Author: Arun

While picking mutual funds, the usual practice is to start with the past returns, run several consistency metrics, ratios etc and finally come up with some funds based on the ranking of all these parameters.

The only issue I find in this process is that the conviction on the chosen fund is predominantly derived from the returns.

Inevitably as funds go through periods where the particular investment style is not in favor and returns lag, our conviction gets tested. Not knowing what to do, we run the process again and replace the existing ones with a new set of funds. Rinse and Repeat.

This unfortunately becomes a perennial trap where we always end up replacing funds and the new ones again repeat the same pattern of not-so-great-performance.

The key problem here is

• All funds good or bad inevitably go through short term under performance
• The tough part is to differentiate between a good fund going through short term under performance which is temporary and a truly dud fund going through under performance which is permanent
• This means we need to derive some way beyond the numbers to derive conviction in the fund so that we can actually hold on to it during the tough times

So, I propose a slightly unorthodox yet intuitive way to pick funds where the priority will be to ensure that you develop conviction and trust in the process. This would help you to stick with the funds for longer periods and have a much better mutual fund investing experience.

So let’s dive in..

Fund selection process

My process will emphasize primarily on a combination of

1. Fund Manager first philosophy
2. Understanding Investment Style & Strategy
3. Communication
4. Emphasizing performance across market cycles

Fund Manager first philosophy

Every fund house will have its own version of – we have a strong investment process and there is no star fund manager culture followed here.

Personally, I don’t think we are there yet (at least in India) and believe a fund manager still remains the single most important determinant of the future performance of the fund. Think Warren Buffet, Charlie Munger, Howard Marks, Peter Lynch, Seth Klarman etc

So my first step would be to filter out a set of good fund managers from the available universe of 100+ fund managers.

But how do we find them if not for the returns?

Simple. Find the guy who has the highest incentive and resources to figure out a good fund manager and follow him.

Any guesses?

Who else, it is the asset management company!

Think about it, the entire business and success of an asset management company is based on the ability to provide superior returns over the long run. And they obviously know a fund manager plays the key and hence would have done all the due diligence to pick whom they think is the best.

Step 1: Creating a fund manager universe

So let us take the top 15 largest fund houses (based on equity assets) and assume that these guys would have done their homework right and picked a good fund manager to lead the team. So all the CIOs (i.e Chief Investment Officers) of these fund houses will get added to my universe.

1. HDFC – Prashant Jain
2. SBI  – Srinivasan
3. ICICI Prudential  – Sankaran Naren
4. Reliance  – Manish Gunwani
5. Aditya Birla Sun Life  – Mahesh Patil
6. Franklin Templeton – Anand Radhakrishnan
7. UTI- Vetri Subramaniam
8. Kotak Mahindra  – Harsha Upadhyaya
9. DSP – Vinit Sambre
10. Axis – Jinesh Gopani
11. L&T – Soumendra Nath Lahiri
12. Sundaram – Krishnakumar
13. IDFC – Anoop Bhaskar
14. MOSL – Gautham Sinha Roy
15. Mirae Asset – Neelesh Surana

Source: http://www.thefundoo.com/Tools/AMCDashboard

Let me add two other fund houses which while small in size communicate extremely well and hence it is easy for us to understand their process

16. PPFAS – Rajeev Thakkar
17. Quantum – Subramaniam

Also the other source which I like to consider for identifying good fund managers is Morningstar qualitative rating. They do a decent job and I will consider all the Gold and Silver rated fund managers. You can check here

• Gold rated – Sankaran Naren, Prashant Jain, Anand RadhaKrishnan
• Silver rated – Roshni Jain (Franklin Templeton), Vikas Chiranewal (Franklin Templeton), Neelesh Surana, Jinesh Gopani, Sailesh Raj Bhan (Reliance MF)

So we add 3 more fund managers as all others are already included

18. Roshni Jain (Franklin Templeton)
19. Vikas Chiranewal (Franklin Templeton)
20. Sailesh Raj Bhan (Reliance MF)

Good, that’s a total of 20 fund managers to start with..

Step 2: Mapping fund managers on the investment style spectrum

Most of the fund managers investment style can be classified as value or growth or blended (i.e mix of both)

Now in order to classify the above fund managers, we need to check if they communicate about their style and investment strategy.

Let us eliminate fund managers who don’t communicate regularly on their website or public forums.

Now to be honest since I work for a large firm I get access to all of them and can get to understand their styles and strategies better. Also this is extremely helpful if there are any concerns on under performance as I can immediately get in touch and get a clear idea on what the fund manager is thinking. But I am ignoring this bias of mine since most of you won’t have access and the only way you can develop conviction is if they themselves communicate about their process and investment style.

