How do we experience good performance?

10 minute read

In our last post here, we took inspiration from Steve Jobs and had decided to simplify our investment portfolio.

The key conclusions were:

  1. Limit the total number of equity funds in a portfolio to less than 4
  2. Only 3 categories for fund selection process
    • Multi-cap Category (core) – 4 funds
    • Mid Cap Category  – 2 funds
    • Small Cap Category – 2 funds

This week, we shall move on to the next step of “setting the right expectations”.

Setting the right expectations

Now before we move on to choosing funds (which in my opinion is really not the game changer it is made out to be), we need to answer the most important yet ignored question.

  1. How do we experience “good” performance? How do we know if we are in the right or wrong portfolio?

When it comes to evaluating investment performance, there are two types of people based on their expectations.

Let us call them

  1. Mr Absolute Abhijit – he needs absolute positive returns come what may
  2. Mr Relative Raju – he needs relative out-performance i.e either to beat his benchmark index or peer group

So whenever the above two open their portfolios and evaluate their returns their perception of good and bad performance will vary as shown below

Regret Chart

Both Absolute Abhay and Relative Raju agree that beating the markets in a rising market is good while under performing during a falling markets is bad. However both disagree on out performance in falling markets and under performance in rising markets.

Now the sad truth is that all of us have shades of “Absolute Abhay” and “Relative Raju” within us. We also keep shifting between these two frames – focusing on absolute performance in negative markets and relative performance in positive markets.

Thus our evaluation of portfolios ends up looking like this..

Regret Chart 1.png

We are happy only when we outperform in a positive market and remain unsatisfied at all other quadrants!

This personally to me, is by far the biggest problem in equity investing as given our unreasonable expectations and short time frames for evaluation, we end up being unhappy investing in equities for most of the time periods.

How do we solve this ?

Let us delve into each and every quadrant in detail..

Quadrant 1: Positive markets + Outperformance

This is a no brainer. This is exactly what we want and naively wish for every time we evaluate our portfolios.

So no problem as long as it is in this quadrant!

But just to be on the safer side, if the outperformance is dramatic then do investigate as to what is causing this (sector calls, concentration, stock picking, market cap allocation, asset allocation etc)

Quadrant 2: Negative markets + Outperformance

Let us be honest. While we might have outperformed on a relative basis, no one loves to see their hard earned money fall in value and this obviously is painful.

Sensex Return Distribution.png

But the reality is that short term declines are inevitable in equity investing. The holy grail of moving out just before a decline and entering just before an up move just doesn’t exist.

Historically, for someone who evaluated his equity portfolio every month, roughly 40% of the time, he would have found that his portfolio had fallen from his previous evaluation point value.

If he extends his evaluation period to 1 year, then still 30% of the times his portfolio would have been down from the previous evaluation point.

Thus if you are evaluating in shorter time frames, you will definitely see losses a lot more often and as a result your overall investment experience will mostly be unsatisfactory despite the fact that the odds are on your side for a good outcome in the long run..

Once you have decided to live with the fact that temporary declines are inevitable, you can decide on the extent of decline you can take and adjust your equity exposure accordingly (what is called asset allocation)

Takeaway: This entire quadrant of a falling market cannot be wished away and most importantly cannot be addressed by mutual fund selection.

It can only be addressed by

  1. Extending Time frame
  2. Asset allocation
  3. Tactical Asset allocation – if you have the expertise, then equity allocation can be adjusted (increased on decreased) based on market conditions (extremely difficult in practice)

If you have the time here is an interesting article on how even if god was your fund manager you wouldn’t be spared of this quadrant’s pain – Link

Quadrant 3: Negative markets + Underperformance

This I believe is a quadrant we must be worried about if our funds fall here. While we have no control over the markets, however if our funds are falling much more than the benchmark or peer group, then this may indicate that our chosen fund has taken higher risks.

Consider this an initial warning signal and we might have to deep dive into the portfolio and find out what exactly is happening.

Again the time frames shouldn’t be too short but at the same time unlike a longer time frame in our previous quarter, a 1 year time frame can be used to evaluate this quadrant.

“Over time, bad relative numbers will produce unsatisfactory absolute results.” – Warren Buffet

Quadrant 4: Positive markets + Underperformance

This is the quadrant where most of us tend to make mistakes and in a knee jerk response quickly exit and mover to newer funds.

