## Tuesday, March 30, 2010

1. I sent you this comment in one of your earlier posts, it would be great if you could respond to it...
In all the topics covered by you so far, what I have gathered is you always present a utopian world...where you say what is the ideal way of doing things in finance and economy as a whole.. I completely agree with you in almost all the aspects.. but I would be really happy to see if you could show us some direction as to how we bridge the gap between efficiency and inefficiency in markets and economy...it would be really great if you could through some light on the transition process. :)

2. In response to the article of Nelson D Schwartz on speculators
Without diluting the quality of conversations taking place here ,I would like to draw attention to a particular piece I wrote, sometime in January 2009, immediately after the Satyam fiasco comes to the fore.

Presenting my opinion in the closing paragraphs of the article, of the important ramifications for capital market policy making.

Do give it a read. The link is here: The Red Flags of Satyam

{Caveat Emptor: The article is investor and Satyam heavy}

Dr Ajay,if you would remember correctly, I mailed to you a long time back, lamenting the state of ETFs in India and the enormous gap with India and US on ETFs.I think, the gap is slowly closing.

But then, the real innovation will come when SEBI allows leveraged ETFs as well.

3. *** Apologies in advance for the long rant ***

@ Soham Das

Active investing products = ~98% of funds sold in India and 98% of AUM.

Active investing products = sexy + higer margins for fund houses and distributors (though considerably diluted by recent SEBI actions)

Index investing = plain vanilla i.e. boring, dull. Low margin, miniscule AUM.

Index investing vs. Active investing = Eat in moderation, do regular excercise, do not get stressed etc etc vs. Use treadmill, aerobics, protein shakes, wheat grass, power yoga etc etc.

Question - which is easier to sell or sells more.

What's 'leverage' got to do with it? Re gap - the US fund industry is close to USD 10 trillion. Indian fund industry is ~USD 150bn

For index investing to pick up you need the committed capital of an index fund house to push the product. 'Investors' would have to compare the after fee returns of actively managed products as compared to index products. I suspect that the situation in India is not at all as bad as it is in the US where a great majority of active products do not outperform the index after fees.

What is the appropriate equity benchmark for India is also a question which needs to be examined. Sensex/Nifty are pure large cap. The benchmarking of practices of Indian funds also needs to be closely looked at. How many active equity funds benchmark against Sensex/Nifty and then merrily pick up 30% mid and small cap exposure?

Many other things would need to fall in place. ULIPs are still very distributor (aka fat commission) driven. So some sort of level playing field for all investment and savings products is required (direct tax code is a step in the right direction).

NPS could be the game changer for index investing if it picks up enough steam.

4. Soham,

Before leveraged ETFs, give me an ETF that allows me to go short (plea to Benchmark/NSE/SEBI). Leveraged would be nice ofcourse.

Also, note that the US has leveraged Mutual Funds as well - so if you want to run leveraged startegies based on EoD closes it is cost efficient to do so using leveraged Mutual Funds that can be traded every day (no lock-in/exit load, etc, etc).

And, whats with the settlement rules in margin accounts? As far as I understand, I can't buy an ETF/stock and sell it on T+1 (I have to wait till T+3)? Or is that wrong? I hope I'm wrong on that!

5. Amit,

Its not that only the inherent "sexyness" of the underlying drives the system. Though there is a significant part of it.

MFs form a major major chunk of the inflow money, because they spend bigger bucks on advertisement, eked out by charging bigger fees from the larger fund, which is brought in by big buck spending on ads . Whoops!

Index investing is not sexy. And I am not a long term investor who buys and holds and forgets for that matter. But, the inherent nature of ETFs serving as a basket of stocks similar in industry and sectors is very important for even slightly rational market agent.

And the rise of ETFs is further jinxed by the "I-dont-understand-I-dont-care-attitude" of SEBI. SEBI doesnt allow the formation of diverse ETFs. The only ETFs we have is NIFTY,BANKNIFTY and NIFTYJR. Among commodities, we have GOLD. End of the Story.
Now pan the camera, towards the Mutual fund business.
Not that they actually make money, but the diversity is huge enough to make it look intimidating,sexy and well... attractive to investors.

