Category: Investing Insight

Investing insight to make you a better investor.

The Problem with Dynamic P/E Funds

shyam September 26, 2015

Executive Summary

Dynamic P/E funds use the market Price-to-Equity ratio to decide on allocation. If the P/E ratio is deemed too high, they allocate more to bonds or arbitrage strategies and if the P/E ratio is low, they allocate more towards equities. This logic sounds good on paper. However,

The market always appears expensive around turnarounds – investors miss out on the recovery trade.
The market always appears cheap during downturns – investors end up being long equities when bonds tend to outperform.
It doesn’t protect against volatility as a pure-play bond fund would (bad fit if you are risk-averse.)
It doesn’t give you the returns of a pure-play equity fund (bad fit if you are risk-seeking.)
Since it dampens volatility, it doesn’t make sense to dollar-cost-average (bad fit if your looking for an SIP.)

It is a solution looking for a problem.

Analysis

We thank Franklin Templeton for running the Dynamic PE Ratio Fund Of Funds to perform our analysis. This is probably the only fund where a true apples-to-apples comparison can be made between a pure-play equity fund, a pure-play bond fund and a dynamic PE fund.

The Dynamic PE fund invests x% in the Franklin India Short Term Income Plan and 100-x% in the Franklin India Bluechip Fund based on the P/E ratio. All we have to do is look at how a buy-and-hold strategy of the components compare to the Dynamic PE fund to gauge the effectiveness of the strategy.

Dynamic PE vs. pure-play Equity

Between 2007-01-02 and 2015-09-23, Franklin India Dynamic PE Ratio Fund of Funds-Growth’s IRR was 10.93% vs. Franklin India Bluechip Fund-Growth’s IRR of 11.53%

Similar returns. Lesser drawdowns. Lump-sum investors will probably be fine with these returns.

Dynamic PE vs. pure-play Bonds

First, let’s compare the Dynamic PE fund to the Short Term Income Plan.

Between 2007-01-02 and 2015-09-23, Dynamic PE Ratio had an IRR of 10.93% vs. Short-Term Income Plan’s IRR of 9.49%

For investors worried about drawdowns, just investing in the liquid fund would have given similar returns with a lot less risk. A 35% drawdown is a lot for a fund that gives bond-like returns.

A bond fund like the Birla Sun Life Dynamic Bond Fund, for example, had an IRR of 9.65% over the same time period

Conclusion

Using the P/E ratio for asset allocation is a bad idea. Investors would have experienced similar returns but with smaller drawdowns if they had invested in a regular bond fund instead.

Related: Dynamic PE Funds

Categories Investing Insight, Your Money Tags mutual funds

Profiting from PE Ratio Obsession

shyam July 26, 2015

Background

We are not big fans of using the Price-to-Earnings ratio. We saw how funds that use the market PE to time the market are no better than a buy-and-hold strategy (sometimes B&H performs better,) and we followed that up with how every single “ratio” has a caveat. And PE is the dumbest of them all.

However, if a large group of market participants pay attention to single flawed metric, then there should be a profitable arbitrage strategy that exploits that anomaly?

Exploiting PE obsession

Researchers in the US figured out a way to do just that.

Active investors with limited attention and capital constraints use fundamental metrics to screen and sort potential investments. Price-earnings (P/E) ratios are extremely popular, and are typically calculated using four trailing quarters of net income. Changes in the rankings of published P/E ratios may influence investor attention and subsequent excess returns. From 1974-2013, decile long-short portfolios formed on characteristics of P/E rankings which are rebalanced monthly earn value-weighted monthly excess returns of 101 basis points with annual Sharpe ratios of 0.79. Decile long-short portfolios which are rebalanced daily earn value-weighted daily excess returns of 16.99 basis points with annual Sharpe ratios of 2.91. Excess returns are robust to size, value, profitability, investment, price momentum, earnings momentum, short-term reversals, and relative volume. Changes to a stock’s P/E ranking predicts excess returns even when the stock’s P/E ratio itself does not change. The return premium cannot be explained by fundamental risk, clustering of attention at round number P/E ratios, or autocorrelation in the regressors.

We haven’t tested this for the Indian market yet. But this is just too cool not to share!

Paper: Rankings of published price-earnings ratios and investor attention

Categories Investing Insight, Your Money Tags investing, quant

Beware of Single Factor Investing

shyam July 24, 2015

Factors are short-cuts

Analyzing financial statements is a cumbersome process for most retail investors. Many don’t have the time, patience or expertise to dig through balance-sheets, income and cashflow statements. Most don’t find joy in reflecting on the many footnotes that accompany such statements. Here lies the attraction of single-factor investing.

Price-to-Earnings (PE) ratio is one such factor. We recently saw how there was no great advantage in investing in mutual funds that use PE to switch between debt and equity. It is a poor market timing indicator even when practiced by professional fund managers.

The ‘E’ in PE

The ‘earnings’ line-item is an accounting driven artifact that is easily gamed and has very little relationship with the company’s value. Here’s what Michael J. Mauboussin has to say about earnings, see appendix for the full note:

… an increase or decrease in earnings does not provide a clear picture of the corresponding increase or decrease in shareholder value. This is because the earnings figure does not reflect the company’s level of risk, does not take into account the investments needed for anticipated growth, and is subject to a wide variety of accounting conventions. Such accounting conventions do not ordinarily affect cash flow and hence do not affect a company’s value.