Unfortunately, this happens as we don’t appreciate the fact that
Even good funds will inevitably have to undergo periods of underpeformance in the short run to perform in the long run

Let us listen to what Corey Hoffstein has to say about this phenomenen in this interesting article here

  • In an ideal world, all investors would outperform their benchmarks. In reality, outperformance is a zero-sum game: for one investor to outperform, another must underperform.
  • If achieving outperformance with a certain strategy is perceived as being “easy,” enough investors will pursue that strategy such that its edge is driven towards zero.
  • Rather, for a strategy to outperform in the long run, it has to be hard enough to stick with in the short run that it causes investors to “fold,” passing the alpha to those with the fortitude to “hold.”
  • In other words, for a strategy to outperform in the long run, it must underperform in the short run.
  • We call this The Frustrating Law of Active Management.

Now don’t go by my words or Coreys. Let us go with facts.

Let us pick the top 5 funds of the last 10 years (as on 20-Jul-2018)

Fund Selector   Returns   Value Research Online.png

Assuming you had the foresight to correctly pick them, would Quadrant 4 (under performance) still happen to these top performers at different points in time?

HDFC Mid Cap Opportunities

HDFC Mid Cap Opportunities Fund Growth Mutual Fund Performance Analysis

DSP Blackrock Small Cap Fund

DSP BlackRock Small Cap Fund Growth Mutual Fund Performance Analysis

Canara Robeco Emerging Equities Fund

Canara Robeco Emerging Equities Growth Mutual Fund Performance Analysis

IDFC Sterling Value Fund

IDFC Sterling Value Fund Regular Plan Growth Mutual Fund Performance Analysis

Aditya Birla Sun Life Pure Value Fund

Aditya Birla Sun Life Pure Value Fund Growth Mutual Fund Performance Analysis

Source: Morningstar

As seen in all the above cases, it is inevitable that all these funds though gave good returns over the long run had to go through under performance in the short run.

(the above examples are just for illustrative purposes and I have conveniently ignored other issues such as size, change in fund manager, strategy etc which may have impacted performance)

Now this will be the case irrespective of whichever decent fund you consider in India or across the world. In fact, even the Warren Buffet has lagged the market one out of every three years.

So for us what this means is when we hit this quadrant  – Underperformance needs to be put in context

  • Underperformance of funds is not necessarily always bad
  • Occasional underperformance in equity funds is inevitable
  • Understanding when the fund manager’s style is expected to do well and when it may struggle is the key to evaluate the underperformance
  • Evaluation of performance across a complete market cycle (covering a bull and a bear market) gives us a better picture

Performance evaluation framework in a nutshell

Thus now that we have a much better understanding of the 4 quadrants our new evaluation process looks like this

FOUR Framework.png

Summing it up

  • While picking good funds is important, even more critical is our discipline to stick to the fund during periods of under performance in the short run
  • This boils down to setting realistic expectations – which can improve our outcomes by reducing the possibility of us panicking and taking emotional decisions
  • We usually have an absolute reference in falling markets and relative reference in positive markets – implying most of the times we will be unsatisfied
  • Performance can be viewed in four quadrants – outperformance and underperformance in falling and rising markets
  • Outperformance in a falling market is still painful; cannot be solved by fund selection – longer time frame + asset allocation is the solution
  • Underperformance always needs to be put in context – it is not necessarily always bad as occasional underperformance is inevitable even for good funds
  • Understanding when the fund manager’s style is expected to do well and when it may struggle is the key to evaluate a fund
  • Evaluation of performance across a complete market cycle (covering a bull and a bear market) gives us a far better picture to evaluate the process
  • This implies a good fund selection process must address two things
    • Performance and risk measured across a complete market cycle
    • Understanding of the fund’s investment style and process
  • A fund’s communication to us on its style and process hence will form a key part of our evaluation

This is an evolving framework to evaluate performance and would love to hear your thoughts so that we can further improve on it.

In the next week, I will take you through my process of picking the funds.

Cheers and happy investing!

If you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 4500+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox. Cheers!

If in case you have any feedback, need any help regarding your investments, want me to write about something or discuss regarding job opportunities, feel free to get in touch at rarun86@gmail.com

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.

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What if Steve jobs was an Indian equity mutual fund investor?

Selecting equity mutual funds just got way too difficult..