Also we are currently trying to pick only for our multi-cap universe and hence we will ignore large, mid and small cap fund managers

So I am eliminating the below fund managers based on the basis of insufficient communication (i.e they don’t communicate well enough on their style and process via publicly available resources)

1. Reliance – Manish Gunwani
2. Reliance – Sailesh Raj Bhan
3. Aditya Birla Sun Life  – Mahesh Patil
4. Franklin Templeton – Anand Radhakrishnan
5. Franklin Templeton – Roshni Jain
6. Franklin Templeton – Vikas Chiranewal
   
7. Kotak Mahindra  – Harsha Upadhyaya
8. L&T – Soumendra Nath Lahiri
9. Sundaram – Krishnakumar
10. Mirae Asset – Neelesh Surana

Further, I am eliminating the below fund managers since they manage only mid & small cap strategies

1. DSP – Vinit Sambre – Communication is good but a mid and small cap focused fund manager
2. SBI  – Srinivasan: A mid and small cap focused fund manager + no clear communication in the website

If there are some managers who communicate well and yet I have left out in the list do let me know with the source link.

This leaves us with 8 fund managers and their respective funds:

1. HDFC – Prashant Jain – HDFC Equity Fund
2. ICICI Prudential  – Sankaran Naren – ICICI Prudential Large & Mid Cap
3. PPFAS – Rajeev Thakkar – Parag Parikh Long Term Equity Fund
4. Quantum – Subramaniam – Quantum Long Term Equity Fund
5. UTI- Vetri Subramaniam – UTI Value Fund
6. IDFC – Anoop Bhaskar – IDFC Core Equity Fund
7. Axis – Jinesh Gopani – Axis Focused 25
8. MOSL – Gautham Sinha Roy – MOSL 35

Now we will have to fit them along the growth-value spectrum

Lets first fill the value bucket first..

1.HDFC – Prashant Jain – HDFC Equity Fund

What is his investment style?

• Early identification of a cycle: He believes that the Indian market operates on the basis of cycles with clear sector leadership and positions himself ahead of a cycle
  • 1995-2000: Infotech was the sector leader
  • 2001-2007: Capex, Banking, Commodities
  • 2008-2015: FMCG, Pharmaceuticals, Automobiles
  • Going forward: Positioned for cyclical recovery via Infra/Banking/Capex
• Contrarian and Value Bias
• No cash calls
• Large cap bias
• Buy and Hold investing – has a low portfolio churn

Source: https://www.morningstar.in/posts/39930/prashant.aspx
Source: https://www.morningstar.in/posts/44081/conversation-prashant-jain.aspx

Wow factors:

• Value investing or early cycle investing means you will have to be ready to go through short term pain.
• Both the fund manager and the AMC must be patient enough to let such a style run its course
• Any new fund manager had he taken the same call  (of being overweight cyclicals and corporate banks) would have been out of job by now
• In Prashant Jain’s own words – “The nature of a fund manager’s job is such that performance tends to be volatile particularly over short to medium periods. Further, given the relative nature of performance measurement, it is virtually impossible for a majority of managers to do well at any point of time. This, and the short-term focus of many market participants, could be important factors for the short tenures of mutual fund managers.”
• So I think the biggest edge of Prashant Jain is behavioral – his conviction to stick with his call and the patience to ride short term pain
• Given his long term track record, thankfully the AMC is also supportive of this style

Performance across market cycles

• Historically he has been able to stay out of both the tech bubble of 2000 and Infra bubble of 2008 and has a proven long term track record of performing across cycles (19% CAGR for HDFC Equity vs 11% for Nifty 50 TRI for the 23 year period from Jan-95 till 29-Jul-2018)

Concerns

1.Fund size is very large

• He manages two funds HDFC Top 100 and HDFC Equity and both have an overlap of 73% (check here)
• The size of HDFC Top 100 is Rs 14,376 cr while HDFC Equity is Rs 20,352 cr. Also the balanced fund that he manages is 36,500 cr (of which 70% is in equity =  ~Rs 25,500 cr)
• So he is in effect managing a whopping Rs 71,000cr in equity
• It has been globally proven that a large fund size is detrimental to returns
• Now the million dollar question is “What exactly is that large size?”
• His historical arguments have been that “You guys are making a big deal about size. Internationally, these kinds of situations arise when the size of a fund reaches say 1 percent of the market. Why should I get worked up about size when my fund is around 0.12 percent of the market? The Indian markets are growing and as the size of my fund grows, the market will be even bigger”
• Unfortunately since there are no formulas available to capture the size at which the fund performance will get impacted, we need to trust the fund manager or the AMC to close inflows when size becomes large
• Their mid cap fund HDFC Mid Cap Opportunities is a whopping Rs 20,000 cr and also the largest mid cap fund (the next largest being 1/3rd of the size at ~7000 cr) – this implies possibility of a liquidity risk (i.e not being able to sell off their holdings if investors suddenly redeem) and also taking meaningful exposures becomes difficult as explained in the article here
• Despite a lot of mid and small cap funds shutting their inflows at sub 5000 cr levels, HDFC Mid Cap Opportunities continues to be open for inflows
• Now while its difficult to pass a judgement whether this is right or wrong, I am not getting the confidence that they would close their funds when size becomes an issue
• He is currently addressing the size issue via concentrated positions (Top 10 stocks account for 60% of the entire portfolio) and higher exposure to large caps

