Dear All,

Please find below a good article as appeared in Morning Star for your reading:

Basic terms to know about debt funds

Investing in a debt fund is quite different from buying a bond and holding it till maturity. In such instances, you won't lose your principal unless the bond issuer defaults. When you invest in a bond fund, however, the value of your investment fluctuates. Here we tell you what terms to be aware of before you invest in a debt fund.

1) Coupon rate

A bond's coupon is the annual interest rate paid by the issuer of the bond. It can be paid out quarterly, semi-annually or annually on individual bonds. The coupon is always tied to a bond's face value.

Say you invest Rs 5,000 in a 6-year bond paying a coupon rate of 5% per year, semi-annually. Over the tenure of the bond, you will receive 12 coupon payments of Rs 125 each.

Bonds that don't make regular interest payments are called zero-coupon bonds, which means they pay no interest. Investors buy such bonds at a discount to the face value of the bond and are paid the face value when the bond matures.

2) Yield

Yield differs from the coupon rate.

Let’s say a bond has a face value of Rs 100 with an 8% coupon rate. This means that the investor will earn Rs 8 per annum on each bond he invests in.

Once the bond is issued, however, it trades in the open market – meaning that its price will fluctuate each business day for its entire life. As interest rates in the economy rise and fall and demand for the bonds moves up and down, it will impact the price of the bond.

Let’s assume interest rates rise to 10%. Even so, the investor will continue to earn Rs 8. That is fixed and will not change. So to increase the yield to 10%, which is the current market rate of interest, the price of the bond will have to drop to Rs 80.

Now let’s say interest rates fall to 6%. Again, the investor will continue to earn Rs 8. This time the price of the bond will have to go up to Rs 133.

There are two aspects to note from this. One is that the yield is not fixed but fluctuates to changes in the interest rate. Secondly, the price of the bond moves inversely to interest rates. It moves to maintain a level where it will attract buyers.

3) Yield to Maturity

The YTM of a debt fund portfolio is the rate of return an investor could expect if all the securities in the portfolio are held until maturity. For instance, if a debt fund has a YTM of 10%, it means that if the portfolio remains constant until all the holdings mature, then the return to the investor would be 10%. However, the YTM does not remain constant as the portfolios are actively managed by the fund manager.

It broadly indicates to the investor the kind of returns could be expected. But it is not a definite indicator since returns may vary due mark-to-market valuations or changes in the portfolio.

4) Modified Duration

As explained in the second point, bond prices and interest rates are inversely related. This means, if there is a rise in interest rates then there is a fall in the price of the bond. If there is a fall in interest rates, then the price of bond will rise.

MD is simply the change in the value a debt security in response to the change in interest rates. So let’s say the MD of the bond is 4.50. What this indicates is that the price of the bond will increase to 4.50 with a 1% (100 basis point, or bps) increase in interest rates.

This provides a fair indication of a bond’s sensitivity to a change in interest rates. The higher the duration, the more volatility the bond exhibits with a change in interest rates.

Since modified duration of a portfolio takes into account all the debt instruments, it will change with regard to the composition of the portfolio.

5) Weighted Average Maturity

This is more commonly referred to as the average maturity of a debt fund. It is the average time it takes for securities in the portfolio to mature, weighted in proportion to the amount invested.

Eg: Rs 1,000 invested in Bond A matures in 5 years

Rs 2,000 invested in Bond B matures in 10 years

Total investment in debt portfolio = Rs 3,000

WAM = (1000/3000)*5 + (2000/3000)*10 = 8.33 years

Average maturity indicates the sensitivity of the portfolio to interest rate changes. The higher the average maturity, the greater is the volatility of returns in the fund. This is seen in debt funds with longer investment horizons. On the other hand, average maturities in liquid funds have been restricted to 90 days while ultrashort funds could go higher but are usually less than a year, making them less volatile to interest rate movements.

The average maturity of a scheme gives you a broad guideline in terms of finding a debt fund suitable for the time horizon of your investment.

http://www.morningstar.in/posts/29789/5-basic-terms-to-know-about-debt-funds.aspx?utm_campaign=bulletin&utm_medium=email&utm_source=morningstar

Dear All,

Please find below a good article as appeared in Morning Star for your reading:

What is tactical allocation?

A tactical move can help generate that extra zing for your portfolio.

Fund managers often say that they are tactically making a move. What does that mean?

The terms “strategic” and “tactical” have their origin in warfare, though are now commonly used to describe actions in business and sports.

The key distinction here is that the former refers to an overarching, long-term effort whereas the latter refers to a more specific action performed in the service of this larger strategic goal. In other words, a strategy is a larger, overall plan that can comprise several tactics, which are smaller and focused actions under the overall plan.