In my last post here, I had discussed on why equity fund selection will become a lot more difficult going forward due to

  1. Recent fund manager changes
  2. Reclassification of funds due to SEBI regulations
  3. Poor communication from most of fund houses

This implies that for many funds, looking at past performance and all the other usual metrics (such sharpe ratio, treynor ratio etc) to compare and identify funds will not work well anymore.

So how do we solve this problem?

Let us take help from one of the best minds that ever lived..

10-Things-We-Can-Learn-From-the-Incredible-Steve-Jobs.jpg

I am lost! Dear Steve Jobs, can you help me with fund selection?

Let’s rewind back to a period, when Steve Jobs was facing a similar issue..

After being fired from his own company, in what would be one of the greatest comeback stories ever, Steve Jobs was once again called back after 12 years in 1997 to save Apple from the brink of failure.

When Steve returned, Apple was in a bad shape. It had a huge and confusing array of products, no clear strategy, and was losing several million dollars every quarter.

For eg, Apple had a dozen versions of the Macintosh, each with a different confusing number, ranging from 1400 to 9600.

“I had people explaining this to me for three weeks!” Jobs said.

Unable to explain why so many products were necessary, Jobs asked his team of top managers, a simple question –

“Which ones do I tell my friends to buy?”

When he didn’t get a simple answer, Jobs went ahead and reduced the number of Apple products by a whopping 70 percent!

Moving forward, his strategy was to focus and produce only four products: one desktop and one portable device aimed at both consumers and professionals.

“Deciding what not to do is as important as deciding what to do” – Steve Jobs

It is this ability to focus that saved Apple.

stevejobs.jpg

Takeaway: Focus & Simplicity..

How do we apply this to our fund selection process?

When it comes to investment portfolios, less is more..

Having reviewed over 2000+ individual investment portfolios over the years, this is my key learning –  majority of problems arise because of us overlooking this simple question..

How many funds do we really need to build a decent equity portfolio?

For any equity investor, the simple objective is to become silent partners (owners) in a group of good Indian businesses from different sectors and patiently participate in the growth of these businesses.

Mutual Funds, ETFs, PMS, AIF etc are actually intermediaries who help us with the above objective.

However, since every fund we pick is a single line item in our portfolio reports, we often forget that each and every fund is well diversified in itself and usually holds around 40-60 businesses on average.

 

Dev5cX6XkAEWdAk (1).jpg

Just like all the above menu items, ultimately represent a form of maggi, all equity mutual funds are in essence an indirect form of ownership in a bunch of good  businesses.

Most of us while we start with less no of funds, we eventually end up adding new funds in the name of diversification, based on the flavor of the season, recent performance, advisors recommendation etc. Gradually over time our portfolios end up having too many funds.

This is like ordering one spoon of all different maggi flavors in a single plate! 

turkmenistan-orient-family-motorcycle-india-1024x808.jpg

This generally leads to a large overlap of stocks across funds, insignificant impact on both upside and downside due to low exposure in individual funds and eventually ending up with far too many stocks thereby unintentionally replicating an index fund exposure (which you can instead buy directly at a much lower cost)

Let us see what Steve Jobs has to advise us in this regard..

“In product design and business strategy, subtraction often adds value. Whether we’re talking about a product, a performance, a market, or an organization, our addiction to addition results in inconsistency, overload, or waste, and sometimes all three. A designer knows he has achieved perfection not when there is nothing more to add, but when there is nothing left to take away.”

So the first starting point is to set a boundary on how many funds you must have in your portfolio.

less-is-more.png

While there is no sacrosanct rule – I have personally kept a limit of maximum 4 funds in my equity portfolio.
(Usually 2-4 funds is the range I would like to work with)

The idea will be to have low overlap and diversify across styles (value, quality, growth etc) and market cap segments (small, mid, large).

This helps us to focus and not to be distracted by new shiny toys (hot themes, NFOs, recent performers etc) every now and then.

Choosing Categories..

Earlier there were no strict definition for the various categories of funds.

However, post the new SEBI ruling, fund categories have been clearly defined and all funds will have to stick to their category rules. This makes our job a lot easier as once we decide on the categories we don’t need to worry on whether the funds will stay true to their category.

So let us evaluate the various categories and decide on categories which will make sense for us.

Pruning-e1504000020504.jpg

There are 9 categories under equity funds which way too high a number!