2.Higher large cap exposure

• Given the large size, there is large overlap with the large cap index – ~40% overlap
• In my view, out performance in the large cap space will become incrementally very difficult as the segment is tracked widely and hence the possibility of informational arbitrage is very low here (compared to mid and small caps)
• Only behavioral edge can produce out performance i.e positioning early in the cycle and riding through short term pain – which is exactly what he is attempting

Communication:

• The investment style of the fund is well communicated via their presentations available in their website
• A lot of public interviews and videos are available
• Further, morningstar which has a gold rating on him also takes extra efforts to explain his philosophy and his current bad patch as seen here and here

My view:

• This fund will fit perfectly in the value end of the style spectrum
• There is a good possibility that the fund will have one or two years of sharp out performance if his call of cyclical recovery starts playing out
• However, size at some point of time will become an issue
• Unfortunately, going by recent evidence (in HDFC Mid Cap Opportunities) I am not sure if they would let us know when that happens
• Since I am on the lookout for a fund which I can stay invested for a long time (say 5-10 years), I am giving it a skip despite my high regards for the fund manager considering possible size constraints

2.ICICI Prudential  – Sankaran Naren – ICICI Prudential Large & Mid Cap

Let me start with a honest confession. Out of all the fund managers I have ever met, I have learned the most from his interviews (be it the private ones via my organization or public ones). So I will be extremely biased and hence do take my views on Naren with a pinch of salt.

What is his investment style?

I have a done a extremely detailed post on Naren here which will help you understand his investment style better.

Click here for the short snapshot

Also here is the recent interview which you must not miss – Link

Wow factor:

1. 27 years of Market experience covering 3 cycles
2. 13 years of fund management experience
3. Robust long term performance track record
   
4. Consistent Investment Style  = Value investing + Contrarian + Evaluating Cycles + Top Down (using the big picture to arrive at stocks to invest in) + Bottom Up
5. Macro overlay + takes advantage of cycles
6. Knowledge of credit markets and credit cycles – its interplay with equities
7. Ability to withstand and stick to investment process during occasional periods of short term under performance
8. Widely read
9. Investment Gurus – James Montier, Howard Marks, Michael Mauboussin
10. Deploys checklists for investing – inspired from Atul Gawande’s Checklist Manifesto
11. Communicates strategies and thought process regularly on public forums (making our lives a lot more easier)

Concerns:

• The AMC has too many funds – more bordering on the asset gatherer types – especially had too many funds launched under their closed ended series
• Signs of corporate governance issues at the AMC: Securities and Exchange Board of India (Sebi) has found that ICICI Prudential Asset Management Co. (AMC) Ltd bailed out the ICICI Securities Ltd initial public offering (IPO), and short-changed its unitholders in the process. Read here
• There were some other questions raised by a site called Mutual fund critic here and here (while not a game changer, nevertheless it needs to be noted)

My view:

• While there are some concerns on the AMC, I have a strong conviction on the integrity of the fund manager
• Here is some support for my conviction from a very experienced and popular blogger Mr Subra in his blog Subramoney – Link: In defense of Naren
• Naren’s experience and stature allows him the rare luxury to take near term pain and stay patient till the contrarian call plays out (which a lot of new fund managers will never have as the short sighted industry won’t let him/her survive)
• I have high regards for him and I believe having his fund is one of the best ways to play the contrarian + value style in your portfolio

3.PPFAS – Rajeev Thakkar – Parag Parikh Long Term Equity Fund

• Value Investing – buy an investment at a discount to its true value – applies to high growth companies, low growth companies as well as declining companies
• Buy and Hold (reflected in low churn)
• Concentrated Portfolio (<20 stocks)
• Agnostic to geographies: 1/3rd portfolio in global companies
• Not averse to taking cash positions if opportunities are not available

• High Conviction – The entire fund house just has one single fund – and this single fund runs a concentrated portfolio of around 20 stocks. So all the resources will be focused on this single fund and shows their conviction and belief. This is a welcome change from the majority of AMCs where they have several funds running different strategies so that at all points in time there will be one fund or the other performing.
• Skin in the game – their own employees own around 10% of the scheme
• Simple to track – as there are only 20 stocks and churn is low
• Clear communication – These guys are way ahead of the industry and have phenomenal transparency in communicating their views and process. They have a good youtube channel (link) where the fund managers regularly communicate their views and also their annual investor meeting is available where they talk about the investment thesis behind their stocks
• Exposure to global stocks – The fund provides diversification via 1/3rd exposure to global stocks