@Amit, :) Check the leveraged ETF products in US. ;) You will be stunned.

@MG,
Lord knows,I am hoping,praying that SEBI wakes up to ETFs.And puhleej puhleej puhleej allow me to go short in stocks(not necessarily only in SSFs, but also in other stocks). If shorting stocks is allowed, I think ETFs will be automatically allowed to be shorted.

You can sell on T+1, because the person to whom you are selling, will receive the stocks on T+4; Check with your broker. Some dont allow it. Some allow it. I think you are using ICICI.

-------------------
Its ironical, that we are discussing only about asset innovation in the Indian capital mkts, on a blog which encompasses the policy making of the entire nation.

6. Congratulations for a wonderful analysis titled Myth of Predictable Alpha, a sequel to the Myth of Eternal Alpha study that was done by Benchmark AMC a couple of years back.

I think both these studies conclusively prove an important point-Indian market is efficient enough and hence out performances of individual active managers are random, transient and unpredictable.

Efficiency of markets is a much misunderstood term-its practical implication is something like this-thousands and thousands of market participants (including a large number of brilliant active managers, analysts and other individuals) making those countless decisions-all those buyers and sellers-everything they know in combination is already in the prices to such an extent that no single participant in the market can ‘out perform’ more than what one would really expect by random chance and that too consistently.

Even if the market was temporarily irrational and making mistakes-all those mispricings would be evident in hindsight. The ‘obvious’ and ‘look I told you so’ in markets is usually hindsight wisdom.

People who still believe that indexing (a Western invention) does not work very well in India should update themselves.

Indexing & passive investing just like other Western inventions-(to mention a few)-mobile phones, stock markets, DCF analysis, MBA education, television and jet engines –is working as well in India, if not better than the West.

With Indian markets turning increasingly competitive-FIIs, MFs, ULIPs, PMS, hedge funds, treasuries, HNIs, advisory-thousands of active managers / investors-predictability of out performance of individual managers would be random and more to do with luck rather than skill.

These ‘eternal’ principles and mechanisms are like the fundamental laws of gravity-they hold good for all competitive markets including India.

Investors as a group cannot beat themselves because they are the market and for every brilliant (or randomly lucky) active investor who out performs-his counterpart by default has to under perform (i.e. randomly unlucky.) Hence the consistent return from a market or its sub-segments has to be the ‘average’ return earned by all investors in the aggregate. The average is best represented by the index.

Indexing should form the plinth or core of any sensible strategic asset allocation plan.

7. Amit –

‘For index investing to pick up you need the committed capital of an index fund house to push the product. 'Investors' would have to compare the after fee returns of actively managed products as compared to index products. I suspect that the situation in India is not at all as bad as it is in the US where a great majority of active products do not outperform the index after fees.’

The comment of anonymous hope answers the notion that in India active management works. We have done some research on this issue. Please do have a look at http://www.benchmarkfunds.com/static.pl?pg=Latest

‘What is the appropriate equity benchmark for India is also a question which needs to be examined. Sensex/Nifty are pure large cap. The benchmarking of practices of Indian funds also needs to be closely looked at. How many active equity funds benchmark against Sensex/Nifty and then merrily pick up 30% mid and small cap exposure?’

We agree, but even after using the wrong benchmarks, the active mangers underperform. Have a look at the papers above

MG –

And, whats with the settlement rules in margin accounts? As far as I understand, I can't buy an ETF/stock and sell it on T+1 (I have to wait till T+3)? Or is that wrong? I hope I'm wrong on that!

It depends on one’s status as an investor. If you are an institutional investor – FII, MF, etc you can sell only on T+3, but otherwise anytime

Soham Das -

‘Its ironical, that we are discussing only about asset innovation in the Indian capital mkts, on a blog which encompasses the policy making of the entire nation.’

It is great we are doing that……….

8. I don't know why index investing vs active management vs whatever came up? Availability of products/instruments should be distinct from success of product strategies, no?

I abhor any treatment of "active management" as one single bucket. There is a lot of diversity of strategies and diversity in purpose/mandate also.