How does this distinction apply to investing?

An investment strategy generally refers to a consistently executed long-term plan. For example, a mutual fund that routinely invests in stocks its fund manager believes are underpriced may be said to employ a value strategy. Or a bond fund that invests primarily in securities that pay above-average yields may be said to use a high-yield strategy. This is also referred to as the core strategy.

While maintaining this as the core strategy, the fund manager may see opportunities that are short-term in nature but have the potential to increase returns. This is called a tactical approach. Such moves may be based on what the manager thinks is happening or will happen in the markets and typically are aimed at boosting gains.

Here are a few examples of moves that could be considered tactical:

• An international bond fund manager who thinks bonds from a given country are temporarily underpriced reallocates assets in that direction.
• A multi-asset fund manager may be concerned that a correction is around the corner and shifts a chunk of assets from the equity side of the portfolio to the fixed-income side.
• An equity fund manager may believe an uptick in infrastructure stocks would take place and may decide to focus a part of his portfolio on a few such stocks.
• A value fund manager may latch on to a few growth stocks for the short term because a strong rally is on.

Tactical moves are not commonly applied to stave off losses, they are essentially short-term moves will add alpha to the fund without affecting the fund manager’s overall strategy.

Although there's no official line of demarcation between strategic and tactical investing, the distinction between acting with a near-term and long-term mind-set is as good a guideline as any. A manager who opportunistically adjusts his fund's allocation based on what is likely a temporary change in the market is making a tactical move. One that makes such a shift with the intention of sticking with the new allocation for many years could be said to be making a strategic one.

Of course, some fund managers tactically reallocate assets more than others. Some may see it as an essential part of their overall approach, others may not give it that much importance.

On a personal front, an investor too can employ a tactical approach. Let’s look at bond funds for instance. Longer the maturity of the bonds in a portfolio, the higher its duration; the higher the duration, the more sensitive is the bond’s price to the fall in interest rates. So debt funds with a shorter duration of a year or so can be used for a strategic allocation. The long duration funds can be a tactical allocation.

In equity too such tactical allocations can be made, however do remember that should you sell before a year, your investment will be subject to short-term capital gains tax.

http://www.morningstar.in/posts/29772/what-is-tactical-allocation.aspx?utm_campaign=bulletin&utm_medium=email&utm_source=morningstar

Dear All,

Please find below a good article as appeared in Morning Star for your reading:

Learn from the Masters: The edge of a value investor

According to Seth Klarman it is long-term orientation and patience.

If relatively unknown to retail investors, it is because Seth Klarman prefers flying under the radar. But when he does express his views, either publicly or via his newsletters, institutional investors across the globe scramble to heed them.

In the first quarter of this calendar year, he raised concerns about a looming asset price bubble and “nosebleed valuations” in certain stocks. "Any year in which the S&P 500 jumps 32% and the Nasdaq 40% while corporate earnings barely increase should be a cause for concern, not for further exuberance. On almost any metric, the U.S. equity market is historically quite expensive.” A few months ago, he commented that “investors have been seduced into feeling good”.

In his out-of-print book Margin of Safety, that has a cult following and sells for over $1,500 on Amazon.com, he writes about stock prices and reality. The real success of an investment must not be confused with its success in the stock market. A rise in the stock price does not ensure that the underlying business is doing well or that the price increase is justified by a corresponding increase in underlying value. Likewise, a price fall does not necessarily reflect adverse business developments or value deterioration.

Hence his advice: Value in relation to price, not price alone, must determine your investment decisions.

Klarman runs one of the world’s largest hedge funds- the Baupost Group, which has racked up 19% annualised gains in three decades (according to ValueWalk). It’s not just the performance that makes him exceptional, it’s his very approach.

At heart, Klarman is a value stock picker. He pays deep attention to risk, is leery of leverage, and has no qualms about holding huge amounts of his portfolio in cash. At any given time, it will not be unusual to see around 30-50% of his portfolio parked in cash. He believes that value investing is not designed to outperform in a bull market. It is in a bear market that the value investing discipline becomes important and helps you find your bearings when reassuring landmarks are no longer visible. It is joked that he is probably the most patient hedge fund manager in the world and can sit on a fairly static portfolio for months without getting restless.

The ingredient to his success

Klarman is of the view that value investing is simple to understand but difficult to implement. It requires a great deal of hard work, unusually strict discipline, and a lot of patience. He believes very few have the proper mindset to succeed.

Since being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds, it can be a very lonely undertaking. A value investor may experience poor, even horrendous, performance compared with that of other investors or the market as a whole during prolonged periods of market overvaluation.

When securities prices are steadily increasing, a value approach is usually a handicap; out-of-favour securities tend to rise less than the public's favourites.