Even Shiller’s cyclically-adjusted P/E (or “CAPE”) has little predictive value in the short term. Shiller CAPE shows its strongest correlation to nominal returns over an 8-year time horizon, and is actually most predictive of real returns over an *18* year time horizon. (Kitces)

Some investors also look at Price to Book and Return on Capital Employed. These ratios provide a convenient short-hand but are far from adequate in forecasting future earnings.

Besides what does the ratio of total assets to total liabilities measure anyway? Intangibles can’t be quantified. Are inventories adjusted to current market prices? Is the loan loss reserve adequate?

Bottom line: Assets are often overstated and liabilities understated. (Fool)

What does “capital employed” mean anyway?

No general agreement exists on how capital employed should be calculated, on whether initial or average capital employed should be used or on how profit should be defined.
Often, accounting profit rather than cash flow is used as the basis of evaluation.
It ignores the time value of money.

Take away

Every style of investing – value, momentum or factor – depends on finding historical patterns and extending them into the future.

Every valuation metric comes with a “yes, but…”

No single factor is a predictor of future returns.

Appendix

Categories Investing Insight, Your Money Tags investing

The Treasure in Treasury Operations

shyam July 22, 2015

Treasury Operations of Banks

First the Wikipedia definition: Treasury management (or treasury operations) includes management of an enterprise’s holdings, with the ultimate goal of managing the firm’s liquidity and mitigating its operational, financial and reputational risk. Treasury Management includes a firm’s collections, disbursements, concentration, investment and funding activities. In larger firms, it may also include trading in bonds, currencies, financial derivatives and the associated financial risk management.

For a bank, this means asset/liability management, hedging interest rate risk, managing reserve and capital requirements, etc. It is also something banks provide as a value added service for their clients.

Revenue from Treasury Operations

Banks break out segment revenues that include revenue derived from treasury operations. However, they don’t carve out how much of it was proprietary trading. This is the average quarterly revenue from treasury operations since June 2014 (in Rs. Cr.) of major Indian banks:

In fact, for a few of them, revenue from treasury operations exceed from those from retail banking.

The need for more disclosure

The revenue from treasury ops is a black box. If most of that revenue is derived from prop trading, then investors need better disclosure of the risks that were taken. Recently, YESBANK got pummeled on a UBS report that raised doubts over their exposure to stressed companies. As a retail investor, we really don’t have a clue about the risks involved in holding equity in what could turn out to be a hedge fund in bank’s clothing.

Categories Investing Insight, Your Money Tags BANKNIFTY

Dynamic PE Funds

shyam July 21, 2015

Dynamic allocation

Ideally, you should buy stocks of companies when they are undervalued and sell them when they are overvalued. But what if the entire market is overvalued? Does it still make sense to try and find “bargains?” When valuations revert to mean, all stocks get dragged down with the rest of the market. To avoid this scenario, there are some funds that use broad-market valuations to dictate total exposure to equities vs. bonds/arbitrage. If this strategy works correctly, then drawdowns should be lower and long-term returns should beat a buy-and-hold strategy.

Let us pick the most popular of these dynamic allocation funds – the Franklin India Dyn PE Ratio FoF – and see how it works in practice.

Franklin India Dynamic PE Ratio Fund of Funds

According to MorningStar, the Dynamic PE Fund holds ~50% of its corpus in Franklin India Bluechip Fund. Instead of comparing the Dynamic fund to an index, lets see how it compares if you just bought and held the underlying fund.

Between 2007-01-02 and 2015-07-20, Franklin India Dynamic PE Ratio Fund of Funds has returned an IRR of 11.44% vs. Franklin India Bluechip Fund’s IRR of 12.67%

The draw-downs have been lower, but the returns have tracked buy and hold.

The twist in this story is the tax angle. To be treated as an equity fund for tax purposes, at least 65% of the corpus should be in equities. The Dynamic PE fund ends up being treated as a debt fund – so you end up paying tax on capital gains. Whereas if you just B&H the underlying equity fund, you pay no tax if you hold it beyond a year.

The Principal SMART Equity Fund

One way that fund managers have tried to work around the tax angle is to invest in arbitrage strategies instead of debt. For example, if you look at Principal’s SMART Fund (SMART from Factsheet – June2015,) even though they have only 43% in equities, the fact that they have 35% in cash-future arbitrage makes the fund an equity fund for tax purposes.

Between 2011-01-03 and 2015-07-20, Franklin India’s Dynamic PE Ratio Fund has returned an IRR of 10.28% vs. Principal Smart Equity Fund’s IRR of 11.86%

The slightly better performance came at the cost of higher draw-downs:

Who should invest?

These funds are good if you are scared about draw-downs and want some reassurance that you will not be buying overvalued stocks. However, not buying overvalued stocks is something that should be expected of all fund managers, irrespective of what the fund is called.

We can argue that shallower draw-downs help investors stick to the investment plan. They are less likely to panic and exit at the bottom. However, this where a good financial adviser earns his keep – holding the investor’s hand during volatile markets and helping him stick to the plan.

This could be a good fit for someone who is nearing the end of their savings phase and want an investment with lesser potential draw-downs. However, the same can be achieved at the portfolio level with a pure equity and a pure bond/arbitrage fund.

This leads us to the conclusion that these funds are good if you have a trust deficit and information problem. i.e. you don’t trust that a long-only equity fund will retrace its draw-down, don’t trust your investment adviser to stick around when the market tanks and don’t have a good portfolio level view on how your investments are allocated.

Categories Investing Insight, Your Money Tags mutual funds