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Why I do not invest in Equity Mutual Funds?

6/9/2019

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For a country of 1.3 billion people, at $1940 GDP per capita, with only around 10% population participating in the equity markets, India remains deeply underpenetrated in terms of equity. A huge part of population does not have any clue what Sensex or Nifty is. Thanks to the ‘Mutual Fund Sahi Hai ’campaign which has created an awareness, interest as well as Euphoria among general public who has been investing only in Fixed Income & Real Estate and always considered stock market as ‘Satta Bazaar’ and has now started looking at Equity as a new investment vehicle. Of late, you can see many LIC agents turning into Mutual Fund advisor.

I personally do not invest in Mutual Funds except for ELSS (where we get instant return in form of tax incentives) and Liquid & Low Duration Debt Funds for Asset Allocation and to park temporary cash. While it is not a bad idea for a know-nothing investor to put his/her savings in a diversified mutual fund and reap the baseline drift compounded over many years, I find many flaws with mutual fund investing (listed below). I believe with little effort on weekends and long term view coupled with technical analysis, one can easily beat most mutual funds. I think someone investing in Index stocks barring PSUs will be ahead of most of the funds.

High Charges
Charge of Mutual Funds for Management Fee & Operational Expenses (called as Total Expense Ratio) is very high (1.5-2% annually). TER is a percentage of the market value of the corpus which is deducted from NAV on daily basis. In the case of stocks, you need to pay fixed annual maintenance charges and one-time transaction charges (delivery based buying is free with discount stock brokers), which work out to be a tiny percentage amount.

Now before you argue about direct plans and call me penny-pincher, let’s do the math. Suppose someone starts a monthly SIP of ₹5,000 at the age of 20 years for his retirement, and if expected return CAGR is 15%, he will be able to accumulate ₹15.5 Crores at the end of 40th year. Let’s say, investor invested in a direct plan where TER was just 1%. If we deduct 1% as TER from the CAGR, then @14%, the corpus will grow to ₹11.2 Crores when he attains the age of 60 years which is ₹4.3 Crores less. Cost & Return in MF is not in your favor. High cost drags down the return and negatively affects compounding.

Falling Alpha
When you pay 1-2% in fees, you would expect the fund to earn a compounded annual return which is over FD and beat its underlying index. Sadly, as we are witnessing, majority of the funds are unable to beat their underlying index, let alone generate Alpha. Quant funds, Smart beta funds, Dynamic funds, Hybrid Aggressive funds, Balanced Hybrid funds, Tactical Asset Allocation, Dynamic Asset Allocation; they have tried all but results have not been impressive. Irony is TER is deducted even when fund is yielding negative return.
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Look at last 2 rows, on a 5 year basis, Nifty ETF was able to beat 37 funds and on a 3 year basis, it was ahead of 53 funds.

Over-diversification dilutes returns
There is a consensus among astute investors that all the benefit of diversification and risk reduction in a portfolio is achieved with 15-20 stocks; anything beyond that only leads to mediocre. However, except Focused funds, most oher funds are found to own 50-60 stock portfolio. An investor holding 5/6/7 different funds in his portfolio, ends up holding over 250-300 stocks. Even if he de-duplicate the holdings through proper analysis, they would realize they pretty much own whatever of the market there is to own, resulting in dilution of returns. You can't beat the market if you buy the market.

Conflict of Interest
The job of a fund manager is to beat the benchmark and he hardly tries to generate 25-40% kind of superior return. Say, in a year when the benchmark was down 20% and fund was down just 10%, it will be termed as outperformer while investors are sitting at a notional loss of 10% on their capital. Since all is to be done is to beat the index by small margin, they closely align their portfolio with underlying benchmark and avoid any undue risk by betting on any high conviction idea. No wonder, you will always find HDFC, L&T, TCS etc. in most categories of the funds. I do not wish to see HDFC Bank under Top10 holdings of a Midcap fund (as in case of DSP Midcap & Axis Midcap funds).

Ethical Issues
Like other financial products, mis-selling is rampant in MF industry too. Selling equity midcap fund showing past returns to senior citizens, selling equity funds with dividend options promising regular income while hiding the facts about DTT, presenting only the regular plan and hiding direct plans are few common mis-sellings I have personally witnessed at CAMS offices. Expert guidance in many MFs is a myth. Many funds are found to be stocking with non-performers or stocks of unethical companies for long (Eg. Motilal Oswal holding Manpasand Beverages even after it’s GST evasion) and not liquidating even when wisdom dictates so. Many fund managers are not reading the Balance Sheet closely and rely on news.

