Dynamic Systematic Investment Plan

Everybody knows SIP are good.The rationale for SIP investing is not  based on any mathematical model but  psychology of consistency.It just to  average the cost of investment using disciplined periodic investment. The underlying idea is that its hard to time the market if not impossible. Various methods have been devised to predict market direction but none have been conclusive.One such way of predicting Index direction to see if it is undervalued or over valued is through PE value

PE is one of the major indicator to predict if market is under valued or overvalued.Lot of  people talk about comparing long term average PE and comparing it with current and thus timing market.

The major drawback with it are:

  • what period to consider for long term 5 year,10 year etc?
  • The Index constituents are changed  frequently(6 months or so) and thus PE keep changing
  • If their had been a major depression in past(2008 etc)  average PE would be depressed.
  • It doesn’t factor in the inflation adjusted price change of Index.
  • Our prediction can be wrong and plan backfire if market tanks so  market timing doesn’t work

Some people use CAPE PE ( capital adjusted PE) which is nothing but average earning over a period as denominator.Again it also suffer from impact of period of  high or low earning in that past  window leading to depressed or inflated PE

Lets take something more simple and easy to observe: The Return of the Index.

The rolling yearly Return of Index :It is the yearly return of the index taken every day using one year  period.Lets plot the return for last 18 years:

As we can see it follows more or less a normal distribution.

Average Return are 15% while Median Returns are 13%. It means that almost 50% times  one year  return where higher than 13% and other 50% times less than 13%

We understand we cannot predict the direction but one thing we are sure we are investing in market because we expect a long term positive expected payoff .It means that in the long run we think its profitable to put money in the market.  Using the  information we got from the graph can we find an edge?

When we are moving towards extremity of the graph we see the frequency of returns are diminishing.So in a way its rare to get those kind of yearly returns!So if one rolling year gave me -50% return there is higher chance that my next few rolling return will move toward the center.

Knowing this  we can apply Kelly Criterion to enhance our return.How?

From the figure we can see that market has given -10% negative return only 8% times.It means this is an unusual return and we have a slight positive chance (maybe  lets say 55% ) that my next rolling return would shift towards  center again(towards normal range) so if i use kelly criterion which say I increase my bet when prices are favorable !  and similarly when the opposite happens  i.e. return are more than normal I slightly lower my bet

In other words when market returns are above the median  returns compared  to our reward to risk is low so place lower bets and when market return is way below average return our returns compared to risk can be high so we increase the bet size!

 

If Ileave extreme rare event my range is broadly from -70% to 100%.So I should have a SIP which can cover the whole range

If 40000 is the maximum possible investment I can do in a SIP then my base SIP should be 10000 and max SIP 40000.

So at 13% median return I will invest 10000 and gradually increase and decrease across range.We have considered median and not average because average returns get impacted by outliers

My Investment pattern will look something like this :

 

I have taken base as 10% and for every 10% change in rolling return I increase or decrease my investment by 10%.Backtesting Result for a daily 10000 base SIP gives :

XIRR = 14.39%

Total AUM accumulated = 18.31 Cr

For a Regular SIP :

XIRR = 13.57%

Total AUM accumulated =16Cr

For Nifty Next50

 

Median is higher at 20%.

Results:

XIRR = 18.44%

Total AUM accumulated = 15.84 Cr

For a Regular SIP :

XIRR = 17.24%

Total AUM accumulated =13.75 Cr

What I have done is I have tried to place bigger bets when odds are favorable and lower bets when odds are unfavorable. In  short time frame luck can cause random results but as my bets keep growing small edge keeps adding until I have a substantial edge which translates into higher profit!!.

Its like tossing a coin which is slightly biased towards head. If i toss it 5 times maybe only 1 head comes ( equivalent to market timing where I might be true yet I fail)  but If i toss it million times I know  more than 50% times it will land on Head

Inference:

  • We are not only able to get higher return but also we are able to collect higher AUM ( because we are making exponential bets which means our SIP are growing faster at decline while reducing less at rally)
  • Results are better for Nifty Next 50 because higher volatility allows more betting but also means we should change our bet size in smaller proportion
  • Perform Monthly SIP as daily is not practical.Keep changing size based on Rolling Return
  • Use Nifty  ETF and Nifty Next index Fund for investment add a couple of mid and small cap fund
  • This strategy should not be used with mutual Funds because Fund manager keep churning the portfolio which will take away the edge!