Performance across market cycles

• The fund was launched in Jun- 2013 and has returned around 18.5% vs 15.5% in Nifty 500
• Earlier it was running a PMS where it had returned 15% vs 13% in Nifty for the 17 year period between Nov-96 and Dec-13. This is very low compared to other good funds such as HDFC Equity (26%) , Franklin India Bluechip (25% CAGR) etc

Concerns

• While intent and integrity is unquestionable, the past performance of their PMS over the long run has been very mediocre relative to other decent funds
• However in their new fund avatar, their performance has been very good till date
• They take large cash calls which might be a drag on their returns at some point in time

My view:

• Personally, I like the fact that they have skin in the game, one single fund showing their conviction and they communicate extremely well allowing me to develop a high conviction on them
• Global exposure is an added advantage
• I don’t expect them to do well in a raging bull market and mostly their returns will be decent over a complete market cycle (as they fall less in a down market)
• Their cash calls might be an issue in the longer run
• I personally like the fund and would add it to the “value” end of the style spectrum

4.Quantum – IV Subramaniam – Quantum Long Term Equity Value Fund

What is his investment style?

• Value Investing
• Buy and Hold (reflected in low churn)
• Concentrated Portfolio (25 to 40 stocks)
• Not averse to taking cash positions if opportunities are not available
• Large cap bias

You can read about their entire process here

• High Conviction – The fund house technically has single diversified equity fund (ignoring the fund of fund and ELSS) runs a concentrated portfolio of around 25-40 stocks. So all the resources will be focused on this single portfolio and shows their conviction and belief.
• Simple to track – as there are only 25-40 stocks and churn is low
• Communication is decent – earlier it used to be much better when their founder Ajit Dayal was in charge (he quit recently)
• Ability to stick to their process in the face of short term under performance (read here)

Performance across a market cycle

• The fund was launched in Mar- 2006 and has returned around 14.4% vs 11.7% in Sensex
• In the ~7 year period between Jan-2008 and Aug-13, which was one of the toughest investing environment for fund managers, the fund was the top performing fund amongst its peers with 4.5% CAGR compared to Sensex returns of -1%

Concerns

• Their founder Mr Ajit Dayal has recently quit the firm (while a process has always been emphasized I generally take it with a pinch of salt)
• They take cash calls which can be a drag on their returns

My view:   

• Personally, I like the fact that they have they have one single fund showing their conviction and they communicate reasonably well
• I don’t expect them to do well in a raging bull market and mostly their returns will be decent over a complete market cycle (as they fall less in a down market)
• Their cash calls might be an issue in the longer run
• My primary concerns are with two things – 1)Ajit Dayal moving out and 2) predominantly Large cap biased portfolio (more a personal choice as I would want a fund which is flexible to take mid cap exposure when valuations are attractive)
• The fund would fit into the “value” end of the style spectrum
• While I like the fund, I would give it a skip as Rajeev Thakkar and Naren’s style is very similar in nature and also they have far more flexibility in moving across mid and small caps

Now don’t get too fixated by the final choice of funds but rather focus more on the thought process and gradually you can evolve your own process. Remember, there are no sacrosanct rules to pick funds and you can pick any fund based on your own parameters.

The real idea is to go beyond returns and identify funds/fund managers where you can derive conviction based on better understanding of their investment process and style. This will allow you to patiently stay with the fund across a market cycle and reap the benefits.

(to be continued…)

In the coming weeks, I will fill the other two buckets – Growth and Blend. Then I will build a live SIP portfolio where I will be investing my own money for the next 5-10 years.

This post is my little attempt to create happy investing experiences to each one of you. 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!

Stay blessed and happy investing folks!

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

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

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..

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.

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)

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

DSP Blackrock Small Cap Fund

Canara Robeco Emerging Equities Fund

IDFC Sterling Value Fund

Aditya Birla Sun Life Pure Value Fund

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

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.

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..

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.

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.

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! 

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.

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.

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

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.

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

Selecting a decent equity mutual fund to build a portfolio was always confusing and difficult.

Unfortunately, in recent times, there have been certain changes due to which fund selection has become even more difficult.

Let us explore each of these in detail and also find out if there is a way out of this mess.

Problem No 1: Fund Managers and the game of musical chairs

In last few years, thanks to the bull market, a lot of fund managers have moved across fund houses and a few of them have even moved out and opened their own investment firms.