The most beneficial time to be a value investor is when the market is falling. This is when downside risk matters and when investors who worried only about what could go right suffer the consequences of undue optimism.

Emotional investors and speculators inevitably lose money; but investors who take advantage of the market’s periodic irrationality have a good chance of enjoying long-term success.

Klarman adheres to Benjamin Graham's margin-of-safety concept – to invest at a sufficient discount so that even bad luck or the vicissitudes of the business cycle won't derail an investment.

Very simply put, his investing style is “mispricing due to overreaction”. He picks up securities that trade at a wide discount to their underlying value, what he calls “the element of a bargain”. In other words, it’s key to establish a margin of safety that not only enables you to make a sufficient profit, but also gives a wide enough discount from the underlying value. This way, you are able to profit even if your estimate of the underlying value is incorrect. Value investors invest with a margin of safety that protects them from large losses in declining markets.

Herein lies Klarman's secret. He will only make an investment if he is extremely confident that it won't lose much value, even if his initial investment thesis proves to be wrong.

But he also notes that investors can be pressured into investing prematurely; the cheapest security in an overvalued market may still be overvalued. This is where the discipline of a value investor comes in which will enable him to wait for an opportunity to buy, offering a better return for money.

The investing philosophy of Klarman can be drilled down to a few key lessons.

• Expect the unexpected

Always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.

• Uncertainty is not risk

Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty - such as in the fall of 2008 - drives securities prices to especially low levels, they often become less risky investments.

• Don’t get comfortable with excesses

When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.

• Understand the different aspects of risk 

Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.

• Have some cash

Be sure that you are well compensated for illiquidity - especially illiquidity without control - because it can create particularly high opportunity costs.

• Be wary of leverage

Beware leverage in all its forms. Borrowers - individual, corporate, or government - should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn. Financial stocks are particularly risky. Banking, in particular, is a highly leveraged, extremely competitive, and challenging business.

• Don’t forget the human element

Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people - not computers - assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioural science, not physical science.

Because investing is, in many ways, a zero-sum activity in which your returns above the market indices are derived from the mistakes, overreactions or inattention of others as much as from your own clever insights, there is a second element in designing a sound investment approach: you must consider the competitive landscape and the behavior of other market participants.

When observing your competitors, your focus should be on their approach and process, not their results. Short-term performance envy causes many of the shortcomings that lock most investors into a perpetual cycle of underachievement. You should watch your competitors not out of jealousy, but out of respect, and focus your efforts not on replicating others' portfolios, but on looking for opportunities where they are not.

• Know when to walk away

Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return.

• Don’t be fooled by high stock prices

The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance.

• There is a time to buy

You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.

Price is perhaps the single most important criterion in sound investment decision making. Every security or asset is a "buy" at one price, a “hold” at a higher price, and a "sell" at some still higher price. Yet most investors prefer what is performing well to what has recently lagged, often regardless of price. They prefer full buildings and trophy properties to fixer-uppers that need to be filled, even though empty or unloved buildings may be the far more compelling, and even safer, investments.

• Always look for opportunities

Most investors feel compelled to be fully invested at all times. To require full investment all the time is to remove an important tool from investors' toolkits: the ability to wait patiently for compelling opportunities that may arise in the future. Moreover, an investor who is too worried about missing out on the upside of a potential investment may be exposing himself to substantial downside risk precisely when valuation is extended. A thoughtful investment approach focuses at least as much on risk as on return. But in the moment-by-moment frenzy of the markets, all the pressure is on generating returns, risk be damned.

• Don’t be comfortable at the wrong time

Most investors take comfort from calm, steadily rising markets; roiling markets can drive investor panic. But these conventional reactions are inverted. When all feels calm and prices surge, the markets may feel safe; but, in fact, they are dangerous because few investors are focusing on risk. When one feels in the pit of one's stomach the fear that accompanies plunging market prices, risk-taking becomes considerably less risky, because risk is often priced into an asset's lower market valuation.

Investment success requires standing apart from the frenzy – the short-term, relative performance game played by most investors.

http://www.morningstar.in/posts/29738/2/learn-from-the-masters-the-edge-of-a-value-investor.aspx

How do banks respond to RBI's Rate Actions? Part 1 : Banks respond faster to hikes, not cuts:

Please find below a good article by Mrs. Uma Sashikanth & Mrs. Deepa Vasudevan of CIEL with regard to bank action on RBI's rate actions for your reading:

How do banks respond to RBI's Rate Actions? Part 1 : Banks respond faster to hikes, not cuts:

As expectations for a lower interest rate regime are growing, the critical question to ask is whether banks would also reduce their lending rates.  If the rate cuts from RBI, whenever they happen, are not transmitted through the banking channel to borrowers, revival of consumption and investment, and therefore economic growth may not be as fast as expected.

