Forget the fund, your return is what matters!

How many times have we invested in a fund based on its past performance. In fact, almost all the time.

How many times, in spite of the lofty performance credentials of the fund, the actual return of our investment sucks. (leave that to you!)

The difference lies in the concept of how performance is measured. A fund’s performance is normally time weighted return (TWR) and is a simple compounding of fund Net Asset Value (NAV) over a period of time. This measure is presented over various time horizons (YTD, 1-year, 3-years, etc). This is the return earned by the fund manager on the fund. 

However, this return metric does not provide a completely accurate view of how much return the investors have made on their capital; to find this, an internal rate of return must be calculated to discern the return on the average capital in the fund. In simple terms, the Capital Weighted Return (CWR) takes into account the cash flows at the beginning and end of the month and is the average rate of return of the investors in the fund.

Why does this difference matter? Because it is quite important .
The first tells you how well the fund manager did over time while the second tells you how well his investors did. It is quite possible that a fund gains a TWR of 5% p.a  over the last three years while its CWR may be -10%. What this means is that even though the fund manager did manage a positive performance, his investors (as a group) suffered a loss. How can this happen? Because investors may be bad in terms of timing their investments.

Various studies and reports have been commissioned to analyze and illustrate the difference between CWR and TWR and how using TWR exclusively can be misleading to investors. It has been found that CWRs trailed TWRs in major indices by an average of 5 percentage points/year over a 25 year period[1]. Moreover, a Wall Street Journal article highlighted the CGM Focus Fund (which had been named the best-performing US diversified stock mutual fund of the decade by Morningstar); according to the article, the fund produced a TWR of 18% over the last 10 years while underlying investors actually lost 11% per year ending in November 2009! This comes out to a discount of an average of 29 percentage points every year for a decade!
Discounts (CWR being less than TWR) are generally caused by rapid asset growth and mistiming of inflows to the fund by the investors. In other words, investors return may be poor due to wrong timing (buy and sell). Conversely, a Premium is the result of a substantial inflow (as a % of AUM) which is also well-timed in terms of market performance.

In short, cash flows into a fund matter more than stand alone performance. It is no surprise that as per updated standards of GIPS (Global Investment Performance Standards), it is now recommended that NAV’s be calculated and reported as on the date of significant cash flows reiterating the importance of cash flows.

An Indian Case Study-HDFC Bank Equity funds (Dec 2004- Dec 2011)

    I took 5 equity funds from the HDFC Bank staple to see if there is a difference between fund performance and the performance of investors underlying in the fund. The analysis was done over 3 time periods (3 years, 5 years, and 7 years). In all but only one instance, the TWR was higher than the CWR leading to a discount. In other words, investors in the fund made lower returns (due to wrong timing) than the fund manager. In some cases, the difference was really significant. Take for instance HDFC Top 200 fund. For the 3 year period ending Dec 2011, the fund returned an impressive annualized 22.56% while the investors in the fund made only 7.38% leading to a discount of 15.18%. We can observe similar discounts throughout the calculation except in one case (highlighted in red) where we see a premium. Another contributing factor to the discount apart from poor market timing by investors could be the rapid growth in assets under management. Invariably all funds experienced extraordinary growth in their asset base. The funds under study grew by an annualized 46% for the last 7 years. Incredible indeed!

What does it say?

• Fund managers are good at managing funds and advisors are good at gathering assets but it does not help investors invested in the fund
• Investors consistently make wrong timing decisions (both buy and sell) leading to underperformance as compared to the fund manager
• Fund houses and advisors do not assist investors in helping them on their timing dilemma leading to such discounts. For them, investment is recommended any time of the year/market cycle.

What should you do as an Investor?

• Never base your decision to invest solely on the past performance of the fund. Insist on looking at the CWR as well. A fund that is focused on the returns its investors make should be a better bet.
• Since you cannot successfully time the market, always spread your investments over a period as this reduces the possibility of a discount in terms of your performance compared to the fund performance
• Be fearful when the market rallies and adventurous when the market tanks. It is psychologically difficult but produces investment magic! And enables you to mitigate the timing risk.

The author thanks Deivanai Arunachalam & Divya Karthik for data support.

---

[1] Enough, John C. Bogle, 2008

How much Apple is making on iPad/iPhone?-Wake up China!

Recently I read up an article titled “Capturing value in global networks” It was truly amazing and eye opener. When Apple used to sell the basic version of iPhone for $200 nearly $116 of that goes to Apple alone. Supply chain management is a long and arduous process with players being involved from across the globe. But with China emerging as a low-cost destination for much of the American producers, I was imagining that a reasonable shift in value chain was happening in favor of China to a large extent and India to a lesser extent.

