Perfecting The Performance Formula

The two basic criteria in making profits are buying low and selling high. But what is common though is the incorrect tendency of most of the investors who buy when the markets are at a high and sell when the markets are down in the dumps. A majority of investors were low on cash and were about fully invested when the markets fell in January 2008. They therefore lost money. And when the market in February 2009 was available at attractive valuations, most investors sat on piles of cash and didn’t enter the market, thus losing out on the opportunity provided by capital appreciation.

[INSERT_1]

Such human psychology can be explained through the theory of greed and fear. When markets spiral upwards an individual is attracted towards the market due to greed, and when the markets begin to slide down investors stay away and even sell due to fear. A prudent investor should always hold higher cash reserves and be in the habit of booking profits when the markets are buoyant. He or she should buy when the markets are low. Meanwhile, when it comes to investment by professional investors like mutual funds who charge a range of fees for their services, one expects them to be wise enough to take the right decisions. However, when we analysed the cash holding of the mutual fund industry starting November 2007, we realised that even fund managers were no different than the common man and had taken wrong cash calls on portfolios during several occasions.

This is evident from the graph which indicates that fund managers didn’t book profits in January 2008 when the markets were at their peak and also missed the bus when the markets were available at cheap valuations in October 2008 and February 2009. The graph suggests that the relationship between the cash holding of the mutual fund industry and the movement of Sensex has been inverse, which in a right investment sense should have been otherwise. Almost every fund house was caught napping in the upward market rally starting March 2009 when the BSE Sensex Index outperformed a major part of the equity funds. The main reason for such underperformance by these funds was mainly on account of the higher cash holding by the fund houses.[PAGE BREAK]

In February 2009, when markets were volatile, although the stocks were available at attractive valuations, fund houses sat on huge piles of cash, so much so that their cash holding stood at almost 20 per cent of the AUM (highest in the period we analysed starting November 2007).

Such incorrect cash calls have cost the equity funds and its 42 million investors dearly. This is also evident from the fact that on an YTD basis (till June 29, 2009), out of the 218 open-ended equity diversified funds, only 42 funds managed to outperform the BSE Sensex Index. It is a serious issue considering that more than 80 per

[INSERT_2]

cent of these funds underperformed the index returns. As per Arvind Bansal, VP & Head – Multi Manager Investments, ING Investment Management, “Many fund managers have been holding cash since early part of 2008. Such managers were the best in 2008. When recovery happened in 2009, some of these managers took time in deploying cash. The primary reason has been that economic fundamentals changed very fast and they did not want to repeat the mistake of January 2009.” (In December 2008, global equities had rallied and many managers had reduced cash. The rally fizzed out in January 2009.)”  The mandate of some the fund houses as well as funds restrict them to take cash calls on the portfolio. And one can defend that by saying that investors give the money to the fund managers for investing and thus a fund should be fully invested. However, it’s proved by our data that cash calls become an important part of portfolio management. Fund managers should therefore also take a judicious call on cash along with other investment-related decisions. According to Kapil Mokashi, Assistant Manager Advisory, Share Khan, “In a nutshell, mutual funds, in the process of acting conservative, have preferred to be reactive rather than proactive in aligning their portfolios with the changing market conditions.” Another argument that a fund manager can put forward is that no one can time the market. Having said that, the attractive valuations of February 2009 should have goaded fund managers to significantly reduce the cash levels and start investing. Most investment advisors may say that mutual fund investments should be viewed with a long-term perspective and the short-term ups and downs should be ignored.

However, the most shocking fact is that in the last three-year period starting June 29, 2006, 97 funds (60 per cent) out of the universe of 162 open-ended equity diversified funds underperformed in terms of the BSE Sensex Index returns. In view of such a high number of underperforming funds, it’s very important to select the right funds if you want to not only grow your investment but also to protect your hard-earned money. “When an investor is putting money into a fund, he or she should look at the investment objective and be diligent about the investment process,” Bansal suggests. Recently an AMC came up with a product that helps investors to systematically sell or book profits. The product seems unique and sounds good. However, shouldn’t such a feature be generalised for all products rather than restricting it to one?[PAGE BREAK]

Another question is about whether such a systematic approach must be followed only by the retail investors or should it also be followed by the fund managers? But it still does not cover the most important part of investing – which is to buy at lower levels – as suggested by Warren Buffet who says, “The price you pay determines your rate of return.” So does this mean that the MF industry should move towards existing product innovation rather than new production generation? Does such underperformance justify the higher charges that the actively managed funds charge? Does it advocate that investors should rather invest in the passively managed funds that carry lower charges and closely follow the underlying index performance as compared to the actively managed funds that have largely underperformed in the index returns? Should one come up with NFOs, despite such underperformance by existing schemes or should one rather look at the consolidation of various schemes as recently initiated by UTI AMC? Should one locate and eradicate the difference between the funds that have consistently outperformed in their category and the index and the funds that haven’t? These are some of the questions that need to be revisited by the MF industry in the coming period. However, as always insisted by DSIJ, the consistency in performance over a long period matters the most in selecting the funds. This is possible with a process-driven and disciplined investment approach – something that only a few AMCs practice. Here, even the fund manager’s track record plays a significant role. In the last two years, when the markets were unsteady and uncertain, almost all the funds recommended by DSIJ outperformed the index mainly because of our stringent selection process. Almost all of our recommended funds are a part of the 40 per cent of the funds that have managed to outperform the index in the three-year period. Thus we would suggest investors to keep investing in the mutual funds recommended by the DSIJ even in the future.