How have the lending rates or the base rates of the banking system behaved over time? The base rate is the minimum interest rate at which banks can lend. All rupee denominated domestic loans have to be made at or above the base rate[1].  A bank can have only one base rate. Banks are free to set their base rates on the basis of any benchmark, or by using any appropriate methodology, provided the method of fixing the base rate is consistently applied. The base rate is expected to include cost of funds, the opportunity cost of funds locked into SLR and CRR, some overhead costs, and some measure of profit. RBI norms required the base rate to be reviewed at least once in a quarter. Changes in the base rate have to be disclosed to the public in a transparent manner.

The base rate system came into force on July 1, 2010[2]. Before that, loans were priced with reference to a bank-specific benchmark Prime lending rate (BPLR). The key difference between the two systems is that banks were allowed to lend at rates below the BPLR. As a result lending rates were not transparent, and RBI was unable to assess if changes in policy rates were being effectively transmitted to bank lending rates. The adoption of a base rate system was expected to enhance transparency in loan pricing as well improve the monetary transmission mechanism.

In July 2010, when the system became operational, leading banks set their base rates at around 7.5%.  Between March 2010 and April 2012, RBI increased the repo rate by a whopping 3.5%. Base rates also moved up to 10% in response to the rate tightening.  The subsequent easing cycle- until July 2013- saw a 75 basis points decline each in repo rate and CRR, while the base rate fell into the range of 9.6% to 10%. Since the start of fiscal 2014-15, the base rate has remained at 10% (Pic 1).

Pic 1 Base Rates and Repo Rate

 

Source: RBI, Reuters, CIEL Research

It can be seen that the transmission from policy rates to the bank base rate is not symmetric. When rates went up in 2010 liquidity was tight, and an increase in policy rates was immediately transmitted to an increase in base rate. But when the RBI dropped rates in 2012 banks not only delayed the lowering of base rates, but also did not persist with it in 2013. This asymmetric monetary transmission dilutes the impact of monetary policy. RBI’s monetary policy actions are effective when it is tightening, but not as effective when it is easing. This one-way effectiveness has been observed by several studies, most recently in the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework, chaired by Shri Urjit Patel[3].

When RBI began to reduce rates in 2012, the banking system was caught in a situation of declining deposits and tight liquidity, which created a “wedge” between deposits and credit. During the 2010-2013 period, credit was growing faster than deposits. Insufficient deposit mobilisation prevented banks from cutting deposit rates. This, in turn, limited their ability to reduce the base rate.  This structural deficiency was primarily responsible for the poor transmission of RBI’s rates cuts by the banking system.  How the situation is different now in 2014, is what we will see in Part 2 of this blog.

Part 2: What are banks likely to do now, should RBI cut rates?

The situation in 2014, as the market awaits rate cuts from RBI, is exactly the opposite of what we saw in 2012 (see part 1 of this blog for that story on transmission of RBI’s interest rate policy): deposit growth has been much stronger than growth in bank credit (Pic 1). This build up in deposits has encouraged several banks to drop deposit rates. Overall liquidity is comfortable. Debt yields have fallen across tenors. Inflation is low, and declining. It is fairly certain that interest rates will be reduced next year. Despite all these favourable factors, base rates have remained at 10% for more than a year. Why have rates not declined? Some banks have announced that they will cut lending rates in April, but most remain uncommitted

Pic 1 Fortnightly Growth in Bank Deposits and Credit 

Source: RBI

To answer this question, we need to look how banks raise their funds. Deposits are the primary source of funds of banks. As on November 28, 2014, deposits (savings deposits, current accounts, and time deposits) made up 91% of bank liabilities. Banks are not significantly dependent on the money market for funds. During periods of tight liquidity, they tend to borrow in the call money market, refinancing from RBI, or issue high-cost Certificates of Deposits (CDs). But when liquidity is ample, as it has been in 2014-15, their dependence on the money market is low. When RBI changes the policy rate, or the repo rate, it directly impacts rates in the money market.

The changes in the money market rates operate on the asset side of a bank’s balance sheet. CDs and CPs are market instruments whose prices almost instantaneously respond to rate cuts by RBI.  A corporate borrower has the choice of issuing a CP or borrowing from the bank. When a bank is able to keep its deposit rates low, and therefore enjoy low cost of funds, it is able to price its loans competitively compared to a CP. However, if it has to lean on CDs to raise money, there is not enough spread to lend aggressively; nor is there enough elbowroom to reduce lending rates.  A period of tight liquidity and high dependence on CDs, therefore naturally leads to a fall in growth rates of credit.  The squeeze on bank profitability that comes from a high borrowing rate is eased when liquidity eases. Therefore deposit rates fall first, before lending rates can fall. Even they do so with a lag, since the impact of policy rate changes on deposit rates is indirect, as it operates through changes in interest rate expectations and inflation expectations. Therefore, banks cannot, and do not, match every drop in repo rate with a drop in deposit rates.  There is an inevitable lag.

