SIP’s: Makes Sense, but to Whom?

This article was published in The Global Analyst

If you have been investing through advisors, or basing your investment strategy on what you read in stock market magazines, you may probably have heard one or all of the below:

1.       You cannot and should not time the market.

2.       You should consider investing regularly (say monthly) so that you can take advantage of market volatility &

3.       Regular investments or Systematic Investment Plans (SIP’s) is easy and flexible and can inculcate savings habit.

To add to the emphasis, imagine you invested lump sum during Jan 2008 or November 2010 when Sensex was at its peak (20,800). At the current level (16,152) your portfolio would be down by 22%. Hence, the case for SIP.

Has SIP’s produced superior results to say a Buy and Hold (B&H) strategy? The table below tells it all.

During the last 8 years of analysis, SIP’s outsmarted a B&H strategy only 2 times. The SIP performance is Internal Rate of Return (IRR) method since it involves regular cash flows. For eg., you could assume investing Rs.10,000 every month for the last 3 years. The IRR of your investment at today’s Sensex value (assuming you cash out) would be an annualized return of 2.6%, while a B&H strategy would have yielded an annualized return of 21.5%, a huge difference of around 19% annualized. Except for the last one year and 4 years, the SIP performance lagged the B&H in all other time periods. The table depicts annualized performance; hence the opportunity loss value could be significant for longer time periods.

The idea of this analysis is not to critique market timing or discipline in investments. Of course, it is a known fact that it is difficult to “time” the market. Ideally we would like to buy low and sell high, but if we get our timing wrong, we will end up buying high and selling low. But the panacea to this is not systematic investments especially in a volatile asset class like equities as can be seen from the workings. In a consistently rising market, SIP’s can produce average purchase cost lower than the peak value thereby benefiting the investors. However, markets are rarely rising consistently and if they do so, the volatility will be far lower. Markets by nature gyrate between optimism and pessimism and hence produce volatility.

The best news for SIP’s lies with the fund houses which can aim for consistent and measured growth in their Assets Under Management (AUM) by enabling you to commit a fixed amount of investment every month. It is good news for them since they earn their fees on the AUM’s and not necessarily on how your investments have performed.

Also, once we sign up for a SIP, rarely ever we take the pain of monitoring its performance vis-a-vis a B&H strategy. Hence, SIP’s once started invariably runs its course, which again is music to the ears of fund houses.

The only argument in favour of SIP’s is that it is easy on your liquidity, especially if you have a monthly income matching monthly investments. However, given the findings, it may make more sense to commit an SIP to say a Post office Recurring Deposit (RD) or to a debt fund than to an equity fund.

The author would like to thank Madhusoodhan for data assistance.

Are you getting enough Salary?

Recently I read an interesting story on salary levels in the GCC region starting from a CEO all the way to the executive secretary. Saudi Arabia tops the list in terms of salary offer followed by Qatar. Kuwait and UAE rank in the middle while Oman and Bahrain rank lower.

Preferred work destinations for expat based on salary

Asian Expat	Arab Expat	Western Expat
Saudi Arabia	Saudi Arabia	Saudi Arabia
Qatar	Qatar	UAE
Kuwait	UAE	Qatar
UAE	Kuwait	Kuwait
Oman	Bahrain	Bahrain
Bahrain	Oman	Oman

The distribution of salaries across expat groups is interesting. Overall, Arab expats receive 25% more salary than Asian expats while Western expat receive 33% more than Asian expat and 7.5% more than Arab expat. However, sharp differences are noticed in individual job category. For eg., in Construction Project manager category, a Western expat will cost 65% more than Asian!

Asian Expat experienced pay increase in Bahrain while their salaries dropped in UAE. However, relative to Arab and Western expats, they experienced considerably lower increases across the board. For the Arab Expat, Qatar was superb with 30% salary increase in 2011 while UAE was flat

Western expats experienced the best gains especially in Qatar (27%) and Saudi Arabia (24%). The Arab spring must have increased the "risk premium" which seems more for expats than for Asians!

Interesting statistics to benchmark!

Effective Financial Risk Communication Beneficial for Investors

This article was originally published in Arab Times

Risk disclosures can convey to investors the nature and magnitude of significant financial risks and how well these risks are being managed. Following an earlier article in the Financial Times (FTfm supplement) Vincent Papa, director of financial reporting policy at CFA Institute, and Mandagolathur Raghu, President of CFA Kuwait, argue the recent crisis have heightened the importance of the quality of corporate communications about financial risk exposures and risk management. This is just as important in the GCC as elsewhere, as the region has battled a series of corporate failures due to the financial crisis.

