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.

Why are markets taking a nasty "U": turn?

Why are markets taking a nasty “U” turn?

Tame the volatility of equity markets with asset allocation

Equity markets are volatile. They have always been volatile. They will remain volatile. In fact, all asset classes exhibit price volatility as long as there are trades happening in open markets involving  so many market participants.

One of the ways to tame this volatility is to know how you invest. Click on the link below to read further ...

Tame the volatility of equity markets with asset allocation

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The English translation is as under:

Last time we wrote about the power of SIP to tame the risk of price volatility. However, this is suitable for individuals having regular income and savings. Someone may wonder, what about those who do not have regular savings? What about the retired investors?

Retired investors invest their money and then draw regularly out of these investments. Many are comfortable with fixed income investments and get the regular income in form of interest. On the other hand, there are some who invest in mutual funds and withdraw their money regularly. At the same time, in case of some, they may have money that may remain invested without any withdrawal from the same.

In fact, it is not just retired investors; many investors from other categories have some money that need to be untouched. No income may also be required out of the same as some other investments may be generating enough.

If such money is going to remain invested for long periods of time, one need to find how much should be invested in the volatile asset class called equity and how much in safe fixed income investments. This process is popularly known as asset allocation. (Asset allocation may involve investment in many other asset categories apart from equity and fixed income, e.g. real estate, international stocks, currency, etc.)

The big question in deciding the asset allocation is: “How much money should be allocated to which asset category?” The answer depends on three things: (1) the need to take investment risks, (2) the ability to take such risks, and (3) the willingness to take risks. One can have a separate detailed discussion on these three. However, broadly, the need to take risks arises when one needs returns higher than the safe short-term Government securities. The ability depends on one’s financial as well family situation and the willingness is a function of how soundly one can sleep at night after making certain investments.

Once the allocation is made to various asset classes, one has choices (1) let the allocations change in line with changes in asset class performances, or (2) rebalance the asset allocation to the original ratios, or (3) take market views and increase or decrease the allocations to various asset categories based on one’s views on the relative attractiveness. Most investors would be better off with taking the approach number 2.

Let us understand this approach, known as rebalancing the asset allocation to the original levels.

Let us assume that after assessing the needs of one of the clients, the advisor recommends investment of 50% of the assets in an equity mutual fund and 50% in a money market mutual fund. The investor and the advisor then decide to review the performance of the portfolio every six months. The review process is also very simple. The objective would be to maintain the allocation between equity fund and money market fund at 50:50.

Given that the stock prices are volatile over shorter terms and move in line with the profits of the company over longer periods, we are likely to see the value of the equity mutual fund go up and down over time. When that happens, the asset allocation would stray from the 50:50 that was set originally.

When the equity prices move up faster than the debt prices, the allocation will get skewed in favour of equity and our review process would restore it back to 50:50 by shifting some money from equity fund to debt fund. In the other case, when the equity prices move adversely, the balance would get skewed towards debt and the balance can be restored by shifting from debt fund to equity funds. What you are doing here is selling equity when the prices run up and buying when the units got cheaper. One is able to do this without having to worry about analyzing what is happening in the market place.

The above example is applicable to an investor, who has a static portfolio without any additions into the portfolio or withdrawals from the same. In reality, the investor may get inflows, which need to be invested in the portfolio or have a need to take some money out of the investments. In such cases, at the time of investment or redemption, the investor has to look at the current market value of the equity fund and debt fund and rebalance the portfolio to 50:50.

Automatically, the money goes into equity fund when the stock prices are low and into debt fund when the stock prices are high.

The only problem with the above is that what looks so simple is very difficult to execute since the approach means ignoring all the sound bytes taking place around you. It takes a lot of courage to chart one’s own course and more importantly, to continue walking that path – at times, all alone.

Maintaining the asset allocation helps an investor work the volatility in one’s own favour.

Wish you all a very Happy New Year!

-        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.

Are you timing market perfectly well for good returns?

Are you timing market perfectly well for good returns?