Sample this:

• Kenneth Andrade who was the CIO of IDFC Mutual Fund left in 2015 to start his own Investment firm Oldbridge Capital
• Anoop Bhaskar replaced him as he moved from UTI to IDFC in 2016.
• Vetri Subramaniam (earlier the CIO in Invesco Mutual Fund) in turn replaced Anoop Bhaskar as the CIO in UTI
• Taher Badshah who was the fund manager at Motilal Oswal has replaced Vetri Subramaniam as the CIO of Invesco mutual Fund
• Pankaj Murarka who was the head of equities at Axis Mutual Fund quit to start his won firm Renaissance Investment Managers
• Sudhanshu Asthanah who was a senior fund manager in Axis Mutual fund quit to start his own firm Tamohara Investment Managers
• Shreyas Devalkar – the fund manager in BNP Paribas Mutual Fund has moved to Axis Mutual Fund
• Gopal Agrawal, the CIO of Mirae Asset Mutual Funds quit to join Tata Mutual Fund – Now recently a Gopal has also quit Tata Mutual Fund!
• Vinay Paharia – the fund manager in Invesco left to become the CIO in Union KBC Mutual Find
• Ravi Gopalakrishnan – head – equities, resigned from Canara Robecco Asset Management Company
• Sunil Singhania, the CIO of Reliance AMC also quit last year to start his own firm – Abakkus Asset Manager LLP
• Manish Gunwani a fund manager at ICICI Prudential Mutual Fund quit to become the CIO in Reliance Mutual Fund
• In DSP Blackrock Mutual Fund there have been a lot of changes in recent years
  • Anup Maheswari the CIO quit recently
  • S. Naganath, the erstwhile president and chief investment officer at the fund house left in May 2017
  • Apoorva Shah, the previous fund manager also moved out of the domestic mutual fund unit to the fund house’s offshore division

Phew, my head is already spinning 🙂

Anyway the simple point is that, for most of the funds where the fund manager has changed, the existing track record becomes irrelevant while choosing the fund.

The fund houses will (obviously) argue that they have a robust investment process and a change in the fund manager will not have an impact, but I think it would be extremely naive of us to believe that.

All said and done, in my opinion, a fund manager is the biggest factor responsible for the returns from a fund. (Think Warren Buffet,  Charlie Munger, Ray Dalio, Howard Marks, Seth Klarman, Peter Lynch etc)

Problem No 2: SEBI and its new fund categorisation rules

In the recent past, the regulator The Securities and Exchange Board of India (SEBI) had rightly come to the conclusion that Asset Management companies had too many funds and there was no common definition for categories leading to significant confusion while selecting funds for investors.

So in October 2017, SEBI, called for the rationalization of mutual fund schemes and defined various categories of funds, along with the scheme characteristics for each fund category. (see circular for categorization and rationalization of mutual fund schemes).

It brought down the list of categories under equity mutual funds to 10.

Source: FundsIndia

And to avoid duplication, SEBI has also mandated that each fund house can have ONLY ONE scheme in each category.

As a result of the above changes, many mutual fund schemes are either being renamed, recategorized or merged/ terminated. This whole revamp is expected to get completed by June-18.

If interested, the summary of the entire changes can be found in Funds India website here

Thus adding to our existing problem of several fund manager changes, the recent SEBI fund re-categorization, has also made the historical returns of several funds (where there is a dramatic change in mandate) irrelevant.

Thus if you are someone who picks funds only based on past performance or other quantitative metrics then please remember that for many funds the past returns and metrics may not be relevant anymore.

Also I have earlier discussed here and here as to why past returns are not a great way to pick funds. I usually check for

1. Consistency in performance across market cycles versus peer group and benchmark
2. Downside risk via capture ratios
3. Fund Manager – do I understand the investment philosophy, process and does he/she stick to it

Given the context of recent changes, consistency and downside risk measurement based on past returns would be irrelevant for many funds going forward.

Thus the key to select funds will be to understand the fund manager, his investment philosophy, investment process, ability to stick to his process and track record.

Herein lies the third problem..

Problem no 3: Lack of communication

Unfortunately unlike the global fund managers, the level of fund manager communication in India via (newsletters, memos, updates etc) is extremely poor or rather non-existent. The only source for normal investors is their public interviews.

However, majority of the fund manager interviews in public magazines and websites are literally indistinguishable from each other.

Barring a select few, most of the interviews are a common script which will include a mix of fancy words such as – high quality business, decent cash flows, decent ROEs, scalable opportunity, sustainable competitive advantage, pricing power, right to win, reasonable valuation, growth, top down, bottom up, good management blah blah

If you don’t trust me, you can check a collection of interviews here..

• https://www.morningstar.in/posts/collection/interviews.aspx
• https://www.valueresearchonline.com/story/archive.asp?sec=62

This essentially means its a struggle from our side to find out what is the underlying investment process and philosophy. So if in case the fund under performs in the interim (which eventually happens), there is no way we will be able to hang on with conviction.

And unfortunately as evidenced by this vanguard study in the US (click here to read the study), even the best funds went through under performance vs their benchmark in at least five years of the 15 year period for which the study was conducted, and 60 percent had at least seven years of under-performance. Further two-thirds of them experienced at least three consecutive years of under-performance during that span.

This implies even good Indian fund managers will inevitably go through periods of temporary under-performance where their style is out of favor or they make some mistakes.

Lack of  communication on what is happening implies we will bail out of the fund as returns are the only parameter communicated to us!

Oops! We have a huge issue..

