a bigger danger if one really understands what is happening. Anyone looking for buying stocks should read the balance sheet. However, if one does not know how to read one, is trying to invest one’s hard-earned money without realizing where the money is going. Isn’t that a bigger danger?

Well, in the absence of abilities one would be better off taking professional help. This is where mutual funds come on.

Very often, we tend to look at things, which are less important and ignore things that matter the most. In the question of managing money, whether direct investment in stocks would be more rewarding than investing through mutual funds, one often misses out the amount of time and effort one has to put in. there could be better utilization of one’s own time – spending time with the family, pursuing some hobbies, etc.

Enjoy life!

Amit Trivedi

The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions.

Dividend or growth - which option is better for a mutual fund investor?

My article in Mumbai edition of Mid-day Gujarati today (page 15, bottom half)

Click here to read ...

The English translation of the same is as under:

Mutual funds are supposed to simplify our lives. However, with more and more attempts at simplifying, the industry has increased the options and the choices for the investors. The number of choices now has reached intimidating proportions.

Let us demystify various dividend options. This should help us take better decisions and make the decision making process easier. We will discuss the objective behind the options and how these can be effectively used in order to achieve our goals.

In the parlance of mutual funds, dividend is distribution of income earned by the mutual fund portfolio. The fund’s money is invested in various securities – these securities generate returns in form of capital gains (difference between sale price and purchase price), interest (debt or money market securities), or dividend (in case of equity securities or other mutual fund schemes). Such returns, if retained in the mutual fund will result into increase in the NAV per unit. Part of these returns can be distributed to the fund’s investors. This distribution is called dividend.

Broadly, an investor can opt for either a dividend or a growth option. Then, within the dividend option, there are choices like the periodicity (in certain cases – especially the debt and liquid funds) of dividend and whether one wants to receive the dividend in hands or get the same reinvested. Reinvestment of dividend results in purchase of more units of the same fund.

The entire hierarchy is given below for a quick reference.

One must note that the dividend frequency options are not available across all types of funds or all schemes. A fixed frequency is not available in case of equity and balanced funds. The daily or weekly options are available only in case of liquid category of funds. Most of the times, there is no payout option in case of daily or weekly frequency and the dividend is compulsorily reinvested.

Which option should an investor opt for? Why?

The answer starts from the objective of the investor. For what purpose was the investment done? What is the goal that the investor wants to achieve through the said investment? Broadly, investors invest their money with one of the three purposes: viz. accumulation, regular income or temporary parking of surplus funds.

Among these three, what one should do with the dividends – whether to take payout or reinvest the dividend – seems quite obvious. Growth option seems logical for accumulation goal and dividend payout for regular income goal. If only life was so simple.

An important factor to consider is the tax treatment of the income as well as the tax status of the investor. Dividends from mutual funds are tax-free in the hands of the investor. However, in case of funds classified as non-equity funds, there is a dividend distribution tax charged on the quantum of dividend distributed to the investors. This tax is charged before the fund pays out the dividend to the investor.

On the other hand, if an investor has opted for growth option, the difference between sale price and purchase price would be considered capital gains. In case of equity oriented funds, gains booked after completion of 1 year from the date of investment are long term whereas those booked before completing one year are short term. (This period is three years in case of all non-equity oriented funds). The short term gains are added to the person’s income for the respective year and taxed at the marginal rate of tax applicable to the assessee for the year.

As can be seen from the above, the tax is likely to be higher on short term capital gains for an investor in a higher income slab. On the other hand, if an investor is in the tax-exempt category or one who does not have a source of income or where the income is below the taxable limits, it would be unwise to opt for dividend option even if there is a need to get regular income. The dividend distribution tax is applicable to all investors irrespective of the level of income.

The last two paragraphs are applicable more to debt and liquid funds than to equity funds. In case of equity funds, many investors perceive that dividend option is better than growth. The logic here is that the dividends are paid out when the fund has made profit. The sad reality is that the dividends may or may not be paid out in boom times when the fund is supposed to have made profits. Many investors expect the fund managers to be able to predict the market tops and thus payout dividends. Once again, the sad reality is that the history does not offer any evidence to the effect. It may be prudent to opt for growth option in equity funds if the time horizon is long, say 10 year or more. The growth option will allow the investor to benefit from the power of compounding.

Amit Trivedi

The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions. He can be reached at amit@karmayog-knowledge.com