Even if banks are able to reduce deposit rates, the change is only at the margin. Existing deposits continue to be serviced at the older (and higher) rates until maturity. This creates a time lag between a fall in bank deposit rates and an actual drop in their cost of funds. The higher the proportion of longer tenor deposits in bank balance sheets, the longer it takes for a drop in deposit rates to reduce overall cost of funds. As on March 2013, 13% of the term deposits of scheduled commercial banks were for tenors upto 1 year, 50% for tenors of 1 to 3 years, and 36% for tenors over 3 years! Given the tilt towards long term deposits, it is not surprising that banks are reluctant to pass on the advantage of lower deposit rates by cutting their lending rates.

There are more stories to tell about the structural differences between PSU and private banks, and the burden of NPAs on bank balance sheets, which will constrain their pricing and lending actions. Those will have to wait until we are able to see the banking sector results for FY 2015 in April.  In the JFM quarter no one speaks about reducing lending rates, given the seasonal tightness, anyway. Those stories can therefore wait.

http://ciel.co.in/blog?Why+are+base+rates+not+declining%3F_165

Investment Management Rules

Dear All.

Please find below a good article as appeared in AdvisorKhoj for your reading:

Investment Management Rules

A few days back I was speaking with an investor. He told me that he does not look at stock prices or mutual fund NAVs in his portfolio during bull markets. However, he pays close attention to stocks and mutual funds during market downturns. Market downturns, especially the sharp ones, present good buying opportunity. Market downturns also help him identify the solid performers and replace the relatively weak performers with the solid ones. Unfortunately most retail investors are not like this investor. In fact they do just the opposite. They get exuberant in bull markets and panic during corrections. If you belong to this group, remember it is natural human emotion. In fact, runaway bull and bear markets are caused by irrational exuberance and panic respectively. As an equity investor you should not be afraid of volatility. In this blog, we will discuss some rules to manage your investments in volatile markets.

1. To be a successful investor, it is less about managing your investments in volatile markets and more about managing your own emotions. The first rule is not to panic in volatile markets. When we panic we are not thinking clearly and usually end up making the worst decision. However, it is easier said than done because getting worried when your investments lose value is only a natural human reaction. Therefore you need to make an effort to stay calm and focused. In psychological terms this is an attribute of emotional intelligence. You should understand the inherent characteristics of equity as an asset class. Volatility is an inherent characteristic of equities. Your investment may lose its value in a market downturn, but remember you still own the asset. Once you ride out the volatility your asset will again appreciate in value.


2. Corrections present a good opportunity to invest, because you can buy assets at a relatively lower valuation. The recent market correction, thankfully it is over for the time being, had a few worried investors calling their brokers. However, the good thing about this correction was that, while FIIs sold, domestic investors bought in the market. If you have invested in mutual funds during this correction, you would have bought your units at 7% lower cost compared to the peak. The sharper the downturn, the better is the buying opportunity. Systematic Investment Plans (SIPs) is a great investment mechanism because it can help investors to take advantage of volatility by averaging out the cost of the units purchased. SIPs help investors stay disciplined during volatile markets and help you achieve your investment goals, irrespective of what the market is doing in the short term.


3. Do not forget your asset allocation during volatile market conditions. Your asset allocation is governed by your risk tolerance and financial objectives. Run away bull markets or sharp prolonged corrections skew your asset allocation. For example, if your optimal asset allocation is 60% equity and 40% debt and the market appreciates 30% in a few months, your asset allocation will get skewed to 75% equity and 25% debt. This may not be consistent with your risk profile. In such a situation, you should rebalance your portfolio to shift from equity to debt. Similarly if the market falls sharply, your asset allocation will be skewed to debt. In such a situation, you should rebalance your portfolio by investing additional funds in equity or shift from debt to equity depending upon your financial situation.


4. Volatile markets help you identify the solid performers from the weak performers. In a bull market everyone looks like a star. However, for your portfolio to give good returns in the long term you need your portfolio to be made up of consistent performers. As the legendary Warren Buffett famously said, “Only when the tide goes out do you discover who's been swimming naked”. Your equity fund may have given 30% return in the last one year, but has your fund manager delivered the returns by taking excessive risks. In a market downturn you will be able to evaluate which funds in your portfolio has more downside risk than upside risk, on a relative basis. It has been proven that consistent performers over a long time horizon give better returns than funds who give high returns in the short term. You should use a market downturn to separate out the solid performers in your portfolio from the relatively weak performers, and then reshuffle your portfolio to replace the weak performers with more consistent performers. But should not judge a fund based on just short term performance. You should evaluate how it is has performed over a period of time during both market rallies and downturns.