Soham,

Shorting ETFs like shorting stocks is fine but I am hoping for something like for example: FXP which is the twice leveraged inverse of FXI.

With such short ETFs (and short mutual funds) I don't have to think about borrowing and all that stuff - I have never actually short sold but found these short ETFs very easy to use.

I am using ICICI - I should look elsewhere. Thanks.

9. MG said,

“I abhor any treatment of ‘active management’ as one single bucket. There is a lot of diversity of strategies and diversity of purpose / mandate.”

I beg to differ…any method of ‘active management’-whether it is stock picking, manager selection, market timing, directional calls, sector selection and so on-assumes the application of human intelligence to find good deals in the market.

Commonly used techniques could be technical & fundamental analysis, quantitative methods, mathematical models, company visits and so on…it could be even astrology!

Passive management or indexing eliminates all guess work and instead invests in the market or its sub-segments (e.g. Nifty, Nifty Junior, CNX-500, Hang Seng indices-Benchmark has ETFs / index funds for all these which are representative of ‘market’ portfolios.)

In direct contrast active management tries to locate (in advance) good ‘pieces’ of the market in the form of stocks, managers, sectors and so on and so forth.

The attempt of any form of active management is to ‘out perform’ the market as represented by the relevant index.

The ‘market’ is nothing but an aggregation of thousands of active (and a few passive) investors-each ‘active’ investor is trying to out guess his counterpart or attempting to maximize his profits. Hence I consider all active investors as having a rational self-interest.

A typical active investor has to beat the market via prices i.e. he has to out guess the market (price.)

This implies that an archetypical active investor (professional and otherwise) must consistently have more knowledge, information, data and insight than the ‘market.’

E.g. the constant endeavour of numerous active investors to find good stocks (deals) in the market makes the price at any given moment the best estimate of what everyone is thinking.

It is humanly impossible for any individual to consistently know more than the market. Prices discount almost everything that can be known-what is
not known is ‘news’ and it hits the market (prices) at random.

To conclude, there may be diverse active management strategies-however the underlying objective (purpose) of each one of them has to be to beat the market.

I wonder how all active investors as a group can achieve that. They cannot because in the aggregate (along with passive) they are the market-I am not surprised the Benchmark study exposes the myth of ‘eternal and predictable’ active alphas.

10. I think there are two problems with the Benchmark study:

1). It takes a selective three year period to compare passive v/s active investing. A more appropriate thing would be to see how various funds have fared over a different sets of periods, say, 3/5/10 years. The difference is significant. A significant number of active funds have done very well, if you compare their performance over a 5-10 year period. They have actually done much much better than the index.

2). This is a more important point. while the study compared absolute number of schemes underperforming. Has anyone compared the absolute funds under management that have done badly. What I mean by this is that suppose we had a MF industry with three schemes with the following corpus size: X - 5000 cr, Y - 150 cr and Z - 30 cr. If, off the three, scheme X outperforms the index by a wide margin and y and Z do not, we tend to think that 67% of the schemes have underperformed...whereas in reality only 3.5% of the industry funds have underperformed!

This has been the case with the Indian MF industry, which is largely dominated by Reliance, Templeton and HDFC. Over a long period of time, most of their schemes have done exceedingly well and it reflects from the fact that they have been able to corner a significant portion of the industry AUM. So on a weighted basis, i think active investment has done well in India and i think it might do the same over the next few years as well.

PS: my views could be biased, because i _actively_ manage investments myself :)

11. I have problems with a lot of your points but I'll pick on one for the moment.

"The attempt of any form of active management is to ‘out perform’ the market as represented by the relevant index. "

Which market do the following "active" funds try to outperform and which index can I buy to get exposure to the risk/return of these strategies if I want to?

Merger Arbitrage
Stat Arb
Convertible Arbitrage
Private Equity
Distressed Credit

12. MG:

Shorting ETFs like shorting stocks is fine but I am hoping for something like for example: FXP which is the twice leveraged inverse of FXI.

This is what I call leveraged ETFs. A super class of ETFs called leverage ETFs which allow you to go short+ with a leverage. Yes, I am familiar with this.