On several occasions, mutual fund have been found not only putting the interests of own business above the interests of retail investors but also breaking the moral code of conduct. As per a moneylife report, last year (in Mar-18), 56 MF Schemes Bailed Out Failing ICICI Securities’ IPO in March and Many Sold All the Shares by June at a Loss, all this at the cost of investors. Last month (May-19), 7 DSP IM officials had provided funds to an ex-employee who in turn traded in securities market.
In many instances, fund managers are found not sticking to their investment philosophy. For example, a value fund taking momentum calls. While it is acceptable for funds with Special Situation or Contrarian Investing style to have a high churn (or turnover ratio) but a fund house following a ‘Buy Right, Sit Tight’ or ‘Buy and Hold ‘strategy cannot afford to have a turnover rate of above 50%.

Constrained Environment
Mutual Funds being structured for a wide mass of retail investors tend to be regulated strictly. Recently, SEBI declared guidelines for Mutual Funds to categorize their schemes; large cap have been defined as top 100 stocks by market cap rank, midcaps have been defined as 101-250 by market cap rank and the rest as small cap. This means that most of the MF industry equity exposure will be relegated to top 250 stocks. This leaves little space for stock picking and generating alpha. There is hardly any prevalence of small cap funds in the mutual fund industry and small cap mutual funds by definition have scalability challenges once they cross a certain size. For this very reason, DSP & L&T fund houses stopped fresh inflows into their midcap plans.

As per SEBI norms, no stock can be over 10% of portfolio exposure. So if a stock due to its superior performance appreciates to become 12% of the portfolio or say a stock classified as mid cap appreciates over time and comes within the large cap basket which doesn’t fit for the investment universe of the fund, fund manager is forced to sell it to bring the exposure to 10% limit.

As MF size grows huge, it cannot simply stop buying low performing companies given the limited opportunities and 10% cash holding cap. You can stop buying further and reduce exposure to Equity when market has become expensive. This is the euphoria time when more and more money flows to MFs and SIPs continue. As a fund manager cannot sit on cash beyond 10% limit, so is forced to buy at high valuations. Fund own Size, less space for taking cash calls, shortage of opportunities to utilize fresh funds, script-level exposure restriction etc. all result in average return of the fund.

You pay for other’s mistakes
Mutual Funds being managed and held as a pool may be at times exposed to vagaries of the sum total behavior of hundreds of thousands of investors. In general, investors tend to invest in rising markets or improving fund performance and there could be times of panic in rapidly falling markets and times of poor fund performance. It may happen that mutual funds at times are forced to buy in rising markets and sell in falling markets because fund managers have discretion on stock picks but not on fund flows. Redemption pressure results in falling NAV of the fund.

You are in a lurch if Fund Manager Changes
Investing in a mutual fund is basically betting on Fund Manager’s capability. Thanks to the bull market, a lot of fund managers have moved across fund houses and a few of them have even moved out and opened their own investment firms. Few examples: Kenneth Andrade (from IDFC to his own venture Oldbridge Capital), Vetri Subramaniam (from Invesco to UTI), Manish Gunwani (from ICICI Prudential to Reliance), Gopal Agrawal (from Mirae Asset to Tata MF and now has quit TATA MF as well) and most recent exit of Goutam Sinha Roy (from Motilal Oswal) which has put redemption pressure on already underperforming Multicap 35 fund.

For most of the funds where the fund manager has changed, the existing track record becomes irrelevant while choosing the fund. The fund houses will (obviously) argue that they have a robust investment process and a change in the fund manager will not have an impact, but I think it would be extremely naive of us to believe that.  A fund manager is the biggest factor responsible for the returns from a fund. (Think Warren Buffet,  Charlie Munger, Ray Dalio, Howard Marks, Seth Klarman, Peter Lynch etc.).

​MF is as painful as Direct Equity
Choosing good MF is as challenging as selecting good stock (go through above point again). An equity mutual fund is more or less as volatile as stock. Both require similar emotional maturity for entry, exit or stay put decisions.
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Why Equity return overweight FD return

4/22/2019

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We all agree on the fact that over the long run, Equity as an Asset class always beats FD return. Of course you have to pay for the extra return in terms of Volatility, riding through booms & the busts. Sensex (as a basket of top 30 Indian companies) was formally started in 1979 with the base price of 100. As I write this, Sensex closed at 38,645.18 today, a solid CAGR of 16%.

Astonishing! Isn't it? And this is CAGR of dumb Index whose members are selected just based on Market Cap. Those who were lucky to lay their hands on few of the multi-baggers, are financially independent now. So, if someone during 80s wanted a return of 16%, all he had to do was to buy the Sensex.

So, what what the reason of this mind-boggling return? And what if I am starting today? What is the guarantee that I will enjoy the similar return in future also? Aren't mutual funds repeatedly saying that past returns are no guarantee for the future?