5. Arbitrage funds are good short term investment options in volatile markets. Arbitrage funds are low risk investments and benefit from market volatility. In volatile markets, arbitrage funds can give higher returns than liquid funds, and certainly more returns than bank deposits. The added advantage of arbitrage funds is that the returns are tax free if they are held for a period of over one year.

Conclusion

In this article we have discussed some important rules to manage your investment in volatile market. Smart investment decisions taken in volatile market conditions can help you significantly enhance the return on your investment. More importantly, you should stay disciplined and stick to your investment plan. Remember equity investment is for the long term, so you should not be bothered with short term volatility.

Is risk synonymous with volatility? When an investor wants to understand risk, must he look at volatility?

Dear All,

Please find below a good article as appeared in MorningStar for your reading:

Is risk synonymous with volatility? When an investor wants to understand risk, must he look at volatility?

The term risk has different meanings for different people.

Ask an investor what comes to mind when talking about risk management, he will state that he does not wish to lose his money, or will want to know as to how much the return can potentially drop by.

Throw the same query to a finance professional and he will tell you that standard deviation is the measure of risk. So what he is saying is that risk is not defined as the likelihood of loss, but as volatility, which is determined using statistical measures of variance such as standard deviation and beta.

(Standard deviation is a measure of absolute volatility that shows how much an investment’s return varies from its average return over time. Beta is a measure of relative volatility that indicates the price variance of an investment compared to the market as a whole. The higher the standard deviation or beta, the higher the risk.)

So while professionals often use volatility as a proxy for risk, it does not measure what an investor intuitively perceives as risk.

It is more helpful to think of volatility as sudden price movements. Volatility encompasses the changes in the price of a security, a portfolio, or a market segment both on the upside and down. So it’s possible to have an investment with a lot of volatility that is moving one way: up (not always down).

Even more important, volatility refers to price fluctuations in a security, portfolio, or market segment during a fairly short time period—a day, a few weeks, a month, even a year. Such fluctuations are inevitable and come with the territory. If you are in for the long haul, volatility is not a problem and can even be your friend, enabling you to buy more of a security when it’s at a low ebb.

The most intuitive definition of risk, by contrast, is the chance that you will lose your principal investment and won’t be able to meet your financial goals and obligations. Or that you will have to recalibrate your goals because your investment kitty comes up short.

Having said that, it is easy to see how the two terms have become conflated. If you have a short-term horizon and you’re in a volatile investment like stocks, it could be downright risky for you. That’s because there is a real risk that you could have to sell out and realise a loss when your investment is at a low ebb.

The same investment with a long-term horizon throws up a completely different scenario. The very same stocks may not be all that risky if you bought them at bargain rates when compared to their intrinsic value and intend holding on to them for many years. However, you will have to contend with volatility which comes with the territory.

In 2008, the global crisis drove securities prices to especially low levels actually making them less risky investments. Indeed, Seth Klarman, one of the world’s most respected value investors, believes that risk is not inherent in an investment, it is always relative to the price paid. So in the midst of volatility and extreme uncertainty of 2008, the risk of investing in equity actually dropped.

Reactions to volatility are very often emotional. Investors buy and sell on reaction, or rather overreaction, to news and speculation without any significant consideration to long-term returns. Recall the sell-off of not just 2008 but even 2011 when volatility went through the roof. Now look at where the market is today. The volatility did not really affect the long-term returns of an investor who assesses risk in terms of long-term failure to meet a pre-determined outcome. Those who ignored the volatility and stayed are better off because of it.

Given this backdrop, defining risk as volatility runs counter to common sense. Do not assess risk and construct your portfolio based on the volatility of the ride. Investment risk is the possibility of suffering losses and its potential magnitude. Another indication of investment risk is the maximum drawdown from a previous high – peak to trough.

So how can investors focus on risk while putting volatility in its place? Come to terms with the fact that volatility is inevitable and if you have a long enough time horizon, you will be able to harness it for your own benefit. Secondly, invest in equity mutual funds via a systematic investment plan, or SIP, to ensure that you are entering the stock market in a variety of environments, whether its feels good or not. Finally, diversifying your portfolio among different asset classes and investment styles can also go a long way toward muting the volatility of an investment that’s volatile on a stand-alone basis.

These moves will make your portfolio less volatile and easier to live with.

The Permanent Portfolio: A Fascinating Low-Volatility Option For The Long Term Indian Investor?

 Worried about fluctuating stock market returns? Worried about sliding gold prices? Not sure how much to invest in equity or in gold? Here is an example of a portfolio based on an ingeniously simple notion that has proved to be remarkably stable irrespective of market conditions – stock/commodity/debt/currency markets!

The Permanent Portfolio in an alternative investing paradigm developed by Amercian investment adviser Harry Browne in 1981. The permanent portfolio comprises of stocks, bonds, cash and gold in equal  proportions (25%)!  This sounds bizarre because for long term goals most investment advisers would recommend (1) significant equity exposure. Typically 100-age. That is 65% equity allocation for a 35 year old and rest in debt. (2) little or no gold  exposure (not more than 10%)  (3) little or no cash.

How can such an unconventional portfolio allocation work for long term goals? The idea behind the permanent portfolio is fascinatingly simple. In his book, Fail-Safe Investing: Lifelong Financial Security in 30 Minutes, Browne writes about four possible economic conditions:

• Prosperity when markets do exceedingly well
• Recession  a general slowdown in one or more aspects of the economy
• Inflation No need to explain this one, right?!
• Deflation Negative inflation. Believe it or not, has occurred in the past!

The idea of the permanent portfolio is to choose instruments which will do well in one or more of the above conditions. According to Browne these are:

• Stocks When the markets do well. Direct equity or mutual funds. Even an index fund should do.
• Cash during recession. For example a liquid fund
• Gold during inflation
• Long Term Bonds during deflation and prosperity

Thus the permanent portfolio is: 25% Stocks, 25% Cash, 25% Gold and 25% bonds. To ensure “an investor is financially safe, no matter what the future brings”. Read more: The Permanent Portfolio Allocation

An ideal portfolio should provide returns that beat inflation with low volatility. Low volatility here means the compounded annual growth rate (CAGR) at the end of each investment year should not vary too much from the final CAGR. Why low volatility? Too much volatility will kill the fruits of compounding, that is why. The permanent portfolio has measured up to these two requirements in the US quite impressively for the last 40 years! For details:Performance and Historical Returns

Will this approach work in India? An expert is likely to say no for several reasons. (1) India is an emerging economy and equity exposure should be higher than 25% for portfolio returns to beat inflation (2) gold is not an effective hedge for inflation (at least in India) (3)  ‘cash’ or liquid debt is unsuitable for long term growth. I am sure there are more. This is as far my thinking takes me. Feel free to add to this in the ‘comments’ section.

Why not check for ourselves? I  have simulated the performance of the permanent portfolio by considering historical Sensex, gold, fixed deposits (instead of bonds) and savings bank returns (instead of money market instruments or liquid funds). One could simply add 1-2% to the SB interest rate to make it resemble a liquid fund. The allocation is 25% in each category, rebalanced each year as noted by Browne in Fail-Safe Investing. You can use the attached Excel file to analyze the performance of the permanent folio for any and every duration between 1979 and 2012 for SIP and lump sum investments.

Short term performance: The permanent portfolio has not always produced great returns for short durations. If you have started a SIP in 2009 you would got an impressive CAGR of 13.62%  3 years later. However if you had started it in 2000, you would have got only 2.2% 3 years later.

Five year returns are a little better. All investments made since 2000 would have yielded impressive double digit returns while investments started between 1992 and 1999 would have  yielded dismal returns. If there is a period in time when multiple asset classes under perform simultaneously (for example gold and stocks in the mid 90s) the permanent portfolio fails to impress for short durations. Nothing to shout about though.The investing paradigm is not meant for short term investing (in my view!).

Long term performance: As the investment duration becomes longer, the benefits of the investment portfolio become clearer.  The average CAGR of every possible 15 year SIP  between 1979-2012 is an impressive 11.2% However SIPs started between 1986 – 1992 would have got only singe digit returns (lowest of 7.8% for a 15 year SIP started in 1986).

When the investment duration is increased to 20 years almost every duration has a double digit return or close to it (the lowest is 9.51%). For a 25 year duration the average CAGR is 11.2%. There are a total of nine 25 periods between 1979-2012. The highest CAGR is 11.48% and the lowest is 10.7%.

Thus for long investment durations (typically more than 20 years!) the permanent portfolio offers a return which is nearly independent of when you start the investment.

Notice the low volatile, steady performance of the permanent portfolio (green line, right axis).

The most important feature of the permanent portfolio is its low volatility. That is the CAGR at the end of each investment year does not vary too much from the final CAGR. For example a lump sum investment in the permanent portfolio started in 1987 would have yielded a CAGR (geometric mean) of 11.9%. The arithmetic mean is 1.4% more than the CAGR. This difference between the two means can be considered as a measure of volatility.