MG:
I personally agree even more fully with the comment to Anonymous, about efficient market.
In my honest opinion, and I know Dr Shah will be miffed, efficient market is a myth.
Beating the markets is tough, but not impossible.And when I say, "beating the markets", I mean consistently.
Worshippers of EMH believe, in Monkey-Shakespeare paradox. If Millions of millions monkeys randomly jabbing away at keyboards, one of them will certainly whip out Othello of Shakespeare.
Well, there are more market beaters than EMH fans would like to accept. Less than what retail paper would like to accept.

And yes, discount in the recent works in neurofinance, EMH believers might have something better in hand to get their heads around.

13. One correction in previous comment: Inverse etfs are one family of ETFs. Leverage ETFs is another family. You have inverse as well as leverage ETFs

Soham

14. Ravi,

'1). It takes a selective three year period to compare passive v/s active investing.. A more appropriate thing would be to see how various funds have fared over a different sets of periods, say, 3/5/10 years. The difference is significant. A significant number of active funds have done very well, if you compare their performance over a 5-10 year period. They have actually done much much better than the index.'

For the analysis of Myth of Eternal Alpha, we have considered all those schemes which have one of the broader indices (S&P CNX Nifty or BSE Sensex or BSE 100 or CNX 100) as their performance benchmark and the scheme should have a history of 6 years back from 2009. BY considering this history, the data considered for our analysis is for 6 years. For this period we have calculated 3 years rolling returns on a daily basis, the first data point is 3 years back; therefore the analysis covers 6 years of data. We would like to consider periods even beyond 6 years but unfortunately the no of schemes launched prior to our data set is very limited. We will keep continuing doing this analysis and thus will have greater no of years we go along.

'2). This is a more important point. while the study compared absolute number of schemes underperforming. Has anyone compared the absolute funds under management that have done badly. What I mean by this is that suppose we had a MF industry with three schemes with the following corpus size: X - 5000 cr, Y - 150 cr and Z - 30 cr. If, off the three, scheme X outperforms the index by a wide margin and y and Z do not, we tend to think that 67% of the schemes have underperformed...whereas in reality only 3.5% of the industry funds have underperformed!

This has been the case with the Indian MF industry, which is largely dominated by Reliance, Templeton and HDFC. Over a long period of time, most of their schemes have done exceedingly well and it reflects from the fact that they have been able to corner a significant portion of the industry AUM. So on a weighted basis, i think active investment has done well in India and i think it might do the same over the next few years as well.'

Unfortunately we do not have daily AUM data and do conduct analysis as suggested we need to have every day AUM data. We would love to do it, but are constrained. If anyone has access to this data please do share it with us. Since last year or so AMFI gives average AUM data, we hope to gather data for a reasonable time and should be able to get back on this issue.

15. Let me respond to some of the arguments, and I write this from the view point of a typical investor who has to pick and choose pieces of the market in advance-whether it is stocks, managers, timing…it includes Private Equity schemes and other forms of active management wherever applicable! One has to see PE schemes etc in the aggregate.
.
However, let us focus on what is applicable to majority of investors…who would pick listed stocks directly or via managers.

The term managers-should apply to all types of active managers-MF, insurance, PMS, advisory and PE, FII, hedge fund etc wherever applicable.

Active management techniques of trying to identify and take exposure to ‘good pieces’ of the market are similar-relative to the passive method of ‘buying’ the market.

Will some ‘pieces’ of the market (in any given time period) out perform it? Of course and we usually get to know this in hindsight. Will there be future Warren Buffets’-yes, do we know them now? No!

We have perfect hindsight explanation about out performance, mispricing and irrationality.

Past data, information and analysis-the tools of active management have little or no predictive value going forward.
How many ‘experts’ subscribed to Infosys IPO-if some did-how many stayed invested through the years-and how many used the same skills to identify future Infosys?

Market efficiency and its practical implication would mean that majority of investors should eliminate guess work of attempting to hunt (in advance) for the good pieces (of any type including Pvt Equity etc wherever applicable) and instead take exposure to an entire asset class.

