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When you right click hysteria, you get both “panic” and “frenzy” as options. An apt word to define extreme stock market conditions which witness periods of melancholy followed by hubris. Both are extreme situations and opportunities to either buy or sell. Several indicators have been devised by researchers over the past to gauge such scenarios.

While some of these indicators are complicated and require heavy data crunching, there are others that are phenomenally hilarious and supposedly have a decent level of accuracy such as the – Underwear Index, Garbage indicator and R-word index. The search for a clinical definition of hysteria takes us to anxiety disorder. The anxiety here is caused due to either missing out on the upside or holding in excess during the downside. Over-dose of media and cacophony of the neighbours/friends add to this anxiety.

Alongside the usual suspects the height of hysteria is raised as we keep hearing the cliché “this time it is different”. It may not be very different despite the – never seen before pandemic driven market collapse and bounce back or the unprecedented support of liquidity. These things have happened in the past, with the only variation in degree and character. Nevertheless, this time it’s different for the presence of the following elements…zero commission brokers, social media influence and crypto. The presence of these new elements has drawn in even the most stable of minds.

Thanks to the likes of zero commission brokers, a group which stormed into the broker lobby couple of years ago with a deal that many couldn’t refuse. It provoked even the uninitiated to give it a try- its free after all! Never in the past have we seen full page/front page ads of stockbrokers screaming at you…. ARE YOU NOT IN YET, LOSER! The target crowd are no longer people suffering a mid-life crisis, rather the young and bold (read novice and looking to make quick money). Focus is on the convenience of execution of a trade or account opening rather than on research and quality of investment. The cool dudes are the ones that appear tech savvy and make money by trading every day. Coincidently for them the markets have gone only one way and their bets have generally been correct. This has created a frenzy of sorts amongst the retail community and certainly FOMO (fear of missing out). SEBI/RBI/Finance Ministry have voiced their concern regarding the rampant increase in demat accounts- to cool off!

Bollywood endorsed crypto exchanges have gone one step further claiming safety of your funds (often misread by the gullible as capital protection). They have been sponsoring big events like IPL and constantly appear on print media as well. While there are many unknowns regarding this segment of so-called currency there is a common understanding of the knowns. This segment is unregulated, these don’t fall under the conventional definition of currency either because it is neither a store of value, medium of exchange or unit of account. Expectation of any future value emerging is speculative and can cause extreme volatility (>>small caps) or face government restrictions (as in China). Certainly not recommended for the weak hearted or retail as it entails both market risk as well as process risk.

Social media are full of advisors (influencers) giving trading tips/strategies upping their views with a loyal set of followers. Showcasing their follower base, they generally follow up with training programs mostly related to F&O trading and technical analysis. It rains money for such trainers especially when markets move like they do now. Exhibiting extraordinary past performance is an easy way to lure the naïve. Sooner than later these followers realise that trading has caused more pain than gain. Majority of these advisors are not qualified or vetted by SEBI and act outside their purview. Thanks to online training these things can be easily disguised. The explosion of social media on mobile has drawn in many with easy looking steps to profit, with available past data, without guidance on how much from savings a person may allocate to this activity while learning.

Sustainable wealth creation through a rational, tried, and tested process requires patience. The procedure of gaining quick money will only increase your risk levels. Equipment is not a major concern, let’s be clear, the app you use will not help you create wealth. Brokerage is a very small component in the big picture so zero brokers or commission brokers should not really matter. Their track record of governance will be more important. Jumping into un-tested waters like cryptos, however tempting it may appear, should not be without life jackets. Simple rudimentary products/instruments work better than complicated ones. Take a deep breath and a step back, this is a time to fine tune your investment objective and prepare a proper plan which should be supported by the strength of your temperament. Don’t fall prey to the hysteria around!

In the bygone era, the Fund manager used to rely heavily on information asymmetry in order to select stocks for their portfolio. Funds were managed based on the information that was privy to a close set of people. This was the time of no internet, few telephone connections and almost non-existent regulations. Envisaging long term growth in companies based on research was more of a myth because there was hardly any public data available for such activity.

We have come a long way from that age. Several important changes that have taken place in the last two decades and have caused a paradigm shift in the fund management industry.

Regular information flow from companies have become mandatory and exemplifies good corporate governance which in turn is an important aspect of stock selection. Majority of the companies have set up separate investor relations department which cater to this need. Quality and timing of information from companies is very important to provide comfort to foreign as well as local institutional investors who rely extensively on research and data. Development of the internet has made this information gathering easy and hence vanquishing the problem of material asymmetry.

Likelihood of insider trading, circular trading or benami accounts have declined significantly over the past with the advent of dematerialization of shares and surveillance being done electronically. Tracking and tracing of illegal accounts have become relatively easy. While rigging of share price continues, it certainly is not rampant as it used to be.

Market participants have increased manifold and no longer a ghetto of specialists that control the trend. More importantly, the level of cognizance regarding companies and market trends by the millennial investors has improved due to the availability of data, increase in education levels and deep media coverage. Various discussion forums serve as a platforms to dissipate information and knowledge freely.

This increased efficiency in the information flow has had a un-expected fallout- The Active Fund Manager.

The performance of active vs. passive investors is narrowing down greatly. The cost involved, fees to be paid and inconsistency of returns have made the active fund managers an over-rated lot. Past performance is almost never an indicator of the future.

Selecting a stock after several years of research and continuous follow up involves significant amount of time, effort and money. Since all the research done is based on past data, an extrapolation into the future involves significant amount of ambiguity and mostly left to chance. Risk of research failure is mostly unacknowledged and left unpunished as there is always a “Disclaimer”.

Rising influence of algo trading and robo advisory has also been an important reason for the advent of passive investing. Robo advisors are creating passive investors by disciplining them through technologies that embody canonical models of financial economics. Robo advisors and their algorithms influence their users and objectify them by automating their investment decisions.

Did you know one of the largest Asset Management Company in India has also been the biggest underperformer in many categories that it operates. Nevertheless they continue to have a huge following, loyal base of clients and their AUM grows primarily due to a brand image that they have created over the past and an overall positive opinion in the media regarding their fund managers. It is also because of their already well-established access to the huge retail and corporate network. Investors flock in more due to the efforts of the distribution and marketing network as a “push product” and less due to the risk adjusted performance.

Did you also know the largest fund house in the world manages only ETFs and other such index following schemes. These passive funds now form the majority of Assets under Management across the world. The Big Three index fund managers (BlackRock, Vanguard, and State Street) alone cast around 25% of votes in S&P 500 firms. The tectonic shift of money into ETFs and other such passive funds evidences the incapability of the active fund manager to beat the benchmark consistently. The new generation players in India such as the Bansal backed Navi and Kamath promoted Zerodha are coming up with ultra-cheap passive schemes to garner majority share. This is convenient to operate for the Asset Management Company using technology and less manpower, moreover it is also easier to convince the investor because there is no question of outperformance or underperformance.

We at Pelican believe in a hybrid model of combining the active and passive way of managing funds. Staying active should not mean churning the portfolio regularly, rather actively tracking the trend in fundamentals, the macro parameters of the stocks selected, and the risk appetite levels of the overall market. We select a basket of 8 solid companies clearly defined by certain criteria, which have seldom required change. In the case of pure play ETFs the portfolio gets widely distributed, hence there is little scope for alpha generation. However marginal exposure to ETFs provide the adequate broad market participation. The concentrated portfolio offers the outperformance, while the ETFs and Large caps reduces the risk. Hence the combination of both ETFs and stocks in our portfolio provide the maximum risk adjusted returns.

Efficiency of the market will increase as we move ahead and information will be available to everyone at pretty much the same time, thanks to technological advancements. The high amounts of capital and time spent on having an informational/analytical edge will dissipate fairly quickly and eventually not be worth at all. Our edge at Pelican is neither informational or analytical as we believe both are increasingly becoming redundant. We focus our strength on institutionalizing our temperament and providing an objective process to buy and sell over a long time horizon. Impatience and desire to avoid volatility on the part of others will present the opportunity.

The all-encompassing want is money. Human love for money is never ending, some manage to get more than others either through force, knowledge, inheritance, talent, or luck. However, it is a myth that the rich know what to do with money. It is also a myth that the intelligent ones are financially savvy. How many rich parents have richer children, historical studies indicate that the graph start to slide from the 3^rd generation onwards.

Source: https://www.genlegco.com/wealth-advisors-family-planning-consulting-services

The graph below is a typical representation of how emotional wellbeing and income levels are related. There is only one thing that connects the two and that certainly is not the amount of money one has; it has more to do with EMPOWERMENT

https://www.morningstar.com/insights/2020/02/13/financial-empowerment

Empowerment is the process of improving the capacity of people to take decisions that are appropriate to achieve their financial goals. Empowerment starts with financial education/literacy. Whatever be your profession or your income levels, your understanding of finance is essential for your security. Understanding finance does not mean being an expert in accounting, reading balance sheets or keeping track of financial jargon. Rather, it is the awareness towards what you earn, how you earn and how you spend the same. What remains after spending becomes your savings, the seed for your wealth creation. Cognizance of your personal finances and clarity on your goals enable changes in behavior. Behavior affects your mental state, and if you are really empowered then there is a better emotional experience through the feeling of pride, joy, satisfaction, and peace.

“Tell me and I’ll forget; show me and I may remember; involve me and I’ll understand” … Steps to empowerment should include reading, discussing, practicing the skill of money management. There is no substitute for hands on experience to understand the process of savings and investment. A rudimentary process backed by discipline and solid temperament is more than sufficient to ride the cycle of boom and bust. Progressive experience will enhance the returns improve the process and relieve the investor from the surrounding cacophony.

There is significant evidence that indicates that a higher percentage of woman have lower levels of financial participation. The potential implications of gender differences in financial literacy and participation within the household reduce women’s active participation within the economy; economic power within the household; transmission of knowledge to the next generation and lead to worsening existing social disparities. As we progress towards a world where individual financial decision-making is imperative, women may be disproportionately vulnerable. Empowering women financially will greatly reduce a root cause underlying gender differences.

Financial inclusivity propels growth of a country. Being financially empowered helps understand the products in our globalized marketplace, choose wisely and participate. Financial empowerment helps an individual make a more assertive, confident, and efficient decision. In essence it helps people in framing proper responses to situations involving risk and opportunities. This is when money starts working for you.

Investing is a process by which schematic purchases are made into assets that are expected to grow over a period. The objective of investing being to secure a financial future and achieve pre-defined milestones. It can be pursued with a good understanding of how the economy works. Condition of the economy give cues on which assets to own.

All Investments involve risk. Risk emanates from the uncertainty of the events that will take place in future. When everything is going well, life is smooth, majority make profit, risk is your best friend. When things go downhill investors lose money in hoards and risk bites. The challenges from risk become acute when significant amount of energy is spent on predicting the future outcome instead of preparing for diverse outcomes. Preparation involves positioning the portfolio in alignment with the trend. This has 4 major benefits – an appropriate price can be arrived for the asset purchased, the quantum of risk can be gauged, a realistic expectation of returns can be made and most importantly it makes the need for short term predictions redundant. Adequate preparation reduces the risk.

Cognizance of the cyclicality of asset prices forms the basis of understanding trends. Getting the trend correct increases the odds of success significantly. An economic cycle is defined as a period from trough to crest (in the graph below). Further each cycle is only a continuation of the previous cycles, there is no beginning or ending. In a progressive economy, a boom is responsible for a bust and similarly a bust eventually transforms into a boom. A good understanding regarding such cycles is essential for asset allocation, re-balancing, and eventual outperformance of the portfolio. Further as the scenario repeats it would not require to re-invent the wheel and develop strategies at every turn of the market.

Once an understanding is developed with regards to the ups and downs in the market the investor should chart out a rudimentary process that can be replicated over several time periods based on the cyclical nature of the economy, including reactions to shock-events. This should simply involve buying when prices are low and selling when they are high. Time tested metrics such as historical Price Earnings ratio, profitability margins, sector fundamentals, GDP growth and so on are some methods to quantify the present valuation levels compared to the past. Since investing is not a scientific process each cycle is confronted with different degrees of euphoria and pessimism. This would require adequate room for a margin of error/safety. The process should judiciously maintain balance between risk aversion and risk tolerance. Allocation of cash becomes an important decision while making an investment. Knowing what you own and how much you can afford should be clear even before starting to invest.

Voracious lateral reading on several subjects helps more often than financial statements. It is imperative to understand how we got here to evolve better in the future. In times such as now (where frenzy rules and the uptrend appear to continue forever), often the compensation for the risk taken is bare minimum or negative. Predictability of an outcome has a certain probability which increases or decreases by correctly gauging the point at which we are in the market cycle. Quoting the legendary Howard Marks “How you deal with cycles is one of the most important things in investing. Cycles will happen to you. What you do in response is key”

The Kierkegaardian conundrum- The story of stimulus

A stimulus package is a set of economic measures put together by a government to stimulate a struggling economy/sector or company. In the case of an ailing economy, the objective of the package is to strengthen and prevent or reverse a recession by boosting employment and spending. Whereas in the case of companies/sectors, it is expected to provide temporary working capital to overcome the immediate cash flow requirements. This is usually a temporary measure to tide over a crisis.

The first such major incident of a stimulus/bailout was provided by the then government to East India Company, when it was at its zenith. Favored by the government of the time via subsides, kickbacks, loot money and several such under the table incentives. EIC was also built on heavily borrowed money and equity funding by speculators. It suddenly went bust post the Bengal famines in 1772 and took with it over 30 banks and several others. The government chose not to liquidate the company or penalize it for its bad strategy, instead focused on providing support for its continuity. The funding continued for few more decades until EIC, finally ceased all commercial operations in 1833. At a great loss to the exchequer, equity holders as well as lenders.

A more recent example of a never-ending stimulus is Japan. The country is yet to recover from the 1989 crisis which was followed up by cheap money to invigorate growth. Central bank influence has been so profound that other than printing money and keeping interest rates negative they have even participated in buying equities via ETFs. It is estimated that the Bank of Japan currently is the biggest single owner of the nation’s stocks with a value of $434bn. It is amongst the top 10 shareholders in 90% of the companies listed on Nikkei 225!

The often-quoted success story of a stimulus program benefitting an economy is the US recovery from the Great depression in 1929. It is debatable whether stimulus was the reason or that the real reason was the emergence of US as a political superpower post WW2, creating unprecedented interest in the country and its currency took off.

Fast forward to the current scenario.  It is estimated that currently the US Fed is purchasing about $120 bn of fixed-income assets monthly. When combined with similar policies of other central banks, these purchases have achieved the basic objective of helping to suppress bonds yields globally. Thereby discouraging the savers and encouraging the speculators. Overall, we now have about $18tn worth of bonds globally yielding below zero percentage. Fed, ECB, BOE and BOJ own financial assets that are more than 50% of their GDP. Increase in money supply is the highest in 2020 by $14tn reaching a staggering number and 16% of global GDP.

Recessions are now becoming a regular global event. Thanks to the convergence of world economies and its interdependence. The cause of these recessions is in the can kicked down the road to resolve the previous recession. Resolutions are by pumping liquidity and keeping interest rates low; instead of resolving structural issues, increasing potential GDP, and keeping debt levels sustainable. Acknowledgement of the problem by Central Bankers and Political will to resolve it by the Governments once and for all, will require biting the bullet.

Expecting growth by resorting to an artificially low interest rate regime is clearly not working. Building a country/company based on cheap money and weak underlying fundamentals will not achieve success in the long term. The earlier we get treatment for liquidity & low interest rate addiction, the more likely are we to avoid some of the more dire consequences of the disease. The Central Bankers and Governments are choosing to remain oblivious to all that goes on in the world, which is not comfortable to notice; hope they own up to the reality they know and work at resolving.

Post the recent GDP announcement there has been a continuous debate regarding the recovery of the Indian economy. While nobody doubts a recovery, the debate is primarily on the shape and period – U, V, W are some of the proposed types and 2-5years is the general drift on time period. The graph below evidences several macro indicators rebounding from the lows of the first quarter. Certainly, looks like V for now, is this be sustainable, what are the pain points ahead…

Core industries, IIP and PMI are production metrics which had been low all through 2019, worsened further this year. GDP declined 24% in the first quarter and 7.5% in the second. RBI estimates the next 2 quarters to be marginally positive and we would end this year with an average decline of 7.8%.  The metrics would certainly look better next year due to the base effect. However, to ascertain the sustainability of the production levels will depend on the demand scenario. Most of the demand that arouse in the second quarter is attributed to the production catching up with lag due to lock downs, building up from a low inventory position to prepare for festival sales. We need to observe if this tapers off and companies start scaling back production resulting in pulling the shape of the graph southwards again (i.e V becomes W).

One simple measure of demand is inflation, which has held through mid-single digits all through this pandemic. RBI targets inflation by end of the year to be around 6.5% and is accommodating by a repo rate much lower. Not clear now if inflation holding up due to data collection not fully recovering and supply side constraints, rather than actual demand growth. Despite a low interest rate and surplus liquidity regime, the real estate, consumer durables, travel, entertainment have been under severe stress due to the lack of demand under gradual opening. Some estimate of loss of GDP potential are at 20%. There will be a loss of output to the tune of $350-400 bn which may take a while to return. The biggest casualty of this would-be job losses for the common man, re-skilling to- new sectors, which keep consumer spending & confidence under pressure. Hence demand for some sectors coming back to pre-covid levels does not mean the economy will be the same again next year (i.e V becomes U).

Corporate numbers also indicate a similar trend. Topline in the second quarter improved by 23.6% on a Q-o-Q basis while bottom line jumped 121% from the lows of the previous quarter. Clearing of inventory, lower purchases, reduced employee cost and high pent-up demand has translated into this stupendous improvement in profits. Zooming out on the Nifty 50 earnings, we observe it was at Rs.450 in the beginning of 2020 and currently it languishes 20pc lower around 360, long way to go.

Another interesting data came from, the K.V. Kamath committee, which was created to provide targeted sector-wise relief to the borrowers. The committee came out with an interesting finding, 29.4% of the total banking debt was impacted by the pandemic alone while another 42.1% was already facing stress before the outbreak. Which basically means, about 72% debt of the banking sector is under severe stress. The committee also recognized that the best of the companies has been affected, businesses that would have otherwise been viable have gone bad and the impact is sector agnostic. Proposals from the committee included, moratorium, restructuring, waiver, and other such concessions. Adding to this problem are populist below par, non-collateral loans such as MUDRA etc. provided to MSMEs; significant portion of which have gone bad and look irrecoverable. Banking sector faces a triple whammy- subdued credit off take, low interest income and rising NPAs. This is a real and present danger the system faces. Short term balance sheet dressing may last only for a few quarters.

Governments have generally followed Keynesian principles during a crisis. They prop up spending, create confidence and gradually private investments follow. However so far this year, the country has not witnessed capital investments either from government, private or foreign players. Allocating funds towards pandemic emergency and other social revenue measures have put pressure on Government infrastructure spending. The delay in new project pipelines impact confidence levels for private players. Ability to focus and execute on the disinvestment target of Rs.2.1 tn for FY21, looks impacted too. Government may find it hard to manage fiscal prudence with lower tax revenues. It is estimated that fiscal deficit will rise to high single digits or more by next year. Rating downgrades come into play in case of that scenario.

All these pain points when viewed in the context of the stock markets surging, makes us grab popcorn to watch. There has been a flood of liquidity from foreigners in the last couple of months, averaging Rs. 30 bln+ per day of late. Fear of missing out has taken the street by storm and retail investors have shrugged off everything negative. Bears have been trampled beyond recognition and valuations have skyrocketed (Nifty is currently trading at 36x PE, which is about 63% higher than the 10-year mean!). All this is attributed to the success of the vaccine, by many, which might bring back normality to the system probably in 6-12 months down the road. We need to observe cash-flow at that point to understand the new normal that emerges. Business models would have changed, humans would have evolved by then and the entire ecosystem might look different going forward. Visualizing the outcome of this complex unfolding system is a tad difficult at the current juncture. Good to stick with poker-face, cut the euphoria surrounding the shape and observe the unfolding economic growth, while conserving cash at such times to invest more prudently later.

“Learn from the mistakes of others. You can’t live long enough to make them all yourself” …

Stock market is a great place to study about winners and losers. Since there is money involved it makes the story even more interesting. Each story provides several insights into the do’s and don’ts of investing and all we must do is to imbibe the knowledge left over by the people before us.

By any measure of scale, Warren Buffet towers in the list of great investors. While every fund manager swears by the Guru, seldom do they follow him in any way. We, diligent followers of Lord Buffet, have managed to implement some of his important tenants for the well-being of our investors. We believe his words of wisdom are applicable under every condition.

1.  Frequently, the best decision is to do nothing

The basic premise is that over a long term the stock markets reflect the economic status of the country. During that long term, mispricing’s may occur, and they create opportunities to invest. These do not occur every day though. Investors need to allocate funds and be prepared to invest at the appropriate time whenever it occurs. In the meanwhile, it is best to do NOTHING.

The decision to act or not to act is based on the robustness of the investment plan and meticulous following of a process. To avoid ambiguity in stock selection and being swayed by exuberance or panic of the market, we at Pelican PMS have selected a set of stocks that would be purchased at predefined levels. We change a stock only if there is significant long-term change in the fundamentals of the stock selected and sell when predefined levels in the overall market is reached. Otherwise, we stay still and give time for the underlying cashflow to grow. This avoids unnecessary churning of portfolio, subjectivity and reduces costs. The table below indicates the typical number of days Pelican PMS has been active for a client-

2. In the short-term the market is a voting machine; in the long-run it acts as a weighing machine.” Occasionally, the voting decisions of investors –amateurs and professionals alike – border on lunacy.

Assets are investment vehicles which have undefined time periods to earn undefined returns. Mature assets at steady state have cash flows that can be reasonably discounted to current date. Any useful asset will grow like a tree over a period and produce fruits only when they mature. It is best to give only a cursory glance to results in the short term and ignore the daily chorus of dramatic, ominous, or euphoric views.

At Pelican PMS we focus on market cycles. Historically every cycle has taken about 5-7years from trough to crest. Growth is a function of how these cycles manifest and are managed by various companies. These cannot be gauged in the short term and it is futile to attempt to do so. Hence, we work only with weighing machines.

3. Financial staying power requires a company to maintain three strengths under all circumstances: (1) a large and reliable stream of earnings; (2) massive liquid assets and (3) no significant near-term cash requirements.

Portfolios should be constructed with stocks that can wither any storm. Basic filters such as reliable stream of earnings and robust balance sheet (high cash and low debt) serves the purpose. Corporate governance and solid track record will auger well to reduce significant risks. Investing money with such companies put the odds in the investor’s favor. 

Stock selection criteria at Pelican PMS follow similar filters. Companies that have adhered to the above criteria, vindicated track record of corporate governance and top position for several years form the basic construct of our portfolio. By investing in large cap companies and market leaders we manage to avoid several unknowns, have better data for analysis and institutional buying support.

4.The ability to fight off the ABCs of business decay, which are arrogance, bureaucracy, and complacency.

The classic error of successful investing is the change in attitude once successful. Achieving success is only one part of the story, staying there makes all the difference. Delusions on personal intelligence and capability to foresee the future, are usual suspects that have caused trouble. 

Pelican PMS has structured its strategy to be process driven rather than based on the whims and fancies of the fund manager. Our model is more quantitative than qualitative, leaving little room for personal attributes to creep in.

5. If our noneconomic values were to be lost, much of Berkshire’s economic value would collapse as well

Inherent attitude towards life is non-monetary, but they form the backbone for all the actions taken. The core of Pelican PMS is client’s interest first. Our qualitative aspects include transparent reporting of performance and expenses, low churn rate, no entry or exit charges, maintaining adequate margin of safety and offering a good night sleep.

 Success of the biggest investment company Berkshire Hathway has been the consistency in the way it operates. They simply avoided most of the common mistakes and moved away from the conventional methods. We at Pelican PMS also intend to do the same, thanks to the wise men we live and learn from!

The Indian stock market has nearly 5000 listed companies. During times of market frenzy there is usually a spurge of stock recommendations by fund managers, brokers, neighbors, chai-walas and others. We see almost 4999 companies in the recommendation list. How many can you buy? One such friend had nearly 120 stocks in his portfolio each bought for a value of Rs.1000. His rationale was simple de-risking of the portfolio by diversification. Do you really need to diversify so much to generate your desired investment return? How do the “professionals” manage money? Is the overly used metaphor “don’t put all eggs in one basket” apply well in investments as well?

Post the stock market crash of 1929, there was an urgent need to formalize the process of managing money. Several prominent scholars started creating theories on portfolio management. One such person who lost nearly all his money got special attention. Benjamin Graham learnt from his mistakes and the losses he suffered that he finally decided to teach his students what not to do and how to become winners (some students did excel!). Diversification is one such theory that was initially promulgated by him to protect the downside. This was later improved and quantified by Harry Markowitz through his Modern Portfolio theory. After nearly 60 years, how have the investors/fund managers evolved and use the concept of diversification as a tool to de-risk their portfolio?

Mutual funds are the easy target. They are the most transparent and provide a lot of historical data for analysis. Hence it is easy to use them for our study. Our study was simple, we took 7 large cap funds (not naming any here..) and broke up their risk and return over a 16year period (2004-2020), then correlated it with the number of stocks they held. We then compared it to a simple portfolio of 10 large cap stocks. 

The table below summarizes the results-

*NoC- No.of companies

10 Large caps selected for the exercise were –

Most large cap funds have anywhere between 30-85 stocks. While most of them managed to outperform the benchmark (avg. annualized performance of MFs were 15.4% vs Nifty 11.1%), their volatility as measured by standard deviation was higher (mean annualized std deviation was 23.9% for MFs vs Nifty 23.6%) and so was their drawdown (avg drawdown of MFs was -28.3% vs Nifty -25.5%). Whereas in the case of the portfolio of 10 large caps,  returns were the highest (18.7%) and risk the lowest (22.8%). Also drawdowns were significantly lesser (-20%). Which basically evidences the fact that risk did not alleviate with increase in holdings nor did it improve the returns significantly. 

This is nothing new that we are stating here, most fund managers are aware of the same. Then why do they expand their portfolio? It could either be their own insecurity regarding their choices, unavailability of quality and sizeable companies to invest or mandatory requirement by the regulator. We believe it as a combination of all of them. Nevertheless, investors are at the receiving end as they do not get the best returns for the risk considered. PMSs do a better job in this regard as they have a much concentrated portfolio and not as much constrained by regulation.

While there is no denial that diversification is a good tool to reduce risk, the portfolio should be built with non correlated business models rather than increasing the number of stocks. There is no magic number and it definitely doesn’t mean more is better. Do not buy all the recommendations that you get, evaluate a few good ones, accumulate and stay with them throughout the cycle. Putting all eggs in one basket is certainly risky; but why should you put only eggs in the basket. Diversify and include items which don’t break like eggs , in that case you are safe!

This pandemic has introduced several peculiar situations into our lives. With no movies, shopping, gyms or offices we have been forced to look for new sources of entertainment. While a few have pursued meaningful activities like reading, yoga, music, art and webinaring a majority have found a new love – The stock markets. There has been a flood of new broking/demat accounts opened since the lockdown in March this year. It appears to be the new fad in town and every neighbor has one. Several first time investors who till recently were on the sidelines due to paucity of time have managed to dabble in the markets for 5 hours in a day. Aggressive brokers have seen frantic account opening activity and doubling of their client base over the period. Supportive regulatory changes such as online KYC have helped ease the process. Technology backed settlement and internet trading has come a long way, making execution significantly easy and child’s play.

The stock market is a great enticer especially because it involves money. Considering that many have faced a reduction in their salary or job loss, a second source of income does come handy. The moratorium package has helped postpone a few months of EMIs, this savings also may have found its way into trading. Another segment that has been a big participant is the small and medium entrepreneurs and realtors. They are unable to deploy funds into their business and the same may have been diverted into the stock market. RBI has been following a benign policy of keeping rates low to improve the risk appetite. Deposit rates have shrunk to a paltry 4%. With nowhere else to go for a decent inflation adjusted return they may feel equities are the only route. There are hordes of advisers waiting for such an opportunity and have been the biggest beneficiary of this sudden spurt of interest. Their influence adds to the frenzy. All the segments mentioned above have started relying on the stock markets for their near-term investment goals, and their investment process is generally defined as speculative trading.

Chart 2: Rise in speculation as indicated in lower delivery trades

What about the big boys who primarily comprise the Mutual Funds and FIIs. Data clearly suggest many FIIs have been sellers for a long time and their exposure to emerging market investments have reduced significantly. As for the Mutual funds, the last two months have seen a decline in fund inflows and SIP stoppages. What this suggest is majority of the volume (estimated 85%) may be contributed only by the aggressive retail community.

Chart 3: Chart on MF/FII inflow

Valuations are determined by two factors – sentiments and reality, the former most of the time overshadow the latter. Sentiments is quantified in the price while earnings determine the reality. While it is evident that the crowding-in of retail activity is the main reason for the increase in price movement, what then is the underlying reality-