Tag: mutual funds

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

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

Relative Returns of Midcap Funds

shyam July 17, 2015

Relative Returns

We wanted to see how different mutual funds compared to the CNX MIDCAP index. We took the annual returns of a dozen funds and subtracted the annual returns of the CNX MIDCAP index. This gives us an idea of how well the fund was managed.

The above result is a bit surprising. Other than the ICICI Prudential Value Discovery Fund, no other fund consistently beat the CNX MIDCAP index. Of course, returns are only half the story, these numbers don’t tell us the risks that were taken to achieve them.

Besides, none of the top funds in a year hold that position over the next (see this.)

Categories Investing Insight, Your Money Tags mutual funds, returns

Optimization vs. Maximization

shyam July 4, 2015July 4, 2015

The dog years of 2010, 2011, 2012 and 2013

According to AMFI, these are the 5 largest funds at the end of March-2015:

Scheme Name	AUM (Cr.)
HDFC Equity Fund – Growth Option	1,280,287
HDFC Top 200 Fund – Growth Option	1,009,121
Reliance Equity Opportunities Fund-Growth Plan-Growth Option	764,383
HDFC MID-CAP OPPORTUNITIES FUND – Growth Option	715,865
ICICI Prudential Value Discovery Fund – Regular Plan – Growth	645,946

What this means is that there is at least one person in your immediate network who would have invested in one of these funds.

Now let’s take a walk down memory lane. 2010, 2011, 2012 and 2013 were the worst years for the Indian economy. The RBI had messed up monetary policy leading to high inflation (double digits), there was a currency panic (rupee went from 45 to a dollar to 65), a never-ending series of scams and a government hell bent on redistribution. The only two asset classes that were doing well at the time were gold and real estate. GOLDBEES, the gold ETF, returned 13.25% (IRR) during that period. Fixed deposits were yielding around 11%. How would a typical investor react if his actively managed equity investments gave the following returns?

Scheme Name	IRR
HDFC Equity Fund – Growth Option	7.00%
HDFC Top 200 Fund – Growth Option	6.74%
Reliance Equity Opportunities Fund-Growth Plan-Growth Option	12.00%
HDFC MID-CAP OPPORTUNITIES FUND – Growth Option	13.24%
ICICI Prudential Value Discovery Fund – Regular Plan – Growth	11.09%

Here is Gold (in red) vs. HDFC Equity Fund (in black):

Needless to say, most investors who dipped their toes into the equity markets in 2010 gave up after a couple of years and still believe that the whole mutual fund business is a scam.

First half of 2015

We are supposed to be in a bull market. But let’s see how the first half worked out for the HDFC Equity Fund:

IRR of -2.39%. And bonds lost money too (in June.) Bull markets are not immune to prolonged periods of a “sideways” market.

Diversification across assets

A standard response to most investing problems in diversification. Invest a little into a variety of asset classes – equities, commodities, real-estate, gold, bonds – and you will be fine.

The problem with diversification is that it always feels wrong. For example, there are “balanced” funds that are supposed to allocate between both bonds and equities. They end up having lower draw-downs because of this. If you compare the ICICI Prudential Balanced Fund with HDFC Equity Fund between 2010-2013, the latter has an IRR of 11.38% vs. 7.00% of the former. But during the bull market of 2014, the balanced-fund gave an IRR of 45.47% vs. the equity fund’s 53.83%. So the lower draw-down comes at the expense of performance. It is a huge cognitive burden for investors to live with.

The kind of assets you pick for diversifying into also matters. For example, there was this big thing back in the day about the “commodity super-cycle.” About how the insatiable appetite for all sorts of commodities from China would keep growing to infinity. Plus, commodities were supposed to uncorrelated with equities. So great for diversification, right? Here’s how Mirae Global Commodity Equity Fund compares to the HDFC Equity Fund:

Commodity stocks did turn out to be uncorrelated but not in a way that you would like. And the commodities themselves are bouncing along multi-year lows right now.

What about bonds? Surely, they are safe. But let’s not forget that in 2009 and 2013, gilts drew-down double digits and their long-term IRRs are between 7% and 10%.

gilt drawdowns

Diversifying across geographies

What if you invested in international funds? After all, the rupee keeps going down, right? Depends on where you look. Between 2010 and 2013 (the dog years) the Birla Sun Life International Equity Fund – Plan A gave an IRR of 16.09% vs. HDFC Equity Fund’s 7%. But before you pat yourself on the back, between 2014 and now, the latter gave an IRR of 3.06% vs. 32.54% of the former. And Religare’s Pan European Equity Fund gave 1.50%.

Diversification means that your overall portfolio will trail behind the best performing asset class du jour. Psychologically, it is a very difficult thing to stick to.

Investing fads and broker recommendations

Of all the poor choices that investors can make, the worst is giving into investing fads. Back in 2004, there was this whole “India shining” marketing slogan. And now there is “make in India”, “smart cities”, “digital India”, etc. And almost every single time, fund houses come out with new schemes that tag along the slogan du jour. Here are some examples:

Morgan Stanley came out with their stock picks if Modi won (Theme created Dec 6, 2013):
morgan stanley strong election result

Here’s one on the Rail Budget (Theme, created Feb 26, 2015)
rail budget 2015 theme

So much for betting on rate-sensitive stocks (Theme, created Feb 3, 2015):
rate sensitive 2015 theme

You can browse through all these recommendations and lists under the “Broker Recommendations” section of our Themes page. We call it Doodh Ka Doodh Pani ka Pani.

Optimization vs. Maximization

The above examples highlight the problems of trying to maximize returns. There will always be an asset class, mutual fund or stock that is doing better than what you own. And there is an entire industry of tip-sheets, newsletter writers and subscription services that promise to pick the next winner.

However, we see investing as an optimization problem. We believe that drawdowns are an inseparable part of investing. Instead, we focus on getting the right mix of assets and strategies based on your risk appetite. And we make it supremely easy to stick to a plan.

For direct equity investors, this means getting Value and Momentum right. We have created Themes based on different approaches to value and momentum investing. Investors can then map our Themes to gain exposure to a specific set of strategies.

For mutual fund investors, this means getting portfolio risk right. We have created Themes based on the risk of the overall portfolio. Investors can now tune out the noise and focus on achieving their life goals.

Investing is not easy, but your journey as an investor will be so much more smoother with us. Get in touch with us now!

Categories Investing Insight, Your Money Tags investing, mutual funds

Investing in European Equities

shyam June 27, 2015

Why Now?

Here are the top 5 reasons why investors should look at European equities:

The ECB’s $1.1 trillion bond-buying program is beginning to kick in.
The slide in the euro’s value against the dollar has also made European exports more competitive.
Valuations appear attractive.
Eurozone corporates are less leveraged, and their profitability has remained resilient.
Greece is a source of uncertainty. Investing during uncertain times bears outsized returns.

How?

Unless you have a foreign equities trading account, the only way you can invest in European equities are through feeder funds or international funds. Feeder funds are just a wrapper around another fund. One such fund is the Religare Invesco Pan European Equity Fund. It feeds into the Invesco Pan European Equity Fund (MorningStar.)

It can be argued that investing in a narrow geographic is riskier compared to investing in a broad international fund. We had highlighted one such fund, the Birla Sun Life International Equity Fund Plan A, in our post about investing in non-rupee assets. If you compare the two, between 2014-03-03 and 2015-06-25, Religare’s fund gave an IRR of 1.27% vs. Birla’s 7.14% Although this blows when compared to the CNX Midcap (IRR of 48.41% in the same period), remember that investing is all about prospective returns.

Risks

There is always the risk that Greece will blowup and drag Italy down with it, causing the Eurozone to implode. Tack on the risk of active management and currency risk (the rupee might appreciate against the euro), it becomes a pretty scary proposition. But remember, investing during uncertain times bears outsized returns.

Call us to discuss whether this fund is right for you.

Categories Investing Insight, Your Money Tags mutual funds