Yes, from the aggregate, a few pieces (stocks and managers) will always ‘out perform’-unfortunately we will get to know them in hindsight…and market efficiency will ensure that ‘alphas’ are random, not eternal and unpredictable.

Benchmark’s study is valid when applied to almost all forms of active management (in the aggregate)

Little wonder Warren Buffett says A low-cost index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth. In this book, Jack Bogle tells you why.” –Little Book of Common Sense Investing.

The above ‘common sense’ is applicable to investments everywhere-when various forms of active management are seen in the aggregate.

Investments is not a ‘championship’ about guessing future out performers-it is participating in a country’s enterprise and is best done when enterprise is bought in the aggregate via an index fund.

Processes, skills, techniques and motivation, used by numerous participants, in any competitive activity (such as active management) are more or less similar-it is no rocket science.

Since there is no ‘patent’ or exclusivity-out performance is random. Peter Bernstein in his book Capital Ideas-The Improbable Origins of Modern Wall Street said The difference between luck and skill is seldom apparent at first glance.

Let me end with a little bit of humour-IPL cricket like active management is a highly competitive activity-i.e. with respect to skill sets, motivation, techniques and processes-perhaps even remuneration.

Hence any one can win or out perform in the zero-sum game and past performance is a poor indicator.

In 2008 it was Rajasthan Royals who won (ranked in the bottom quartile before the event) and in 2009 it were Deccan Chargers (who were at the bottom after season 2008) but out performed and won in 2009.

Who will be the ‘alpha’ team in 2010? Chances are that past performance will not help an analyst-but even if it did-can one use the same analytical techniques and predict the ‘alpha’ team of 2011?

Looks like ‘alphas’ are not ‘eternal’ and in fact ‘transient’ and ‘random’ in all competitive fields!
But I can bet that we will read voluminous & perfect hindsight explanations about the 2010 champions-and the losers. Cricket to my mind is also an ‘efficient market.’

16. Ravi wrote,

This has been the case with the Indian MF industry, which is largely dominated by Reliance, Templeton and HDFC. Over a long period of time, most of their schemes have done exceedingly well and it reflects from the fact that they have been able to corner a significant portion of the industry AUM. So on a weighted basis, i think active investment has done well in India and i think it might do the same over the next few years as well.

In active management we get excited by the ‘time-weighted’ return (change in NAV) of good portfolios since inception and other time periods.

But that does not tell us what return was earned by the average fund investor...for example what was the NFO AUM of some of the good schemes that began 10 or 15-years ago?

To ascertain the return earned by an average investor, one has to consider the currency or rupee-weighted return-typically the inflows and outflows that impact a scheme.

This should be huge in popular active schemes as big money flows into them in hindsight and also exits after a bad performance. (This data is not easy to obtain.)

Time-weighted returns do not indicate the returns actually earned by an average investor…this is similar to the clichéd tale ‘Had you bought Infosys at inception…your wealth creation would have been…whatever the number!’

The point is what is the return of an average investor who most probably discovered this good ‘piece’ of the market in hindsight? And God Forbid if it started to turn bad-most of us would become aware in hindsight.

In an index fund or ETF-since I am eliminating the guess work of ‘market pieces’-stocks, managers and so on…I have a decent chance of earning the market rate of return (whatever it maybe) over the long-term and in the process fulfilling my financial goals. The market return is the long-term consistent return from an asset class and its sub-segments.

Benchmark’s CNX-500 or total stock market index fund is a very good representative sample of the market because its maps more than 90% of total market cap.

Indian markets will obviously generate ‘alphas’ in the future-the point is whether they can be predicted and are they eternal? No, unless an investor is consistently ‘lucky.’ One should also question what kind of risk was taken to generate the alpha?

Hence should I spend time in hunting (guessing) for good ‘pieces’ from the haystack or instead buy the entire haystack i.e. enterprise in the aggregate via passive portfolios?

In my humble opinion, logic suggests that the latter is a more efficient method of participating in an asset class. This fundamental principle (like the law of gravity) has been proven abroad and it is happening in India too. It would be worthwhile to note that gravitational acceleration everywhere on our planet is 9.80 metres per seconds square (Wall St and Dalal St included.)