Thus for all of us looking to pick a few funds and build our equity portfolio we have three issues

1. Significant fund manager changes in recent times
2. SEBI’s new scheme re-categorisation leading to change in mandates for many schemes
3. Lack of communication from fund managers

Not all is lost..

While I have painted the whole industry with a broad brush on the lack of communication, there are a few exceptions where the communication has been good or has started to improve in recent times

1. PPFAS : These guys are by far the best and are way ahead in terms of their communication
   • You tube channel where they discuss various insights on behavioral finance, industry trends, investment process etc  https://www.youtube.com/user/ppfasltd/featured
   • They have an annual shareholder meet where they discuss their portfolios: https://www.youtube.com/watch?v=hrRLx-s1xsg
2. Motilal Oswal : They have a good website and have clearly communicated their process
   • https://www.motilaloswalmf.com/blogs/chairman-speak
3. DSP Blackrock: Recently the level of communication from the fund house has significantly improved
   •  Fund and Strategy communication: Insights
   • A detailed note on DSPBR Opportunities fund: Link
4. Quantum: While the website is a little clumsy and outdated, you can find decent communication about their process
   • https://www.quantumamc.com/
5. IDFC: Recently the communication has improved. Especially on their flagship product – IDFC Core Equity Fund (Link)
6. ICICI Prudential Mutual Fund – The details on the website is still not that great. But there are frequent interviews of the CIO Sankaran Naren from which we can get a sense of their investment philosophy and process
   
   • You can check my earlier post on this here
7. UTI: Again a recent move in terms of improving communication
   • https://www.utimf.com/articles/?filter-type=category&filter-value=blog

So while fund selection has become more complicated, the fact that some fund houses are improving their communication means we can still work around and build our portfolio.

In my next post I will explain my thought process on how I would go about selecting funds for my portfolio.

Till then, 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 4300+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox. Cheers!

When I entered the investment world, I had a simple wish – to figure out how to enter exactly before a bull market, ride the wave and get out at the top.  Once I figure this out, I will be rich and can spend the rest of my life whiling away on the shores of some exotic beaches.

Let me take you through my journey in search of the holy grail..

Someone somewhere should have figured it out..maybe the mutual funds

I started with the logic that “If market timing was possible, someone somewhere must have figured it out”. My job is to figure that someone, somewhere.

In India, who do you think will be the most interested in solving this problem?

While all of us would obviously want to know the answer, the mutual fund industry has the highest incentive to figure this out as their entire business is based on providing returns.

Sample this – the top 3 mutual fund companies – HDFC, ICICI Prudential and Reliance make a profit of above INR 500 cr each.

This means they have enough money to subscribe to the best of research, tools, technology and hire the best of the brains.

Here is a sample of what the industry was paying its fund managers in 2016

Good. So hiring talent wouldn’t be an issue.

Most of the fund managers are very experienced, have great long term track records and have spent a long time figuring out processes to make money in the stock markets.

So logically someone from the mutual fund industry should have figured it out right?

Going back to 2007 – just before the 50-60% crash due to the global sub prime crisis.

Prashant Jain – HDFC Mutual Fund (26-Nov-2007)

Do you see a market crash in the near future?
In my opinion, a “crash” is probably too strong a word for the Indian market. But a correction can never be ruled out. It is true that the Indian market is somewhat expensive, but it offers a unique combination of size and growth. Global investors are increasingly looking at India as a mainline asset class and are therefore, investing with a long term view. If you look at Indian P/E’s of nearly 20, 15-20 per cent earnings growth, interest rates of 4-6 per cent prevailing outside India and an appreciating currency, then Indian P/E’s still look reasonable. India is somewhat expensive compared to the past and to the prevailing interest rates locally. But when viewed in the global context and in view of improved size, fundamentals and visibility of the Indian economy, the market does not appear to be unreasonably valued.

Source: Link

Mahesh Patil – BSL MF (28-Nov-2007)

Do you see a market crash in the near future?
I don’t see a major market crash in the near future. The long term trend is still up. However, after the smart rally we have seen in the last few weeks, one can expect a short correction of about 5-7 per cent in the near future.

Source: Link

A Balasubramaniam – Birla Sun Life AMC (24-Dec-2007)

Do you see a market crash in the near future?
During the recent run up of the market, post the US Fed cutting the Fed rate, we have seen the CNX MidCap under perform the larger indices. This has resulted in an increase in the valuations gap between large- and mid-caps. We analysed the results of all manufacturing companies in the BSE 500. We saw sales rise by 24 per cent while PAT grew by 70 per cent on year-on-year basis. Given the lower the inflation and a softer interest rate regime, we expect the coming quarters to go quite robust. This would widen the valuations gap between large- and mid-caps further. Hence we believe mid-caps would be very attractively valued.

Source: Link

Birla Sun Life AMC Factsheet (31-Dec-2007)

Investors have now started worrying about a possible US recession and the consequent impact on the emerging markets including India. We believe that a near recessionary US economy is unlikely to have as significant an impact on emerging markets as in the past. Indian economy, is resilient to the impact of any potential US slowdown (domestic consumption driven and low export-to-GDP ratio at about 15%). India has diversified its exports base – commodity and country wise – share of US exports now stands at 15% of India’s total exports from 22.8% in FY2000. Research indicates that for every 1% fall in GDP growth in the US, India’s growth will only be affected by 0.25%.

We believe India is entering a period of increased stability with limited impact on growth. India’s level of trend growth is expected to be sustained at  8% plus, due to  improved  macroeconomic stability, liberalization in a number of key areas and gradual improvement in infrastructure.”

Srividhya Rajesh – Sundaram AMC (6-Dec-2007)

Do you see a market crash in the near future?
While we are of the opinion that there may be a bubble (in terms of valuations) being formed in the market, we do not forsee it being pricked in the near future. Given the global liquidity conditions, we expect the bubble to last longer.

Source: Link

Anand Shah – ICICI Prudential AMC currently the CIO of BNP Paribas Mutual Fund (20-Dec-2007)

Do you see a market crash in the near future?
The rise is the reflection of very strong GDP growth rates in the last three years and expectation of the same being sustained in the foreseeable future. We believe that strong earnings growth of India Inc will sustain going forward and thus market valuations are reasonable on a one-year forward earnings basis. Also, the balance sheet of India Inc is stronger then ever. We are of the opinion that the market might remain volatile in times to come, however a market crash is unlikely.

Source: Link

ICICI Prudential AMC Factsheet (31-Dec-2007)

As we step into 2008, Indian economy seems to be in fine shape, more capable of handling global slowdown than many peers. Globally, subprime related issues are resulting into credit squeeze. Banks are worried to carry out normal borrowing and lending amongst each other. ECB and US Fed are pumping liquidity to ensure that credit squeeze does not result into recession. Our feel is that with minor hiccups central banks world over will be able to stimulate global economy with series of rate cuts, pumping of liquidity and pro-growth statements.

Indian economy aided by domestic growth is likely to be an oasis of growth among the global desert. Q3FY08 results are likely to be in line with market expectations, except for some treasury gains or losses which are difficult to forecast. Big queue of IPOs and QIPs expected in 4QFY08 will keep up the supply pressure and also maintain momentum. FIIs, after turning sellers of Indian equities in 3QFY08 will have to think twice before selling in 2008. Chinese markets are running at higher valuation than Indian markets and as long as that gap is maintained, there is not much worry on the de-rating of Indian valuations. The domestic investors led by retail, insurance companies and mutual funds are taking lead over FIIs in articipating in Indian equities.

Net-net, the outlook for Indian equities in 2008 seems to be positive on the back of:

• Economy, which is likely to grow above global average based on domestic factors
• Valuations which are at premium over other EMs but at discount to China H share market
• Domestic investors now stepping up to take lead over FIIs

Thus, despite the mutual fund companies having the best of intentions, best of brains, great long term track record, enough money to deploy the best of technology and vast research resources –

Yet, none of them were able to predict the short term!

Maybe your wealth manager..

The notion before joining my organization (a reasonably large and reputed wealth management firm currently handling around 10,000 crs in AUM) was that, “Hey, here are these guys advising the richest of the richest. Obviously they must be knowing the secrets to make quick money. Let me figure this out and get my life sorted!”

7 years down the line, after having the fortune to have interacted with some of the best investment minds, getting to work along with some of the largest family offices,  figuring out what the other wealth managers are upto and doing all permutation and combinations of trying to figure out a precise timing model, I realised –

None of us can predict the short term!

Maybe Mr Warren Buffet

Here is a man who is currently the second richest in the world!

He has a 52 year track record of compounding at 21%!

He reads 500 pgs every day!

He is accompanied by yet another genius – Charlie Munger!

And yet they too weren’t able to time their way out during a correction and had to go through several corrections – 49% down in 1974, 23% down in 1990, 20% down in 1999 and 32% down in 2008!

Oops! Even Warren Buffet and Charlie Munger can’t predict the short term!

Maybe the other popular global fund managers..

Prem Watsa referred to as Canada’s Warren Buffet:

While his hedging of equity portfolio made a killing in 2008, he has been quite wrong for several years since 2010-2016 post which he took a U turn on his call and removed all his hedges.

March, 2010: “Our reading of history—the 1930s in the U.S. and Japan since 1990—shows in both periods nominal GNP remained flat for 10 to 20 years with many bouts of deflation.”

March, 2011: “Even onions and chilis went up 64% and 38% respectively in 2010!! We shy away from parabolic curves, so we continue to maintain our equity hedges!”

March, 2012: “Ben Graham’s observation that ‘only 1 in 100 survived the 1929-1932 debacle if one was not bearish in 1925’ continues to ring in our ears!”

