Chasing Performance & Behavior Gap

When Gold, especially in form of Jewelry is bought, its not bought by calculating the CAGR returns it shall provide over the next 3 / 5 years. When one buys a home for his own use, he is not calculating how many times it can become in the next few decades. But not calculating really mean that we are ignorant of returns?

Every month hundreds of vehicles are sold despite irrefutable evidence of how by just a few years it will be worth closer to scrap than any vehicle. Aren’t the buyers conscious of this fact?

Value Investors claim to buy good business choosing only businesses that keeps generating consistent returns for their shareholders. But do all good businesses make for good investments?

From the religion we profess to the acts we commit, everything is based on a some philosophy we agree with and one we would like to follow. Investing should be no different, or is it?

Last weekend, I raised a question on Twitter as to what drives Investors when it comes to Mutual Funds. The results were a tad of a surprise to me.

What is your Primary Criteria when investing in a Mutual Fund / PMS?

— Prashanth (@Prashanth_Krish) August 5, 2017

Returns are important and the very reason we finally invest, but Returns are post-ante – something we really have no control with. What we have control over a larger degree is the Philosophy that is followed by the fund house and how well we believe in them.

The reason for a investor to bet on a Philosophy than a Star Fund Manager or even Returns is that without there being stead fast belief, one can never be comfortable as to whether the fund continues to remain one that is worth staying invested or one from which it makes sense to move on.

In the 2000 bull market, one person who stayed away from Participation was Warren Buffett. For a time, he was heavily wrong as market broke every rule that seemed to bind it in the past as a new set of investors made bets that paid off immensely.

Such was the divergence that when the Nasdaq Composite was touching new all time highs, the Dow was a very close to its own All time High, the stock price of Berkshire Hathway was down 50% from its peak.

Rare would be the man who held Berkshire Hathway shares in those days while ignoring the hot stocks that had turned ordinary Joe’s into multi millionaires. “GREEN LIGHTS” Business Week proclaimed. “The stock market’s rise is a accurate reflection of the growing strength of the new economy. Productivity growth, although understated by official statistics, is raising as companies learn to use technology to cut costs, a necessity for competing in global markets”. (Quote sourced from the book, Bull: A History of the Boom & Bust, 1982  – 2004).

Its one thing to believe in a philosophy and quite another to be able to take the hits that come along with it. As Momentum Traders, we Invest / Trade without bothering about the companies in which we put our monies to work. The philosophy that guides us is historical evidence of cycles and belief that as long as we are trading with the larger trend, we shall come out better than where we started from.

From the outside, all Mutual Funds are the same – all of them try to gather as much of assets as possible and try to maximize gains for their investors, or are they different animals?

The last one year has been phenomenal in the markets with Nifty 50 up by 17.72% and Nifty Next 50 up 27.00%. Based on above data points, would you invest in a fund that has under-performed both the Indices with its 1 Year Return being just 15.39%. What about another fund that benchmarks itself to Nifty 500 which over the last one year has been up 17.30% verus 21% return by the Benchmark it follows?

The fund that is up 17.72% is Quantum Long Term Equity Plan while the fund that generated 17.30% return is Parag Parikh Long Term Value Fund.

The Behavior Gap

In 2012, Carl Richards a Certified Financial Planner came out with a book titled – The Behavior Gap – Simple ways to Stop Doing Dumb things with Money wherein he coined the term, “behavior gap” to explain the reason as to why Investors in Mutual Funds under-perform the funds they are invested into.

Behavioral Gap is not academic. As the following chart from Axis Mutual Fund shows, this is as real as it comes.

As can be seen, the difference can be substantial but without understanding the source of where this gap comes from, its easy to fall prey.

Momentum Chasing is Bad

Being a Momentum Trader, this is a tough to say but true when it comes to Mutual Funds. Chasing Momentum can easily land you in trouble for unlike stocks where Momentum Investing has great value, in funds, this can easily backfire.

Currently the best performing fund among Large Caps is the JM Core 11 fund (Best performing fund based on 3 year look back) and yet its AUM is just 32 Crores. The reason is not hard to fathom if one were to look at the performance of its funds with a longer track record. JM Equity Fund for example is the worst performing fund over the last 10 years (Large Cap) with return on Investment being a pitiable 4.03%. These days, you can get better return on Investment than that on your Saving Account.

Every fund worth its name claims to have a philosophy that is said to ensure better returns for its investors. Its quite another matter as to how many funds really follow what they preach.

Motilal Oswal Mutual Fund has a Philosophy of “Buy Right, Sit Tight”. Motilal Oswal MOSt Focused 25 Fund is the 3rd best fund among all Large Caps. Their 3 year return has been 19.75% but is the Return based on following of the Principal they profess?

The fund has a Turnover of 86% which seems to suggest that the Portfolio is going through a lot of churn. With markets flying, this is providing returns better than average, but what when the Tide goes down?

A competing fund (Large Cap focused with similar AUM) one of whose core philosophy has been to keeping costs as low as possible has generated a return of 13.75% over the same period. Turnover of the fund – 20%.

Does the above example mean that Higher Turnover is better or should one care less about Turnover as long as Results are above expectations?

While there is data lacking to reveal whether a higher turnover is better or worse, the following is evidence from United States where one has more data points to get a better perspective

Source: The Perils of Portfolio Turnover by David Blanchett.

One of the under-performing funds these days is Parag Parikh Long Term Value Fund. This fund philosophy is simply to Buy and Hold for the long term stocks that they believe are Value (Buying securities at a discount to intrinsic value). The fund has a Turnover Ratio of just 10% but a 3 year return of just 14.73% versus the best fund among Multicap funds – Franklin India High Growth Companies Fund which has given a return of 20.63% (Turnover Ratio being 44%).

Once again, the fund house in question has a philosophy of investing across Value and Growth and for now seems to have delivered way better than pure Value fund. But is this is a good model for eternity?

The Prime Objective for investing in Mutual Funds is the ability to hire a fund manager who believes in values we understand are willing to bet upon. Comparing one fund to another purely based on short term returns hence makes little sense and yet going by the Inflow / Outflow Mutual Funds data shows, this is what is happening with Investors chasing the best funds of the day.

Momentum Investing in Stocks on the other hand actually offers better Risk to Return as the upside is unlimited versus limited upside for even the best of funds. Strategies that work in one market needn’t really work in another and trying to force it can only result in broken goals and un-necessary disappointment .

“All I want to know is where I’m going to die so I’ll never go there.” – Anonymous