 Where do the largest financial risks to companies arise?

Financial risk exposures arise from a number of factors including volatile currency exchange rates, interest rates and commodity prices. They also arise from complex financial instruments such as derivatives instruments and from debt instruments used in the capital structure. Different business models dictate a businesses susceptibility to different types of risk.  For example, Airline companies contend with jet fuel price uncertainty while mining companies have to contend with fluctuating commodity prices. Companies with global operations will likely face foreign currency risk. Banks are susceptible to credit risk during all phases of the economic cycle and credit risk primarily arises due to the possibility of borrowers failing to fulfill their obligations to banks.

Why are financial risks currently so high? 

For both financial and non-financial companies, financial risks are influenced by the economic cycle. For example, credit risk related losses typically materialise during strained economic environments when borrower firms and individuals are likely to be financially distressed. Credit risk can in turn exacerbate the funding risks faced by banks and cause problems refinancing the debt portion of the capital structure. For example, during the ongoing European sovereign debt crisis, European banks have suffered a significant reduction in the levels of wholesale funding available, especially short-term funding from US money market funds.  The recent crises also highlighted counterparty risk. Significant losses could occur during stressed market environments for the financial institutions that are net sellers of credit protection via credit default swap contracts (CDS). Another facet of counterparty risk is “wrong-way risk” where counterparties who have provided credit risk insurance cannot fulfill all their insurance obligations due to being financially distressed.

 How well do companies communicate about financial risk management?

Financial risk management can occur through many enterprise choices. For example, banks hold liquid assets to mitigate the risk that customers will withdraw their deposits. Banks can hold greater equity capital buffers to absorb unexpected losses. Additionally, risk management entails hedging activities that are undertaken to mitigate particular risks faced by companies. Hedging occurs through financial instruments such as derivatives and through economic hedges such as foreign currency revenue receipts being hedged by foreign currency borrowings. But companies are typically opaque about specific hedging strategies and this can result in investors only becoming aware of ineffective hedging strategies belatedly when losses are incurred.  This is especially true in relation to complex and synthetic hedging strategies.

 Are there specific financial risks that the GCC region is exposed to?

Since most of the GCC countries are pegged to the US dollar, currency risk is the predominant issue. While the much talked about GCC monetary union aspires to bring about a unified currency (along the lines of the Euro), it is still unlikely to mitigate the currency risk. Also, the GCC region comprises a number of major conglomerates that are predominantly family businesses. While in the past they carried enormous goodwill , popularizing the concept of “name lending”, the financial crisis has created some large scale corporate defaults drawing attention to this increased level of risk in the region. Lack of transparency and communication also exacerbates the problem in GCC. However, the non-development of a derivatives market may reduce this impact albeit marginally.

How can risk communication be improved through financial reports?

CFA Institute conducted a study on risk disclosures under international financial reporting standards (IFRS). The study made several recommendations for improving risk disclosures to convey useful and understandable information for investors. One of the key recommendations is that executive summaries should be provided for all key risk categories that any company bears. These summaries should be succinct and portray an entity-wide picture of key risk exposures and the effectiveness of risk management.

Another recommendation is that there should be an integrated presentation of related risk information. Such integration is particularly necessary for banks, where Basel III disclosures are often reported in a disparate fashion relative to the IFRS requirements. We also recommend sufficient breakdown of information, clear presentation of all quantitative details and significant improvement of qualitative disclosures, focusing on adequately communicating the company’s specific risk management strategies.

Regardless of the arsenal of choices employed to manage financial risk, high quality risk disclosures are required to allow investors to make a more informed evaluation of the effectiveness of risk management strategies. To this end, risk disclosures need to communicate sufficient detail about the nature of applied risk management strategies. 

The Death of the Investment Policy Statement?

This article appeared in Arab Times on 19th March 2012.

For half a century, portfolio managers have been taught that the basis of every solid investment process is an investment policy statement (IPS). The 2008 financial crisis has called this view into question. Following an earlier article in the Financial Times (FTfm supplement) Kevin Terhaar, Director of Examination Development at CFA Institute, Stephen M. Horan, PhD, Head of Professional Education Content at CFA Institute, and Mandagolathur Raghu, President of CFA Kuwait  examine the role of the IPS and whether it can survive.