Peer to Peer Lending(P2P) Investing Strategy based on Kelly Criterian

Peer to Peer lending is a mechanism where  people can invest or borrow money from other people through an online platform. These companies provide a market place for loans  like Amazon and Flipkart provide for buyers and sellers. It has been very successful in US and UK.Basic Features of P2P lending are:

  • Unsecured Lending  for a tenor from 6 months to 3 years.
  • Regulated under RBI policy
  • Invested money is returned in the form of EMI (Prinicipal + Interest)
  • Interest Rate vary from 12% to 36% depending on credit risk of the borrower
  • Each platform has its own credit risk analysis report  for borrower which is available for Lender to read.

Three important questions  to consider in P2P lending

  1. Why P2P lending?
  2. Which Platform to Invest?
  3. How to Invest?

Why P2P Lending: How do people generally invest for SIP ? They keep their money in either saving bank or RD,some put in Liquid Fund and rest put lumpsum in Mutual Funds( either Equity or Debt) .We have already discussed SIP has better risk return reward compared to lumpsum. Comparative Analysis of parking money in different assets for SIP:

These figures are for putting money for 3 years.beyond that we can utilize indexing benefit to  put some money in Debt funds

How does P2P lending EMI return look like? If the Return is 15% and Tenor is 2 years

We can either invest the SIP in equity mutual fund or we can reinvest to more borrower:

 

Which Platform to Invest?

There are many P2P lending platform available in the market .I have tried quite a few and then finally choosen 3.Things to look before choosing a platform

  • Credibility:Should be known and trusted name
  • Minimum amount to invest should be less.
  • Large number of borrowers.
  • Good borrower analysis and data available.
  • I suggest to atleast invest in 3 different platforms.

The platforms which  I have chosen are:

  1. I2I  Funding (https://www.i2ifunding.com/referral/ud8cwng83a/invest)
  2. Faircent
  3. lendenClub

Comparison

I have chosen these 3 as they are established names and also provide decent minimum investment .

 

How to Invest ?

Investing in P2P is like betting on a  borrower that he wont default. So if we know approximate default rate we can calculate the risk adjusted return .P2P  sites have historical default rate for various risk categories

This approach in investing is based on the Kelly formula which is employed by gamblers in casinos. It is an optimization strategy which maximizes long term returns.In simple terms it says that you increase your bet size when chances are favorable and reduce when chances are not so favorable.

Kelly Formula is basically

x = ( Expected net payoff ) / (Payoff on Success )

=( Probability of success* (Amount you get in success) – (Probability of failure* loss in Failure))/ (Amount you get in success)

Lets see some example:

A)

So lets say a loan in Category F has  5% historical default rate and you get 25% interest.

So your bet size according to Kelly is :

Probabilty of success = 95%

Probability of default = 5%

(25%*95% – 100%* 5%)/25% =75%

It means you can put 75% of your bank roll in this bet

B)

loan in Category C has  1% historical default rate and you get 20% interest.

So your bet size according to Kelly is :   (20*99% – 1%* 100%)/20% =94%

It means you can put 94% of your bank roll in this bet

Basically you are better off in second .So you should put higher money in second bet.

 

Now with Principal Protection: Max loss is zero

Company pays 15% Interest ,default percentage is 5%

Kelly Ratio =  (95%* 15% – 5%* 0)/ 15%

=  95%

It is  common sense that principal protection lower our max risk and thus   bulk of our earning should be in it!

Important thing is expected payoff works  when we have many outcomes. How do we get many outcome.We place small but multiple bets.

Let Say Somebody has 100000 to invest .How should he invest.

  • Diversification  1 : Choose multiple platform to avoid risk of bad credit risk model in any one platform
  • Diversification  2: Place small multiple investment based on expected payoff.
  • Diversification 3: Use principal protection  as it has high expected payoff.

So how will 100,000 invested look like:

Put   around 70% in I2I under principal protection.For some very safe creditor you can choose 75% protection instead of 100%.

so Now 70% of  100000 invested means :  70000

Average return :15%

Default Rate : lets take a stressed figure  of 10%

net Return = 13.5% = 9450 Rs

 

Invest the remaining  in Faircent and Lenden Club across borrower.Try to invest minimum bet size as you can place multiple bets:

Average Return 30%

Default Rate 10%

Net Return =  30*% 90% –  10% loss on Principal = 17%

So you get 17% of 30000 = 5100

 

In total you made= 5100+9450 = 15500 rs on an Investment of 100000.

 

Things to consider:

  • keep Reinvesting the EMI  you get  in lending or  use it as SIP for Mutual Fund.
  • Use P2P as a replacement for you short term(less than 3 years) money parking strategy if you are in 30% tax slab.
  • For tenor higher than 3 year Bond funds give better risk adjusted return if you in 30% slab.
  • Try to use at least 2-3 Lakh INR to be able to be diversified across decent number of borrower.
  • Remember P2P is substitute for  money kept  in FD or short term debt not for Equity SIP
  • Its a great way of diversifying in asset class not  highly correlated with Equity

Systematic Investment Plan Stress Testing

We all know the  benefits of doing Systematic Investment Plan(SIP) .It helps to average our buying cost and negate some of the impact of volatility.Many website allow you to calculate return if you do SIP based on average mutual fund performance.

The million dollar  question is how would a SIP performance look like in a major market downturn and how effective it is compared to a lumpsum investment. In the past 100 years 2 major market crashes stand out.The great depression of 1929 and the Japanese stock market crash.I dont consider 2008 crash as an issue ,it is pretty obvious the duration of the recession was not much and people who  kept on  investing made money.

Lets  see if those recession happen today what catastrophe we would be dealing with! Look at the charts of the two brutal crashes,both  lasted decades.

Great Depression
Japanese Market Crash                                                                              

I will superimpose monthly return of S&P levels of 1929 to  current Nifty levels. So Lets say Indian market enters a great depression and on top of that our poor investor had just started his systematic Investment  Plan.Our investor doesn’t panic and he keeps on investing . Lets see  how his wealth and fortune will change.

  • Great Recession Super imposed on Nifty (10000 considered as starting point).
  • Someone who would have entered  lumpsum  today would take 25 years just to break even!!!.You can see on the graph the initial level is attained near 2043
  • Maximum drawdown  would be 85%.For 1000000 invested he would lose 850000!!

.How does SIP payoff perform?

  • I have plotted graph of SIP monthly investment vs SIP performance.(black line is the growing SIP contribution,red is the value of assets)So in 2035 (17 years) we would be  break even and most of the time our drawdown are not bad. compared to Lumpsum. Worst drawdown is -350000 .We can clearly see our investment  are less volatile ! Infact by 2043 our investment would have grown by 80% 

Incremental SIP 

Now what happens if I increase SIP .08% every month ( assuming people generally grow salary at 10% a year.Take a  monthly percentage which will compound to your annual growth number).

We can see our profit and loss volatility drops further. We are averaging more at a lower level ! In 7 years we are   breakeven  and beyond 2040 profits are going to rise up exponentially

Comparison Constant SIP vs Incremental SIP:

Lets compare the returns for 25 years( i.e as of 1/07/2043). We use XIRR  when we are considering periodic cashflow. Basically XIRR tells us the net return when cashflow are erratic

  •  XIRR for Regular SIP =  5.77%
  • XIRR for Incremental SIP = 7.52%

For the Lumpsum investment we will consider CAGR (Compounded Annual Growth Rate).

  • CAGR for lumpsum = .08%

So we see Incremental SIP is the best followed by regular SIP and the Worst is Lumpsum.

People generally tend to think if they dont put all the money in equity at one go they will miss the rally.Actually difference between SIP and Lumpsum  is the incremental return you get for holding the asset till SIP starts.If we can find good money parking method our SIP can beat Lumpsum even in bull market. As we know long term equity average return is around 11% .If we can find an asset to park close to 11%( highlighted in green,20 bucks parked in those assets)  we are almost replicating the market with added advantage of very low volatility!

Points to Consider

  • Always go for SIP to avoid huge draw downs
  • Gradually increase the SIP  based on your earning growth even when market is going down.
  • One big factor is in a recession  people will lose their job or will have lower income so its almost impossible to rely on external cash inflow  for continuing SIP.It is therefore very important that people only put a  part in SIP and rest in some other assets  which they can use to continue there SIP under adverse situations
  • As we see  if we can find good money parking assets then we do not miss the opportunity cost of not being fully invested in market and also  lower the risk of stock market volatility
  • I will show in my next post how Peer to Peer lending(P2P) can be used to create an ideal platform to perform SIP.

 

 

 

Replicating a Mutual Fund Portfolio

Mr X want to invest 1,000,000 INR  in equity Mutual Fund. We will assume he is making a lumpsum investment .He wants to stay diversified so he picks these 3 mutual funds:

  1. Kotak Select Focus(60%)
  2. Reliance Large Cap Fund(20%)
  3. Reliance Small Cap Fund(20%)

What does the combine portfolio of all three mutual fund look like:

  • Total Portfolio had 216 Securities
  • Adding up common securities we get 190.(26 securities were common)
  • List of top holding in consolidated portfolio
 No Name.of.the.Instrument Weight(%)
1 Cash 8.53
2 HDFC Bank 5.60
3 HDFC 3.53
4 ICICI Bank 3.37
5 Larsen 3.31
6 Reliance 3.03
7 Infosys 2.14
8 SBI 2.03
9 IndusInd Bank 1.98
10 Hero Motocorp 1.96
11 Maruti Suzuki 1.96

Few things are evident.

  • Its not as diversified as he thinks.Quite a few overlapping securities
  • More than 30% is put in 10 securities out of 190
  • Around 8% portfolio(80000 INR) is in cash.

Now I segregate the portfolio based on market cap size.I have created 5 categories(Mega Cap Stocks> 50000Cr,Large Cap 30000>&<50000,MidCap>10000&30000,Small Caps<10000).

  • Mega Cap Stocks:37.316 %
  • Large Cap Stocks: 5.756%
  • Mid Cap Stocks:  9.098%
  • Small Cap Stocks:39.296%
  • Cash: 8.534%

Now I check the cheapest ETF and Index Funds available in the market in various market cap categories(liquidity in ETF is important).I choose the 2 products:

  • ICICI Pru Nifty ETF
  • Reliance Junior Bees( Index Fund Tracking Nifty Next 50)

*As of now no liquid ETF tracking Nifty Next 50 so we use Index Fund.In future we may get good ETF substitute

Performing the same segregation for ETF and Index Funds I get :

  • Nifty 50 :Mega cap 95.62%Large Cap 4.14% Mid Cap 0%,Small Cap 0%
  • Nifty Next 50:Mega cap 40.65%Large Cap 37.40% Mid Cap 20.57%,Small Cap 1.14%

I want to add a small cap fund to get exposure to small caps

  • Portfolio allocation for Reliance Small Cap:Mega cap 1.89%Large Cap 1.80% Mid Cap 3.30%,Small Cap 83.28%,cash 10.73%

Now If i wish to replicate my MF portfolio I will need to find the weights to put in ETF and Funds to achieve portfolio level allocation :

if w1 weight in Nifty 50

w2 weight in Nifty Next 50

w3 weight in Small Cap Fund then

 

Let Matrix A be the matrix of Allocation in my funds

Nifty 50(%) Nifty Next 50(%) Small Cap Fund(%)
Mega Cap 95.62 40.65 1.89
Large Cap 4.14 37.40 1.80
Mid Cap 0.00 20.57 3.30
Small Cap 0.00 1.14 83.28

B Matrix is the output Matrix:

MF Portfolio
Mega Cap 37.32
Large Cap 5.76
Mid Cap 9.10
Small Cap 39.30

This is an over determined Matrix. We can solve this using ordinary Least Square or linear programming.Simple solver in excel can also solve this.

Solving overdetermined matrix i get :

Allocation
Nifty 50 31%
Nifty next 50 16%
Small Cap Fund 47%

 

So If I put the given amount in these 3 funds I will be able to replicate the MF.I still have 6% left. I put that in Nifty Next 50

How does this portfolio performs in comparison to MF portfolio .Almost Similar Performance!

lets Compare Volatility:

MF Portfolio Volatility:12.27%

Replicating Portfolio:11.5%

 

Why did our portfolio show Lower Volatility.One reason is because we are more diversified than MF portfolio though allocation wise we are similar( remember we have all top 100 Securities,making us more diversified stock wise). Secondly in active management Fund manager is not only churning the stocks but also cash.Being overweight cash in a fall and then under weighing in rally can have a leverage like effect.

The advantages of having a large part of portfolio in ETF and Index and some in small cap fund has lot of positives apart from obvious lower cost

  • You dont run the risk of a fund managers under performance .Picking  the right Fund is like picking a stock and ending up with a bad fund can cause lot of damage.The risk of manager’s discretion in fund management is eliminated in ETF
  • You actually know allocation of your portfolio
  • Using various  Index option Strategies to hedge or for gaining yield  is very easy as we have direct underlying to Trade.
  • During market crash you can just buy the market rather than hoping that  fund manager correctly guesses  the sector which will bounce back.
  • Mutual Fund lack transparency.No clear demarcation in categaorization ,you end up aggregating similar stocks through multiple funds .No realtime tracking of mutual fund portfolio.You have to trust their NAV numbers.

The bottom line is invest in  Index ETF and Nifty Next 50 ETF and then choose a small cap fund  wisely.You dont have to fret about 100 funds now!!!Happy Investing

 

 

Mutual Fund and ETF Investment Strategy

Equity Investment through Mutual Fund is growing at a very fast pace and so has been the number of Asset Management Companies in the market.Mutual Fund Companies charge a fees called expense ratio for managing the funds. ETF on the other hand track the broad market Index.The fees for ETF are lower (.05%-.2%) compared to MF(1%-2.5%). There are many articles on MF and ETF comparison weighing pros and cons of each.
A combination of both can be used to generate more optimum returns.A three tier  analysis of the Mutual Fund and ETF will give insights to construct  a robust portfolio :

  1. Comparison of  various Mutual Funds with  Benchmark Index(and Total Return Index)
  2. Dissection of a “Large Cap” marketed Mutual fund
  3. Replication of Portfolio with ETF,Index Funds and Small Cap fund.

Total Number of Funds  in Large Cap Category: 114

Total Funds older than 5 year :90

Nifty 50 and Nifty Next 50 Total Return Index (includes dividend) Annualized Returns across various  period

Index 1Y Return 3Y Return 5Y Return
1 Nifty 50 15.29% 9.46% 12.17%
2 Nifty Next50 12.11% 16.18% 19.19%
3 Nifty 50 TRI 16.60% 10.77% 13.46%
4 Nifty Next 50 TRI 14.29% 17.93% 20.85%

 

Out of 90 funds 36 were able to beat Nifty 50 Total Return Index Return for 3 year. I took the 3  year period because if you compare older returns you will see more Mutual Fund out performance because market was not very efficient and lot of alpha was there to pick which has gradually eroded mostly in the Large Cap space.

Below is the List of funds which made the cut.

Scheme Return 1Y Return  3Y Return 5y
1 Tata Equity P/E 13.80% 18.30% 24.80%
2 Sahara Power & Natural Resources 6.20% 16.80% 16.80%
3 IDFC Focused Equity 21.90% 13.80% 15.30%
4 Tata Retirement Savings Progressive 16.70% 17.80% 20.20%
5 Axis Focused 25 20.70% 17.50% 18.00%
6 JM Core 11 11.40% 15.10% 18.10%
7 Canara Robeco F.O.R.C.E 17.50% 15.70% 18.30%
8 ICICI Prudential Indo Asia Equity 12.30% 11.20% 18.90%
9 Templeton India G 12.40% 14.50% 17.10%
10 Invesco India G 22.30% 14.30% 19.40%
11 Reliance G 12.90% 13.80% 19.90%
12 Sahara R.E.A.L -G 13.80% 17.30% 24.10%
13 Kotak Classic Equity -G 20.70% 12.60% 15.80%
14 Aditya Birla Sun Life India GenNext -G 14.50% 16.20% 19.80%
15 Kotak Select Focus -G 10.10% 14.80% 20.70%
16 HDFC G 13.70% 13.30% 15.20%
17 BOI AXA Equity 20.70% 12.70% 16.30%
18 ICICI Prudential Dynamic-G 12.60% 11.90% 17.80%
19 ICICI Prudential Focused Bluechip Equity -G 15.30% 12.50% 16.80%
20 Sundaram Select Focus 16.20% 11.20% 13.90%
21 ICICI Prudential Top 100 -G 9.10% 11.30% 16.40%
22 HSBC Equity -G 13.40% 11.80% 14.30%
23 Indiabulls Blue Chip -G 12.40% 13.30% 13.70%
24 Escorts High Yield Equity-G 4.70% 15.70% 23.90%
25 Escorts G 17.20% 15.10% 22.00%
26 Principal Large Cap -G 12.60% 11.00% 15.80%
27 UTI Equity 18.30% 11.60% 16.80%
28 Invesco India Dynamic Equity -G 14.50% 11.40% 15.40%
29 Axis Equity -G 20.70% 12.00% 15.10%
30 Escorts Leading Sectors -G 16.70% 14.70% 23.10%
31 Canara Robeco Large Cap+ 12.50% 10.80% 13.80%
32 Aditya Birla Sun Life Top 100 -G 9.80% 11.30% 17.40%
33 Peerless Equity -G 7.40% 12.70% 13.80%
34 Invesco India Business Leaders -G 16.10% 10.90% 15.40%
35 SBI Blue Chip 13.20% 12.50% 17.90%
36 Quantum Long-Term Equity -G 9.00% 12.70% 16.10%

So 40%(36/90)  were able to beat Nifty.Lets go one step further and see what holdings these so called “Large Cap” Funds have.I will take SBI Blue Chip as it is quite popular in the Large Cap Category.Here is a snapshot of the holdings:

Wow its marketed as a Large Cap Fund and  it has not more than 50% in stocks with market capitalization more than 50000 Cr .Well the thing is categorization by market cap  is very subjective and  often misused.

Its not fair to compare a multi cap fund to Nifty 50 TRI index. We should compare it to atleast Nifty 100 .ie.  50%Nifty50 and 50%Niftynext50 which  gives around 15% return!!! Using this benchmark hardly 10%  funds  are beating Index investment.Picking the ideal Mutual Fund is  again a matter of luck to an extent !

Now another surprise

Around 8% of money is in cash generating close to 6%. Its not a bad thing to keep money as cash and deploy when right time comes but what if we can generate higher return from that cash! .Secondly it means that Fund Manager is using 92% money to invest and beat 100% of Index.Doing this consistently is tough .

So summarizing what inference we have drawn:

  • Most Mutual Funds are not able to beat total return index
  • Most Large Cap Funds are generally Multi Cap Fund
  • Around 5-10% of money is parked as cash.

Now lets say Mr X bought 3 funds (1 Large Cap,1 Mid Cap,1 Small Cap) .In reality he is holding some amount of Nifty and lot of Small and Midcaps. How can he get the same exposure more efficiently. What we do is we replicate our portfolio using low cost Nifty  ETF, Nifty Next50 Index fund and one small cap fund for the Alpha.We put the extra cash according to our risk appetite. I will demonstrate in my next post how I replicated a mutual fund portfolio and achieved higher return at lower volatility.

 

Hidden Costs of Investment Products

Iphone is popular,so is Versace ,Chanel and BMW. We only pay premium for products were we perceive  higher value.It can be in the form of quality,features and so on.Some people argue that these brands are overpriced because certain similar products cost far less. The argument is quite subjective because for someone the prestige of owning a Prada bag is superfluous but for others it could be a pass to fit in a social circle.

What about Financial Products? Can the brands command a premium .is it justifiable?Well like other products a higher cost must translate into some kind of value.The problem lies in the fallacy that there are ways to achieve higher returns without taking additional risk .So now when I have a cap on the value of return someone can give me , what is the company offering me extra? maybe lesser risk .Again the lowest risk technically is in the sovereign bond .So now when  i have both a cap and floor of risk adjusted returns and its  a small range to spend a portion of it on products which add no value!

I have worked in Asset Management,Proprietary Trading,AIF ,Structured Products and one thing has been common if someone can make money they will do it for themselves not sell it for small commission!

Lets take an example:

A fund X gives its client 10% return  on a average.

It charges 2% fees.

what is the client left with ,8% and that too offcourse with higher risk than a government security.

If a low cost debt fund  is paying 8.5% for that tenure and it has indexation benefit you will get close to 8% Returns.Its better to take a known risk for a given return than an unkown risk.

So our high flying company X is a rip off for the client.Took more risk and gave inferior returns .That sucks! The Company charged me 25% fees(2%/8%) for nothing.

This is no anomaly! The amount of money people trust on such institutions is mind boggling! No wonder finance industry is a coveted place to be in.

One should only use an investment product or service if it provides a payoff or exposure to asset classes which can not be  feasibly achieved through replication at a lower cost.Examples of it would be PE firms investing in growing startups or P2P lending platform

Let’s see what kind of money management services are there in the market and how they have fared and then we will figure out ways make our money grow ourselves!

AIF/Hedge Fund: Indian hedge Fund Market stands at 3.5Bn Dollars.Most structures charge investor a 2% management fees and 20% of profit generate over a given hurdle rate. They are available only for high networth people.Strategies like Long Short stock baskets ,Derivative trading are used to generate Return.

If a firm generates 20% and hurdle rate is 10%.Net return would be 20%-(20%*10%)-2% = 16%

Over that you might end up paying more if you go through an Investment advisor or RM .So after tax you will be making around 10%.Looks good standalone but when we compare it to the benchmarks results seem dismal.

Report generated by EurekaHedge shows the comparative Analysis:

The Returns have been less compared to the equity market but if they provide hedge against a bad time then it might be good deal.The correlation figure show that results are highly correlated to Indian Equity Market.

Below is 12 month rolling alpha considering zero risk free rate.

Had we considered risk free rate at 7% our alpha numbers would have dipped in negative territory.

There is no denial that some funds give good return during some year but to find those funds and be in those funds at the right time is no easier than picking a multibagge r. Then why do so many people flock to put money in these products.Good marketing,Shiny Prospectus with big numbers, Fancy strategies

 

PMS: The case for PMS is that they are more customized than mutual fund and can provide returns and risk profile as per the investor demand.The drawback is higher tax implication ,management fees.Minimum investment is 2.5 million INR so you need to have a big portfolio to put in a part in PMS.Again fees structure can vary but generally includes 2- 2.5% fees plus profit sharing .It doesn’t leave much if returns are low.

The performance of PMS has been very diverse.On hand some PMS have generated 40% CAGR while some  couldn’t even get through 2 digit returns.

The correlation with broad market is high as investment is in long equity position. Comparative Analysis of top PMS with Mutual Funds:

A couple of PMS might have given better return than the small cap Mutual funds but an average PMS with management fees,commission etc which could be close to 6% will be losing bet.These performance are in a bull market and we should not mix bull with brain!!

Mutual fund investment any day provide better risk reward ratio because:

  • PMS in not tax efficient .Dividend are taxed at higher rate as you own the stocks
  • Mutual Fund offers to invest through SIP(systematic Investment Plan).You can average your cost which is very helpful in a falling market
  • Higher Fees in PMS offset any alpha they can create in the portfolio

Structured Product:Structured products offer investors the potential to earn returns tied to the performance of an index or basket of securities. Rates of return vary and are generally paid at maturity, along with the face amount of the investment, subject to the credit risk of the issuer.

Structure of the product comprises a zero coupon bond with an option:

Some of these provide principal protection and give a comfort to the investor that they can participate in the market while protecting the capital.In essence they are trading their market risk for credit risk of the bond.

I have worked in Structured Products and the cost embedded in these products are huge.Most of these products can be replicated at lower cost by people with some understanding of derivatives. I will dwell upon details to create various structures  in my future posts.

 

Mutual Funds: Mutual funds market has grown immensely in the last few years ,thanks to the raging bull market and it has been a great well creator for many.It definitely has cost attached to it called expense ratio(TER) .If you buy a regular plan through broker you end up paying even more.

So is mutual fund the most optimized solution. Most mutual funds are not actually how they market themselves to be.Lot of so called Large Cap Funds have mid cap holding etc .So we need to understand in totality what kind of portfolio we want and then use combination of low cost ETF ,Debt Funds and small cap funds to replicate our desired portfolio.The difference in alpha between ETF and mutual fund have diminished over the years as market have become more efficient

Another factor is that lot a of MF keep around 7-8% money in cash.Replicating using ETF we are able to get higher leverage with same volatility.Using equity options in conjunction can further enhance returns.I will  post my replication of a mutual fund portfolio using ETF ,Index Fund and small cap which is able to generate higher return at same volatility!

 

Life Insurance:Life  Insurance is something which is not possible to replicate for a  normal person but it comes with a caveat.A term insurance is not possible to replicate but whole life Insurance and ULIP can easily be replicated using combination of Term insurance ,mutual funds(Debt,Equity) and ETF .Not only they can be replicated but also provide better return.So if somebody wants to create a retirement corpus its wise to  buy a term insurance and based on the corpus he wants to create invest in various assets which can provide that return in that tenor.I will  provide a comparative analysis of various insurance products with do it yourself superior strategy!