But take a look at the charts again. While iPhone is assembled in China, Chinese labor makes only about $3.5 in the $200 pie. Japan is even worse at just under a $1 in the $200 value chain of producing and selling iPhone. After Apple, the next biggest beneficiaries happen to be Koreans (LG and Samsung) that provides the display and memory chips. Even here their gross profits of the sale price of iPhone is just 5%.

According to the study, there are no known Chinese suppliers to the iPhone or iPad. The iPhone and iPad are assembled in mainland China factories owned by Foxconn, a Taiwan-based firm. This is true for most of the name-brand products from US firms.  

In short, Apple’s success does tremendously benefit its shareholders, workers and the US economy in general than China or Korea . It is clear that in the global innovation network, advanced economies capture significant value compared to developing countries. Being lead firms, they have total domination over global suppliers in the global value chain. (Intel is a rare exception!). This is due to very high levels of investment in the research and development for a sustained long period.  Asian economies focus and emphasis on low-cost prevents them from committing substantial amount in research and development.  Investors will invest in “value creators” than “value assemblers”. China and India should look to encourage creation of  lead firms that can afford to keep product design, software development, product management, marketing and other high-wage function within its shores  (like Apple) in a rapidly globalized economy. This cannot be a miracle and it is a long journey that they should start sooner than later. If they start today, they can create one in the next ten years but it is worth the effort.

If not, they will remain as players that just pick up the nickels.

Is Market Vulnerability on the rise?

This article was published in Arab Times.

It is widely believed that recent years have suffered historically high volatility in stock market returns.  Following an earlier article in the Financial Times (FTfm supplement) Rodney Sullivan,  Head of Publications at CFA Institute and Mandagolathur Raghu, President of CFA Kuwait both put today’s market volatility into historical context, and discuss the various sources underpinning market riskiness over time.

 How does recent market volatility compare historically?

Recent years had seen relatively higher market volatility.  However, many observers would be surprised to know that since 2000, a period widely viewed as encompassing high uncertainty, markets have demonstrated market volatility near long-term historical averages, overall.  For example, from 2000 to 2011, the annualized market volatility for MSCI to Europe Australasia and Far East was 19 percent as measured by standard deviation of returns.  However, that same level of volatility is consistent with that observed during the last 40 years (1971-2011).  Interestingly, looking further back in time, even recent market volatility is not a jaw dropper.  For the 40 yr period 1926-1971, data shows that volatility for large-cap U.S. stocks demonstrated a 25 percent annualized volatility as compared to around 22 percent during the most recent three years. 

How do the GCC markets measure up on this?

In general GCC markets exhibit higher risk compared to emerging markets, but GCC markets lack extensive history and therefore we should be cautious before making any definitive conclusions. However, going by the standard metric for risk i.e., standard deviation, the near term risk for GCC markets is lower than long term risk in line with the trends observed above. The annualized risk for the last two years for S&P GCC index is 15% while the same for the last 5 years is nearly 25%. Even other risk measures point to the same trend. For example, the maximum drawdown (defined as peak to trough fall) during the last 2 years was 10%, while the same for the last 5 years was a staggering 62%. 

Markets are therefore as risky now as in the distant past? 

Looking back, market volatility, while certainly the highest most of us can recall, it’s not at all unprecedented.  However, volatility is but one measure of risk.  Additional consideration should be given to other measures such as available liquidity, the amount of leverage employed, and portfolio drawdown associated with market disruptions, where markets suddenly exhibit large negative returns as witnessed during the global financial crisis in fall 2008 and the so-called “flash crash” in May 2010.

Are markets now more susceptible to these sudden disruptions?
Even though overall standard deviation is now roughly in line with historic measures, standard deviation is but one measure of risk.  Research has shown that markets are more vulnerable now to sudden reversals than formerly.  So, yes, markets increasingly appear hypersensitive to unexpected news or events impacting markets adversely.  

Why is market vulnerability on the rise?

Studies suggest a number of possible culprits for the rise in market vulnerability. Assets invested in passively managed equity mutual funds and exchange-traded funds (ETFs) have grown steadily in recent years, reaching more than $1 trillion by the end of 2010.  More importantly, ETF trading now accounts for roughly one-third of all trading.  ETF trading is accomplished largely by basket trading or the simultaneous buying or selling of the many stocks within a given index. Consequently, stocks within that basket or index tend to move together throughout the trading day.  This, in turn, increases market correlation to unexpected news or events—an undesirable effect on markets.

What are other reasons behind the rise in vulnerability?