SEBI Equity Fund Categories .png

Source: Value Research

“If you give the consumers too much freedom, they are overwhelmed by choice and confusion. If you limit their freedom by too much simplicity, they feel constricted. The trick is selecting the right places to restrict consumer options.” – Steve Jobs

Since we have already restricted ourselves to less than 4 funds, I usually prefer the core funds of my portfolio not to have any restrictions in terms of which market cap segment to invest (across small, mid and large cap segments). I would rather let the fund manager decide wherever there is opportunity and to invest without any restriction.

Hence, multi cap category funds (which don’t have any market cap restrictions) will form the core of my portfolio.

Also if you notice, the categories Dividend Yield, Value/Contra have no clear cut definition – in other words for all practical purposes these are again multi cap funds.

I would also consider focused funds as a part of the multi-cap category as they also don’t have any restriction in investing across large, mid and small caps. Their only requirement is to keep the overall no of stocks to less than 30.

Also Large and Mid cap category while they have restriction of 35% minimum each in mid cap segment and large cap segment, still in reality will end up more or less similar to any other multi cap fund.

William-Shakespeare-quote-530x256.jpg

Thus Multi Cap Category funds for my selection process will include

  1. Multi Cap funds
  2. Large & Mid Cap Funds
  3. Dividend Yield Funds
  4. Value/Contra Funds
  5. Focused Funds

“We wanted to get rid of anything other than what was absolutely essential, but you don’t see that effort. We kept going back to the beginning again and again. Do we need that part? Can we get it to perform the function of the other four parts?” – Steve Jobs

Sector Funds will be eliminated..

To pick sector funds implies I need to do my analysis on what is happening in the sector, take a view on the various drivers of the sectors and most importantly time both the entry and exit into the sector. Too much of an effort and hence the lazy me has decided to give this category a skip.

Thus we are left with Large, Mid and Small cap categories.

Large Caps: Prefer Index funds instead

This is a space where I believe post the new classification norms, beating an index fund is going to become incrementally difficult.

Let me explain why..

  1. Going forward, new rules by SEBI make it compulsory to hold 80% of portfolio in top 100 stocks at all points in time – earlier since there were no agreed rules, the mid & small cap allocation was used to improve returns and used to be in the range of 10-30%. This gave funds an unfair advantage over pure large cap Nifty index against which they were compared. This advantage is reduced to the extent that they can take exposure to mid/small caps only upto 20%.
  2. Earlier the Nifty Index returns were reported without the dividend portion which meant the returns were understated by roughly 1%, giving an additional advantage for large cap funds to optically show out-performance. This advantage is no more available for funds as the new total return index includes dividends.
  3. The costs of large cap ETFs have dramatically come down, to the extent that they are almost free (they are available at 0.05%. Check here)
  4. In developed markets, evidence points out that the passive funds (read as index or ETF funds) have a clear advantage over active funds. Thus eventually as the Indian markets mature and gets more participants and wider tracking, it will become incrementally difficult for large cap fund managers to provide large out performance in the well researched large cap segment
  5. Ambit has done some research on this here and comes to the same conclusion
  6. Even a fund house (Edelweiss mutual fund) has acknowledged this and has reduced their expense ratios in large cap category. (source)

Thus given the above apprehensions I am doing away with this category.

Mid Cap Category and Small Cap Category: Will be used opportunistically when category valuations are attractive

Over the long run, the mid and small caps are expected to outperform the large cap category. However they will remain extremely volatile with severe ups and downs and valuations need to be taken into account while investing in this category. This will be our second and third category for fund selection.

Thus we will in effect have three categories from which to select funds:

  1. Multi-cap Category – 4 funds
  2. Mid Cap Category – 2 funds
  3. Small Cap Category – 2 funds

These 8 funds will be our universe from which we will be constructing our portfolios. Mostly as stated earlier, I will be working in the range of 2-4 funds picked from the universe.

Summing it up:

  1. Inspired by Steve Jobs, my philosophy of fund selection and portfolio construction – Focus and Simplicity
  2. I will limit the number of equity funds in my portfolio to less than 4
  3. I will have only 3 categories for my fund selection process
    • Multi-cap Category (core) – 4 funds
    • Mid Cap Category  – 2 funds
    • Small Cap Category – 2 funds

(to be continued)

In the coming weeks, I will discuss in detail my thought process on how I personally go about with my fund selection and portfolio construction.

Till then, keep rocking and happy investing as always 🙂

If you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 4500+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox. Cheers!

 

If in case you have any feedback, need any help regarding your investments, want me to write about something or discuss regarding job opportunities, feel free to get in touch at rarun86@gmail.com

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments