Category: Investing Insight

Investing insight to make you a better investor.

Index Valuations, Part II

In Part I of Index Valuations, we showed how the relative PE (price-to-earnings ratio) and PB (price-to-book ratio) of the NIFTY 50 and NIFTY MIDCAP 50 indices have varied over time. What would a portfolio that weighted each of these based on the relative valuation ratio look like?


Suppose, the relative ratio (R) = Ratio(MIDCAP)/Ratio(NIFTY)
Then, at the end of every month, re-weight the protfolio so that portfolio (S1) = R * NIFTY + (1-R) * MIDCAP, and
portfolio (S2) = (1-R) * NIFTY + R * MIDCAP

Ratio can either be PE or PB

PE based weights:
PE weights

PB based weights:
PB weights

It looks like:

  1. a portfolio with PB based weights is a lot less volatile than the PE based one.
  2. PB portfolio recovers much faster that the PE or plain-vanilla indices from deep drawdowns
  3. PB out-performs an equal weight portfolio

You can track and map this strategy to your portfolio using the PB weighted NIFTY/MIDCAP Theme.

Code and charts on github.

What is the right benchmark for funds owning US equities?

Some funds, the Parag Parikh Long Term Equity, for example, have a carve out for international (primarily US) equities. From a tax perspective, if a fund owns at least 65% of its portfolio in Indian stocks, it is treated as “Indian Equity Fund” for taxation – 15% short-term gains and 10% long-term gains (if held beyond one year). Otherwise, short-term gains (if held for less than 3-years) are added to your income and taxed at your marginal rate. So there is some advantage in packaging US stocks inside a an Indian equity fund. However, what is the appropriate benchmark in this case?

The PP-LTE Fund benchmarks against the NIFTY 500 TR index. But based on its portfolio, it should ideally be benchmarked against a 65/35 Indian Midcap/US Large Cap index. If you construct an Index with the M100 ETF making 65% of the portfolio and the rest allocated to the SPY ETF (tracking the S&P 500 index,) you will get an idea of the fund’s alpha/excess returns.

Parag Parikh Long Term Equity vs. 65/35 M100/SPY:

If you rebalance the 65/35 monthly, the LTE Fund’s annualized returns are 16.47% (Reg.) and 17.10% (Dir.) vs. the 65/35’s 15.30%. That’s excess returns of 1.8% for the direct plan, delivered to investors in a tax efficient manner, after all costs have been factored in. Another way to look at this is that even if the present management is replaced and investors do not have faith in the new one, they can just replace the fund with two ETFs and get almost to the same place.

Code and charts on github.

Most investors would be better off indexing

If you had invested in this fund in April 2006, would you still be invested in it?

Between 2006-04-03 and 2019-03-08 (13-years), SBI Magnum MIDCAP FUND – REGULAR PLAN – GROWTH has returned a cumulative 268.66% vs. NIFTY MIDCAP 100 TR’s cumulative return of 321.39%. Annualized returns are 10.96% and 11.96%, respectively.

A point of out-performance, a gallon of pain:

Between 2008-01-01 and 2013-01-01 (5-years), SBI Magnum MIDCAP FUND – REGULAR PLAN – GROWTH has returned a cumulative -27.09% vs. NIFTY MIDCAP 100 TR’s cumulative return of -1.54%. Annualized returns are -6.34% and -0.31%, respectively.

When it comes to discretionary active management, the problems are many:

  1. There are over 40 asset management companies. Almost all of them have a midcap fund. Almost all of them claim to be “value” investors.
  2. Value, as described in Graham And Dodd, cannot scale to the 10’s of thousands of crores that these funds collectively manage.
  3. So almost all funds are, at best, index plus a value and/or GARP and/or quality tilt.
  4. And occasionally, fund managers blow it. They hop over to other funds. Or retire.
  5. And occasionally, the investing style goes through a bad patch.
  6. And usually, the business of fund management (accumulating assets) wins over the profession of fund management (superior risk adjusted returns.)

There is no way that any investor can dodge all these minefields. So, the risk that a mutual fund investor takes = market risk + manager risk + style risk + capacity risk.

Investors should primarily allocate to index funds (take only market risk.) Actively managed discretionary mutual funds should be a niche.

Index Valuations, Part I

The NSE website has PE (Price to Earnings), PB (Price to Book) and Dividend Yields of indices going back a decade. Even though their methodology of calculating these has its drawbacks, they are consistently applied to all the indices. This makes an apples-to-apples comparison possible.

Here are the historical PE and PB ratios of the NIFTY 50 and NIFTY MIDCAP 50 indices:
NIFTY 50 Historical PE

NIFTY MIDCAP 50 Historical PE

And their relative ratios:
Relative NIFTY 50/MIDCAP 50 Historical PE

Relative NIFTY 50/MIDCAP 50 Historical PB

In the next part, we will explore if these can be used to time or switch between large-caps and mid-caps.

Code and charts on github.