The rise in index trading is, of course, only one possible contributor to this phenomenon.   A second possible source relates to active mutual funds that are managed against an index benchmark. Research indicates that the level of closet indexing among active managers has been noticeably increasing since around 1995.  Given that many active funds are managed relative to specific benchmarks, say the S&P 500 Index, their trading is likely to be concentrated in underlying constituents of the respective index benchmark.  As such, these funds may also contribute to the rise in market risk through basket-type trading.  Another possible source relates to the rise of various quantitative investment strategies.  Overall growth in such investing may contribute to periodic disruptions as all quant managers find they are trading the same securities on the basis of similar quant-driven signals.   Finally, we can also look to the role human behavior plays in market activity and aberrations. As social animals, certain embedded cognitive and emotional behaviors lead us to make errors in judgment precipitating market disruptions. Consider how we are often overconfident in our ability to manage investment risk leading us to fall into the trap that the future is predictable rather than uncertain. 

Are there other reasons behind the rise in vulnerability for the GCC?

The factors which contribute to volatility in the global context (like high ETF trading or basket-type trading) may be less at play in the GCC. Index trading is still not that popular compared to active management of funds. For GCC, lack of institutional investors may be contributing to higher risk coupled with low liquidity. Domination of retail trade may also induce behavioral biases contributing to higher risk.

What does this increased vulnerability mean for investors?
Whatever the drivers behind the rise in market vulnerability in recent decades, the result are a meaningful decrease in the current ability of investors to diversify risk. This is particularly important for portfolio management because diversification is less effective where there is both increased market volatility, and company-specific volatility. These changes have introduced additional challenges for risk management in equity portfolio construction. Furthermore, the diversification benefits of equity investing have decreased for all styles of stock portfolios (small-cap, large-cap, growth, and value). Specifically, an investor looking to maintain the same level of risk relative to the market now needs to meaningfully increase the number of stocks held. So the ability of investors to diversify risk by holding an otherwise well-diversified portfolio has markedly decreased in recent decades.  All investing, indexed or otherwise, currently appears a more risky prospect for investors.  Investors can improve their investment processes by incorporating the impact of increased market risk into their risk-modeling and asset allocation framework.

Investment Strategy: 2012 and beyond

This artcile was originally published in IIK website

2011 was no easy  year from an investment perspective. Given the fact that Indian diaspora is mostly exposed to Indian stock market, it is disheartening to see that India figured among the worst stock market performers during 2011. However, this article is not about telling you where to invest in 2012. Rather the article is a humble attempt to sensitize readers towards more long lasting investment habits as I am sure there will be many more years of challenging times ahead as well as opportunities. For the sake of easy read, I would organize them as Do’s and Don’ts

DO	DO NOT
Have a plan for your savings	React to opportunities based on friends and relatives
Invest regularly in small amounts	Try and time the market
Update your current investment value on a monthly basis	Procrastinate
Spread your risk into various categories of investments	Place hug bets on a single company or asset
Plan and provide yourself insurance	Link insurance with investments
Seek financial advice from experts	Base your decision solely on this. Listen to your heart as well

 Have  a PLAN:

When it comes to investing, most of us go for the easy option of accumulating our savings in the bank and remitting the money back to India with deployment mostly in fixed deposits. In some cases, we will go by opportunities cited by friends and relatives either in the stock market or in the real estate with occasional gold purchases. In other words, we react to opportunities with no concrete plan backing it.

Instead , we should have a well laid out plan to deploy our monthly savings. This plan should take into account your family circumstances, your age, your ability to take risks, your willingness to take risks (this is psychological) and your current and future income. While creating a plan, it is important to foresee liabilities like housing, education, healthcare for elders, etc.

Invest Regularly

Since our earnings happen fairly regularly (say monthly), our investment should also happen fairly regularly. There is always this temptation to time the market be it stock market or real estate. However, please note that it is impossible to time the market. In hindsight everything looks to be crystal clear in terms of what is a top and what is a bottom. But if you have to look forward, we should understand that we cannot predict when the next crisis will hit and from where. Hence, systematic investment in regular interval can smooth the impact and save you the trouble. Technology has made this even easier today where you can instruct your mutual fund to invest even on a daily basis.

Update your investments

It may be boring, but it is the most important thing to do at least on a monthly basis. It is critical to list all your investments in an excel file and seek current market values in order to decide whether to keep the investment or dispose of the investment. Procrastination or tendency to postpone things (lets do it tomorrow) will lead to sometimes heavy damages. Alternatively, timely reckoning of events can save you a lot of trouble.

Spread your Risks

Different investment avenues have different risk profiles. For eg., equities are very volatile in that their prices can go up or down quite fast. Real estate is illiquid and may be documentation intensive. Fixed income may be subject to interest rate risk. Gold may be linked to US dollar. Even money market investments suffered during the financial crisis. Hence, it is important to spread your investments so that the risk of huge fall in your asset value is reduced. 

Plan for an Insurance

The importance of a bread winner in a family can be understood only in times of loss of life for unfortunate reasons (like heart attack/accident, etc). Many people do not take this risk seriously or even if they do they may not have taken enough insurance to protect their family after they are gone. Unlike in the past where we had only one insurance company, we now have several insurance companies offering a range of products to suit your requirement. However, care should be taken not to over insure (as it may turn out to be costly) or link insurance to investments.