17. Minorities tend to do well in many societies. Quakers, Parsis, Overseas Chinese etc are good examples. On the other hand, some minority communities haven't done that well. I don't want to name any. So the evidence is mixed. I don't like such books though. Such books are a bit racist and triumphalist in nature. Different communities have been at the pinnacle at different times. Let's stay humble.

18. I mostly agree with Anonymous!

Maybe(?) it makes sense for the average individual to take up a job or be a labourer (passive investing) than to attempt to start his/her own business (active fund management). Simply because most of the large and successful companies/institutions that we know of today are, maybe, lucky! Creating these lucky companies would have involved, besides luck, significant amount of risk taking, focus and hardwork, innovative thinking, again....most of which are mostly proven in hindsight(?)

Even science and its discoveries are great only in hindsight. Edison, once famously said (i hope he has), "I have not failed 1000 times. I have successfully discovered 1000 ways to NOT make a light bulb". Maybe he was lucky the 1001th time.

Does this mean, that going passive is the right or a more efficient way? I certainly think not.

But, yes, Anonymous is right, gravity is the same (=9.8 m/s^2) everywhere on this earth, but then there are who'd like to fly (achieve alpha returns). For the rest, ofcourse and for good reasons, we are better off simply walking (accept market returns).

19. Ravi said,

I mostly agree with Anonymous!
Phew! Thanks friend! Ha Ha....

My point was very simple-if we see the world of investments through the eyes of an investor / advisor...there are a large number of active management options. Such as individual stocks, MF schemes, insurance schemes, PMS schemes and so on and so forth.

As an investor when we actively begin to pick individual ‘pieces’ of the market for the future-they seem like clones-almost like all those IPL teams before the competition begins.

We then begin to see out and under performance, in ‘real time’ as history unfolds into the future-therefore the ‘prediction’ game is nothing but throwing darts and selecting alphas which we believe (out of hope) will remain eternal.

This is the myth of ‘eternal and predictable’ alphas which the Benchmark study pointed out.

Hence for an investor / advisor it is more efficient and logical to bet on the ‘whole’ which is always greater than the sum of its ‘parts or pieces’...just as it makes sense for entrepreneurs who are ‘selling’ the active management solution to keep talking about ‘alphas’.

However the advisor / investor should question-if everyone is going to be above average-who will be below average?

…Just as it makes sense for entrepreneurs’ to take risk and create companies-some of which will turn ‘lucky’ or ‘unlucky’ in hindsight.

All investors are in a sense ‘passive’-even folks who actively invest in individual stocks remain ‘passive’ in the company’s business.

For example, no quintessential, large / small institution or investor is going to wake up and tell the management that they don’t agree with a specific business plan or diversification or product launch-and instead it should be done differently.

A typical investor-institution or otherwise is passive by default because he does not have the expertise of an entrepreneur in running a business or a company.

The exception could be Warren Buffett who almost runs his companies like an entrepreneur.

Hence when most of us as investors / advisors are simply taking a passive stake into enterprise via equities-it is better to be a smart laborer and make a logical attempt in achieving financial goals.

As Benchmark’s study proves their ‘labor’ portfolio has outperformed many Michael Schumachers’.

Yes, Ravi I agree if someone wants to fly high and in the process entertain himself (achieve alpha returns) my sincere advice is-do so with a small portion of the portfolio.

But make sure that the core equity allocation is in the passive index which should act as a parachute in case one crash lands.

I agree indexing is ‘boring’ and that is its downside-there is no thrill that one experiences in trying to throw a dart into the future to find the next Google, Infosys and Warren Buffett-I seriously wonder how many active investors consistently achieve this?

Put it differently, indexes will always remain (are eternal)-whereas individual managers, stocks-the pieces are transient, not eternal and not predictable!

I have enjoyed participating in this healthy debate!

20. Before having leveraged ETFs or whatever, it would be good to have ETFs that move like ETFs. Go to Google Finance and try overlaying the price graph of an Indian ETF with its index. Does it look like an ETF should?

Except for Benchmark's Bank ETF for a short period, every Indian ETF I've looked at is the same story.

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