Well, I am not going to get into usual jargon like India as a developing country has a long runway for growth or Modi's revival of economy to aid hyper-growth. Let me present you the logical reason for the higher return of Equity.

Suppose, bank gives you interest on FD @7%. The entrepreneur (or business man) takes loan from bank at rate say @10-12%. So the business man has to do only such a business that with certainty earns a return greater (say 14-15%) than the bank interest rate. If this condition is not met, then the depositors money in FD is not safe. When an industry starts earning an ROI which is even less than the cost of capital (simply say borrowing rate), then it certainly is a ticking bomb. We have witnessed several such examples in the form of defaulters like Kingfisher Airlines, Bhushan Steel, Alok Industries and now Jet Airways. So, if we assume that our money is safe in the bank; by the same hypothesis Industries will keep generating returns higher than that of the bank.

There are 3 forces which try to hold this hypothesis of Industries earning return higher than the deposit rate.

First entrepreneur himself. The business man (the captain of the ship) will give his blood and sweat to make his venture successful (read earning high ROI). Captain is always the last to abandon the sinking ship.

Secondly RBI, whose primary job is to keep the financial equilibrium (supply/demand) intact by cutting/raising interest rate. When businesses start under-performing due to economic reasons, RBI intercepts and lowers the interest rate. This eases the interest burden of businesses. At the same time, common man (depositor) gets more purchasing power leading to more consumption; in turn facilitating more sales and earnings for businesses leading to higher rate of Industry return.

Thirdly, during adverse economic conditions or slowdowns, Government interferes and provides support to businesses like free land, discounted spectrum, free landmines, tax rebates etc. So that job losses can be contained and depositors money remains safe in he bank for the overall stability of the economy.

In worst case scenario, even after these efforts, Industries are under performing, then few companies will close down. This leads to reduced supply (and high demand). Remaining companies now enjoy less competition and will raise prices to earn more than their borrowings.

Now think hard! So many unfavorable events happened between 1979 and 2019. Harshad Mehta Scam of 1992, Ketan Parekh Scam during late 2000, US Housing Crisis of 2008, BREXIT, LTCG, majority Governments, coalition governments; market has endured all. In spite of all these, market return was impressive and you know the science behind it now.
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Hope now you have an assuring reason to repose you faith in Equities. You also now have something to explain to that friend of your father who keep pestering you for an LIC endowment policy! Next time you meet that uncle, pull out the Excel and show him the XIRR ofthe policy.
Happy Investing. Good Night!

XIRR Calculation in Excel
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Managing Money: Back to Basics

6/4/2018

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If you want to work for money, you will be doing that throughout life. If you can’t protect your money, financial predators will chip it away. If you don’t budget your money, others will make you fritter it way. If you don’t invest properly in the right assets, your money will be eaten up by the monsters of income-taxes and inflation. If you are reckless and do not invest your money properly, you will lose your wealth at the next unexpected event.

Although we all love money, it’s difficult for us to understand money and very tough to achieve financial independence. That’s simply because we all “work for money” rather than making “money work for us”. In this article, I try to make readers understand the nature of money, solve its mysteries and how to make it work to achieve financial independence.


Enhance Your Income
The first and foremost thing is income. We all have to learn to enhance our incomes. We all have some talent—we have to identify our talent, hone our skills, gain experience, improve our networking and increase our knowledge because that is the key in the current high-flying technology and information era. We all have to try to consolidate our strengths and minimize our weaknesses and aim to earn as much as possible because income is the first tenet of the profit & loss account.

Start Saving Early
Whether it is life, sports, exams or any other activity, there is nothing better than starting early. There is a saying that what you plan to do tomorrow, do it today; it best applies to the world of savings and investments. For example, if one saves Rs 25,000 annually at an expected rate of return of 10%pa (per annum) for 30 years, the total corpus would multiply to a staggering Rs 3.80 crore. Now, for whatever reason, if that individual were to delay his/her decision by, say, just five years, then, at the same expected rate of return, the corpus would be Rs.2.07 crore, almost half the corpus in the first case. Thus, by starting five years early, one could have almost doubled one’s investment corpus!

Increase Your Net (after tax) Income
Earning more income is just the beginning and will not, in any way, solve your financial problems, unless you follow the other rules. The second most important thing is to enhance your net, or after tax, income. There are lots of financial predators and the biggest amongst them is income-tax which legally picks money from your pocket. There are three kinds of income: 1) earned income (like salary where the person actually works to earn money), 2) guaranteed income (where the return is guaranteed like bank fixed deposits and, hence, there is negligible risk) and 3) portfolio income (where neither the principal nor the return is guaranteed like dividend from shares, rent from real estate, capital gains, etc).