March, 2014: “While it is very painful and costly waiting, we think your (and our!) patience will be rewarded.”

March, 2015: “While the deflation derivatives are very volatile, if we are right, these derivatives may become as valuable as our CDS derivatives became in 2007/2008.”

March, 2016: “We have warned you many times in our Annual Reports of the many risks that we see and the great disconnect between the markets and the economic fundamentals. These risks may be coming to a head in early 2016, as I write this Annual Report to you—right out of the blue!”

Howard Marks in one of his recent memos

“The memos that have raised yellow flags in the current up-cycle, starting with “How Quickly They Forget” in 2011 and including “On Uncertain Ground,” “Ditto,”and “The Race Is On,” also clearly were early, but so far they’re not right (and in fact, when you’re early by six or more years, it’s not clear you can ever be described as having been right).

Since I’ve written so many cautionary memos, you might conclude that I’m just a born worrier who eventually is made to be right by the operation of the cycle, as is inevitable given enough time. I absolutely cannot disprove that interpretation. But my response would be that it’s essential to take note when sentiment (and thus market behavior) crosses into too-bullish territory, even though we know rising trends may well roll on for some time, and thus that such warnings are often premature.

I think it’s better to turn cautious too soon (and thus perhaps  under perform for a while) rather than too late, after the downslide has begun, making it hard to trim risk, achieve exits and cut losses.”

Other famous investors such as Jeremy Grantham, John Hussman, Seth Klarman, Bill Gross and James Montier etc have all sounded the warning bells in the last few years which is yet to play out.

These are some of the best guys, who had navigated the earlier sub prime crisis and dot com bubble successfully. Even these guys as seen above haven’t been able to get the direction of the market right in the short run.

Simply put, predicting what the markets will do in the short run is hard, in fact damn hard and almost impossible to do on a consistent basis. You can be amongst the best investors with a superb long term track record and yet the short term is still too random to predict.

Most of these experienced investors realize this and usually take calls which work over a longer time frame and look at producing reasonable returns over a complete market cycle (i.e periods covering both ups and downs).

Their intent is not to predict the future, but to evaluate the risks and margin of safety in the present scenario and correspondingly adjust their portfolios. This implies going through a period of pain where they look wrong and the key is to have the patience and conviction to stick to the decision which is far easier said than done.

If this is the case for the best investors, then we need to realize the fact that the utopian world where we don’t fall but yet capture the equity returns upside is extremely difficult pull off on a consistent basis. Or to be honest, I would put it as wishful thinking.

How do we deal with this?

This brings us to the uncomfortable question, if experienced investors find it this difficult then then how do we normal investors deal with this uncertainty.

My answer is simple – we accept corrections as a part of life rather than trying to avoid them.

And hence, the maximum extent of decline which we are ready to accept will decide our equity exposure.

Here lies the proof of the pudding – Indian fund managers despite their inability to predict short term returns have had a phenomenal long term track record.

So lets wrap our heads around this new perspective of actually facing the corrections rather than trying too hard to completely avoid them

• Equity market is all about faith: Equities in the long run is basically a bet on human progress. You are simply betting that entrepreneurs (who take higher risks) on an aggregate will get compensated with higher returns
• Market corrections are not a bug but a feature – and it is next to impossible to predict when the next one is coming, how steep the decline would be and how long it will last
• It is prudent to assume that our equity portfolios will go through a 30-50% decline at-least once in every decade
• 10-20% corrections should be expected to be a regular affair
• It is ok to realise that you wont be able to predict the fall and in fact you don’t need to predict the fall to create long term returns
• The way you behaviorally respond to a fall (which is completely under your control) is all that matters for your long term returns
• Now if you won’t be able to handle a decline of such an extent, it is better to reduce the equity allocation correspondingly and use a combination of equities and debt
• A plain vanilla, disciplined re-balancing strategy to maintain your equity allocation on top of this is a simple yet effective strategy
• While short term is still too random, taking a slightly longer view – as witnessed from the best of investors its possible to develop some reasonable and approximate estimates on expected equity returns (based on mean reversion in valuations and profit margins)
• You can check out my framework to estimate 5-7 year returns here
• If the estimated return environment is extremely low, you can focus on reducing overall risk (avoiding overvalued segments and practicing adequate diversification)
• Also remember that valuations are an indicator of risk and not a precise market timing tool – so if you are under weighting based on valuations, the actual time taken for the risk to manifest (based on the catalyst) is anyone’s guess. So be prepared to have the conviction and patience.As Keynes mentions – The market can remain irrational longer than you can remain solvent

• Overall a simple asset allocation + re-balancing + lower costs + long time frame + focus on risks + faith in equities + sticking to the plan = good enough investment returns
• And repeat “No one can predict the short term returns”

This is an evolving framework and would love to hear your thoughts. Do you think it is possible to time the markets?

If you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 3500+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox. Cheers!

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