What is the IPS and why is it valuable?

The IPS is a document that describes the investor’s risk tolerance, return expectations and objectives, liquidity needs, and other constraints. It may be drafted in relation to either an investor’s entire financial position or only the portfolio under consideration.

Traditionally, an important part of the IPS has been the benchmark portfolio, or strategic asset allocation—what asset classes are to be included and in what proportions. Such a roadmap is best practice because it provides the investor with a foundation for setting long-term exposure to systematic risk and making decisions on manager hiring, tactical (i.e., shorter-term) asset allocation changes, and other investment implementation choices.

What is the practice in the GCC?

The GCC region is dominated by the presence of High Net Worth Individuals (HNWI), as a result of the hydrocarbon economy and the wealth generated through it in the last few decades. However, wealthy investors in the region have a two-dimensional approach to wealth management. They split their investments into local/regional and global. Given their proximity to and visibility of the local/regional markets, HNWI’s prefer to manage their investments in the region personally whilst they prefer to outsource the management of their international allocation. In general, the international allocation is guided by an IPS while the local/regional management tends to be managed reactively, though there are no firm studies to substantiate this. The approach to asset allocation also differs by geography. Given the limited range of asset classes open to investors  in the region, most of the wealth is deployed in equities (public, private and family business) and real estate while international portfolios are reasonably diversified with other asset classes especially bonds, hedge funds, commodities, etc.

Why has the IPS come under attack in the last few years?

After the tech bubble burst in the early part of this decade, a number of renowned investment pundits observed that many investors were badly served by their high-equity allocations. They believed that the solution was to de-emphasize strategic asset allocation.

What are some alternatives?

Some commentators went so far as to recommend that investors discard the notion of a benchmark entirely. The best course of action was to seek out sources of returns, wherever they might be found. 

Rather than investing according to a fixed plan, nimbleness was the order of the day. This approach was sometimes mistakenly called the “endowment model” in sales pitches, especially if it emphasized alternative assets.

What are the pitfalls of discarding the IPS?

Investors aim to maximize a portfolio’s expected return (for a given level of risk) but often find that they are thwarted in attaining this optimum by their own behavior. Behavioral finance has taught us that investors’ decision making is typically subject to biases. 

In a return-seeking setting, investors are highly vulnerable to herding behavior because when making decisions, they tend to place the greatest weight on their most recent experiences. 

How has this prescription turned out?

Combining the “IPS alternative” of searching for high returns with extrapolation of recent past market environments has proved to be exactly the wrong advice at the wrong time. A number of high-profile investment managers and funds increased equity exposure immediately before the stock market downturn.  In the case of GCC, exposure to real estate investments compounded the issue.

Likewise, as returns soured and pessimism reigned in late 2008 and early 2009, many reined in their risk by reducing equities, high-yield bonds, and other higher-risk assets. Adhering to a well-constructed investment policy would likely have produced better results. So, it is not at all clear that fund trustees and managers have the processes or the ability to capitalize on opportunities or avoid ill-advised risks.

What can be done to rectify this situation?

Rather than discarding the IPS, investors and investment committees would be better served by relying heavily on the IPS to guide their long-term investment decisions. 

Despite declarations to the contrary, many investors have quite a short-term investment horizon, especially in turbulent investment environments in which many react to losses by selling risky assets and moving to cash near the bottom. To counteract this behavior, the IPS can incorporate an investment “philosophy” and instructions that codify guidance as to how the portfolio will be managed, particularly in difficult markets. HNWI’s in the GCC region will be well advised to insist on developing and implementing an IPS by their local wealth managers just as they do with international wealth managers.

How can an investment philosophy provide guidance?

Simple portfolio rebalancing rules are very helpful in this regard. In addition, the IPS can specify ranges or boundaries at which asset weights will trigger a purchase or sale to bring the portfolio back to its strategic allocation. 

An IPS that specifies a “default” portfolio and a rigorous investment management approach may result in a somewhat contrarian investment style—one in which an investor buys assets whose prices have been knocked down because other investors are fearful and sells assets during more halcyon conditions.

Why is this sort of guidance important?

Without a framework for making asset allocation decisions, investors will find themselves adrift and more susceptible to getting caught up in the herd. The result is likely to be poor investment performance.

By adhering to a well-thought-out and well-developed investment policy, investors stand a better chance of achieving their long-term investment goals.

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