Seek Advice

We have always been seeking advice from friends and relatives, but it would help to seek advice from a professional financial advisor who is trained in this profession of providing advice. Also, the age and experience of the advisor is very important if you have to trust the advice. However, remember even advisors can go wrong. Hence, do listen to what your heart says in the matter as well.

Behavioral Finance—Nothing New Under the Sun

This article was originally published in Arab Times

According to a recent survey, an overwhelming majority of members of the CFA Society of the UK believe behavioural analysis is a useful addition to modern portfolio theory but is insufficient to replace it. Following an earlier article in the Financial Times (FTfm supplement) Stephen Horan, CFA, head of professional education content and Mandagolathur Raghu, President of CFA Kuwait CFA discuss the role of behavioral finance in investment decision making.

The GCC stock market has for a long time depicted behavioral biases swinging between irrational exuberance and deep remorse. The speculative character of the market combined with lack of institutional investors lends itself to this problem. Retail investors in the region exhibit wild mood swings and distort valuation based pricing even during the medium term. This article aims to clarify certain recent trends in behavioral finance and how an understanding of this evolving subject can be useful for GCC investors.

What is behavioral finance?

Behavioral finance combines the classical theories of economics and psychology. In essence, it attempts to explain deviations from the standard view that economic actors make purely unemotional or rational decisions. In forecasting, for example, investors tend to be overly confident in their accuracy, place undue emphasis on recent experience, and anchor their expectations using others’ predictions. 

How long has the field existed?

It is often traced back to the late 1970s when academicians such as Daniel Kahneman, Amos Trversky, Robert Shiller, Hersh Shefrin, Richard Thaler and Meir Statman started researching investor decision making in a robust manner. As far back as 1934, however, in the first edition of Security Analysis, Ben Graham referred to investors having “unlimited optimism” followed by periods of “deepest despair.”

Around that same time, John Maynard Keynes spoke of “instability due to the characteristic of human nature that a large part of our positive activities depend on spontaneous optimism rather than on mathematical expectation.” Behavioral economists refer to this as optimism bias.

What role has behavioral finance played in the investment landscape?

The principles of behavioral finance do not lend themselves to mathematical modeling because they are typically advanced in the form of cognitive biases. Recognizing, for instance, that investors are often overconfident in their abilities does little to help them determine whether a particular asset (or the market) is over or undervalued.

Whether they are an accurate depiction of reality or not, most classical valuation and macroeconomic models are based on the assumption that investors are purely utility maximizing rational decision makers. The weakness of these models is that they often suffer from the illusion of precision. Although not suffering from the illusion of precision, at the opposite extreme, behavioral finance is extremely difficult to model.

What are the latest developments?

Recently, researchers have been using MRI technology to map the neurological reactions investors have to making a profit, suffering a loss, confirming an expectation, or experiencing a surprise. This fascinating research, called neuroeconomics, shows that reactions in the brain to some investment experiences can be similar to when an addict takes drugs or a gambler wins a bet. 

The field is also benefiting from evolutionary biology insights that help explain how heuristics, which can sometimes lead to “irrational” decision making, play a critical role in survival because they help people efficiently avoid catastrophic outcomes.

What are some remaining challenges?

Behavioral finance still lacks a set of unifying principles that tie together observations of human behavior and brain activity in a way that not only explains behavior but can also be used to model corrective action or profitable trading opportunities. 

Does behavioral finance create profitable trading opportunities?

Yes, in fact, many mutual funds exist that implement some level of behavioral finance in their investment strategies. A 2008 study of these funds in the Journal Investing, however, found that they did not generate abnormal returns during the period examined.

At its core, the discipline of value investing is largely based on behavioral finance principles. Implementing a strict value-based or contrarian investment philosophy can require exceptional fortitude, especially in volatile markets when it might be difficult to convince one’s investors’ of its wisdom.

What lessons can investors draw from behavioral finance?

Individuals can learn that they are susceptible to overreactions in both bull and bear markets. The best way to stay focused on a long-term investment strategy is to document it in an investment policy statement along with an investor’s return requirements, risk tolerance, and investment constraints. It can then serve as a useful reference in both quiescent and turbulent markets.

What are the lessons for fund managers?

First, managers might consider maintaining liquidity, limiting leverage, and creating other cushions in anticipation of possible market stress. If “irrational” investor behavior creates opportunistic mispricing, it may take considerable time to dissipate and may get worse before it gets better.

Second, even if strict behavioral finance investment strategies are not highly successful, managers might augment their existing strategies to avoid herding, overreaction, regret aversion, and other behavioral biases that interfere with their effective implementation. For example, a diverse investment committee can help to encourage fresh ideas and minimize groupthink; and procedures to measure, monitor, and control some behavioral biases can help improve decision making.