Please remember, the tax structure is discriminating. As a general rule, there is maximum tax on earned income, as if the government wants to punish you for working hard to earn your income. Also, there is maximum tax on guaranteed income from portfolio because the tax policy assumes that you are an idle investor and, so, are not taking risk with your money to earn the return. However, the moment you are buying market-linked products, there is a lower rate of taxation from portfolio income. Hence, rather than working hard for your money and paying higher taxes, you have to be smart to let your money work for you and pay lower taxes.


Unnecessary Revenue / Capital Expenditure
Examples of unnecessary revenue expenditure are: a foreign trip, costly dinners at five-star hotels, etc. Unproductive capital expenditure would mean too much investment in assets which produce negative income, like car, holiday home, etc. But, we all have to incur expenses for our existence like food, clothing, medical, etc. Therefore, we have to learn to budget for these expenses and plan a judicious use of our finances. And, finally, what is the use of money if we can’t enjoy life? So, at some point of time, everybody has to incur unnecessary revenue expenditure or bad capital expenditure, but you don’t pay for them—let you assets pay for them. Treat all money equally, i.e., the money you got from, say, a lottery ticket or from the estate of a deceased relative or any windfall gain, with the same respect as the money you have earned from your hard work.

Keep a Contingency Fund Ready
The most certain thing about life is that it is uncertain. Therefore, everyone has to have a contingency fund; because you don’t want your long-term financial freedom to be sacrificed because of short-term problems. For example, one would hate to dip into the corpus fund set aside for one’s children’s education to meet an emergency medical need. Hence, keep adequate funds in liquid assets like short-term bank fixed deposits (FDs) or liquid mutual funds to meet any kind of unfortunate untoward emergency need.

Goal-based Investing
An individual would have different goals in life which would demand varying amounts of financial commitment. There would be basic goals like food, clothing, shelter, education, medical, etc. Then, there will be lifestyle goals like car, consumer durables and the like. Finally, there would be aspirational goals like purchasing a holiday home, enjoying a costly foreign vacation or sending children abroad for higher professional education and so on.

​Investing is not beating your neighbor, or performing better than some mutual fund manager. Investing is about being able to pay for all your future needs effortlessly, live a worry-free life and be able to achieve your higher self-actualization goals. Therefore, the success of a goal-based strategy is measured by how well an investor’s portfolio is tracking against a stated goal.

A traditional investment approach generally focuses on outperforming the market while staying within one’s threshold for risk. A goal-based strategy uses individual asset pools with an investment strategy that is tailored to the client’s specific goals. The two biggest advantages of goal-based investing are: it increases one’s commitments to one’s life goals by enabling us to gauge tangible progress towards these goals, and it reduces negative behavioral biases such as impulsive decision-making and over-reaction.


Liability Side – Good Debt and Bad Debt
Learn to distinguish between good and bad debt. According to me, bad debt would be that debt which is used for unproductive capital expenditure. On the other hand, good debt would be that which helps you  to create an asset which then puts money in your pocket (income) as well as scope for future capital appreciation, e.g., rental property which earns rent, shares which earn (tax-free) dividends. Also, both have potential for future capital appreciation. Never borrow to incur revenue expenditure, like a foreign trip or bad capital asset like a car or a holiday home, because they will not only take away money from your pocket in the form of interest payments but also put you into incurring wasteful revenue expenditure in the form of maintenance like petrol, repairs, property taxes, etc.

Asset Side – Create Good Assets
Always aim to create good assets which will provide income to you. For example, equities which will give you tax-free dividends, rental real estate which will give you rent, etc These have multiple advantages like they are either tax-free up to a limit (dividends) or subject to lower rate of taxation after exemptions (rent) than earned income (salary). Use the power of leverage to create good assets—let the income from the good asset pay your loan interest. And, once the loan installments are over, the future income (taxed at lower rate) on the good asset as well as the good asset is yours for life. And the trick of enjoying life, as well as securing your financial future, is to ensure that the portfolio income from your good asset pays for your revenue expenditure or bad capital expenditure.

Don’t forget that income-tax reduces your gross income; interest on loans (on revenue expenditures / bad assets) diminishes your net income and inflation eats into your remaining income. Follow the simple rules stated above and you are on your road to achieving financial emancipation.

Originally published on moneylife.in
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    Man is made by his thought. As he thinks, so he is. One’s perception of his life  greatly impacts  his standard of living, his success and failures,  the way he responds to the odd situations, the extent to which he makes his presence in the society he is living in.  The prime purpose of this blog is to share my thoughts and the other parallel thoughts from external sources which interest me with the readers of my blog.

    ​This blog is about all the things that float through my head, things that make me happy, things that make me wonder, thoughts that settle comfortably in and thoughts that come visiting once in a while. Come in and spend some time in my world. I have something for everyone. You are most welcome to express your views and take part in the discussion. I would love to read your comments, suggestions, appreciations and criticism.

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