Category: Investing Insight

Diversification vs. Returns vs. Currency hedging

Some Indian funds, under the guise of diversification, invest in foreign equities. However, the benefit of diversification comes from investing across asset classes. Does investing in the same asset class, i.e., equities, really give the investor uncorrelated returns? Or are funds using international equities as a rupee-short in disguise?

World Equity Correlation

When you run correlations between the monthly returns of the S&P 500, Nasdaq, FTSE 100, Nikkei and CNX 500, here’s what you get:

A zero or negative correlation would validate the diversification claim. But that is not the case. Indian equities are loosely correlated with international stock markets.

World equity Returns

When it comes to returns, Indian equities have outperformed all the main indices.

Currency hedge

The 50% depreciation in the rupee since 2000, however, make a strong case for adding short-INR/long-USD assets.

Competency

Although Rupee depreciation makes a case for holding dollar assets, why do it in a convoluted way by buying individual stocks? The competency of an Indian asset manager in picking stocks in a foreign market is questionable.

For example, the PPFAS fund holds about 20% of its assets in foreign equities. This, at a time when most developed markets have given up on stock-picking and have turned to indexing instead. Can a manager, sitting in India, select stocks in a foreign market that outperform that market?

The problem with a mixed-in portfolio like PPFAS is that it is very difficult to break performance down to its components. Between 2014-01-01 and 2015-02-25, PPFAS Long Term Value Fund has returned a cumulative 44.20% with an IRR of 37.45% vs. BSE MID CAP’s cumulative return of 58.84% and an IRR of 49.50%. (http://svz.bz/1DZzX1L)

Conclusion

Exposure to US Dollar assets makes sense given the historical depreciation of the Indian rupee against the US dollar. However, we are not convinced that buying a fund that tries to pick stocks in foreign markets is the way to go. Investors would be better of being net short the rupee, or buying the S&P 500 ETF separately.

Churn and Burn

When retail investors trade stocks, the market impact of trading decisions are de minimis. However, when a fund trades its portfolio, it has a noticeable market impact. According to a study quoted here in the Economist article, when academics compared the returns of the funds with their estimated trading costs, the funds with the highest costs had the lowest returns.

For contrast, lets compare the DWS Tax Saving Fund with Templeton India Growth Fund.

DWS Tax Saving Fund

First, investors would have been better off buying a CNX Midcap index fund. Between 2006-06-01 and 2015-02-19, DWS TAX SAVING FUND has returned a cumulative 143.52% with an IRR of 10.74% vs. CNX Midcap’s cumulative return of 209.71% and an IRR of 13.83%. (http://svz.bz/1EHGTxu)

Second, the fund looks like a fun trading vehicle for the manager rather than something that is meant to build wealth over the long term. Here’s how the manager has churned his portfolio:

Not only should you stay away from this fund, but you should use it in informational videos on how not to churn your portfolio.

Templeton India Growth Fund

First, even though returns are not the absolute best that it could have been, between 2006-06-01 and 2015-02-19, Templeton India Growth Fund has returned a cumulative 267.72% with an IRR of 16.09%.(http://svz.bz/1EHIljm)

Second, the portfolio doesn’t look like a mad scramble like the one above. Markedly fewer holdings for longer:

When you compare the two funds with each other, you can see who is doing a better job (http://svz.bz/1EHJCa2):

Conclusion

Beware of funds that churn their portfolios frequently. It might be a reflection of shoddy research, poor conviction or immaturity that you end up paying for.

Tracking the big guys

Small investors can stay nimble and can buy stocks in companies that big investors or funds cannot. If you are a small and smart investor, you should be able to generate market beating returns over the long-run. But what about funds that generate superior returns in spite of their large size? Given that portfolio disclosures have to be made every month and the manager cannot really predict the cashflows in and out of his fund, if he is consistently beating the market, it points to some real skill (or a really long streak of good luck, we’ll let you be the judge.)

Irrespective of whether it was skill or luck that produced the alpha, it makes sense for individual investors to track what different fund managers are doing. Besides, if you are thinking for buying or selling a fund, you should get comfortable with the manager. But how do you go about visualizing a fund?

NAV based metrics

Our FundCompare tool provides a convenient way to chart fund performance vs. different benchmarks, observe historical drawdowns, etc. For example, if you wanted to compare IDBI Equity Advantage Fund to the MNC index, you can do that with the tool. (http://svz.bz/1CQUAI0)

But what if you wanted to drill into the actual portfolio? Most websites give you a static snapshot of the portfolio on the latest disclosure date. But anybody who has managed money will know that portfolios are path-dependent.

Portfolio Videos

Given the sheer size of the data, it makes sense to try and visualize portfolios through videos. Here’s how the IDBI Equity Advantage Fund portfolio “looks” like:

It is almost as if the manager did his portfolio selection back in Jan 2014 and let his winners ride. An almost static portfolio, much like our Themes.

Contrast that to ICICI Prudential Value Discovery Fund:

This manager is way more active than his IDBI counterpart, going in and out of stocks at a rapid clip. A lot of small positions, except for ICICI bank which is almost 8% of the fund. Given the size of the fund (more than 8,500 crores), the market impact on these trades are likely to be significant.

The UTI MNC Fund takes a different track: a smaller portfolio with concentrated positions and very few high in-and-outs.

There you have it: three different funds and three different approaches to portfolio construction and management, easily told apart through 45-second video clips.

Coming up next

We plan to roll out portfolio videos for the funds that we have recommended our clients and in which we have ourselves invested. If you have any specific funds in mind that you want us to create videos for or looking to invest, give us a call or send us a WhatsApp!