If we compare this to a more common asset allocation in which we use 70% equity exposure and 30% debt (FD) exposure, the same lump sum investment started in 1987 would have yielded a CAGR of 15.1% for annual rebalancing. The volatility however is 3%. Thus the yearly returns of a permanent portfolio fluctuate considerably lower than a typical long term portfolio. Lower returns is the price one must pay for this low volatility. You can play with this rebalancing simulator to gauge the performance of conventional equity:debt portfolios.

Note: In the simulation I have used a SB account and added 2% to it so that returns resemble that from a liquid fund. This is not really necessary since it does not make a significant difference to long term returns.

What about risk? Assuming that the permanent portfolio minimizes volatility for long term investments, we need to consider risk. For long term investments the risk of importance  isloss of value. That is the returns should comfortably beat inflation in order for any corpus to be effective. In this regard I am not too sure about the performance of permanent portfolio. While it does provide consistent returns of 10-11% for durations above 20 years or so, it is important to recognize that I have not included taxes in the calculation. I would think post-tax returns would hover around 8-9% for a net 11% pre-tax return. This just about equals inflation. Not a bad performance at all, but not great either.Not great because such a return may or may not be sufficient for a financial goal. It certainly good enough for someone with a frugal lifestyle with retirement 25 years away. A long term (~ 15 years) portfolio with (100-age)% in equity still remains the best bet (historically) for comfortably beating inflation.

So why bother? The Indian investor should take the permanent portfolio seriously for several reasons:

• It is a good option for the investor with a volatile temperament. Many investor get jittery and all worked up when equities do badly for many years together. The (100-age) equity exposure formula may not be well suited for such investors. Panic is likely force them make dramatic mistakes and kill the power of compounding. The permanent portfolio with limited exposure in equity (and gold!) maybe better suited for such investors. Of course I am assuming such people look at the overall portfolio growth and not at individual asset classes! A little too much to expect?
• It is a fantastic illustration of how proper diversification can protect a portfolio. In the 2008 market crash the permanent portfolio fell only by a remarkable ~ 2%!  The % allocation to each asset class need not be 25%. The key is to choose asset classes with little or no correlation in performance.
• It seems like a good option for someone in their mid-20s planning for retirement at 60.
• It is certainly a good option for the contended investor. Someone who does not worry about what returns others are making (others refer to friends and asset classes!). Someone who is clear about what return is required for his/her goals.
• As the Indian market evolves and (assuming) the economy develops, the gap between actively managed funds and index funds should narrow. Under such circumstances the permanent portfolio should offer much more consistent returnsrivaling long term equity returns.

Who is it not for? It is certainly not for those constantly obsessed with returns. Not for those who wish to ‘build wealth’ (someone please explain to me what that means). Not for those who question the 25% allocation: Since gold has crashed, why should I not increase exposure in gold now? If I maintain 25% exposure in equity at all times? Will I not miss out on chances to invest more during market crashes?

Implementation: There are many ways in which a permanent portfolio can be constructed. Ways which are far more rewarding and maybe tax efficient than the one I have used for the simulation:

• 25%  good large cap fund, 25% gold etf, 25% ‘income’ debt fund and 25% ‘liquid’ fund. (1/4 asset classes has no long term capital gains tax)
• 25% good large cap fund, 25% gold etf, 25% ‘income’ debt fund and 25% arbitrage fund. (2/4 asset classes has no long term capital gains tax)
• 15% good large cap fund, 10% good mid-cap fund, 25% gold etf, 25% ‘income’ debt fund and 25% ‘liquid’ fund
• Can you suggest ways in this can be done better?

What do you think about the permanent portfolio? Do you think it is suitable for Indian retail investors?

Download the permanent portfolio simulator: Indian Edition

Resources:

• Fail-Safe Investing
• The Harry Browne page on FB
• Permanent Portfolio Family of Funds
• Permanent Portfolio Book
• Permanent Portfolio from the Early Retirement Extreme (ERE) Wiki Page
• Independent Review of the Permanent Portfolio Fund (PRPFX)
• Recent performance of the Permanent Portfolio

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Simple Steps to De-risk Your Investment Portfolio May 28

Simple Steps to De-risk Your Investment Portfolio

 

May28by pattu

The recent upward swing in the markets has left most people happy. Some are excited because they have never seen wealth grow at such a frantic pace and some are just happy – happy that their convictions and time in the market has paid off.
While current market valuations are still on the reasonable side (Nifty PE ~ 20.2 and CNX 500 PE ~ 20.7) and one can still invest, to gain from this upward movement we must go easy on the euphoria and train our minds to become fearful.
Yes fearful – As Waren Buffett said be greedy when others are fearful and fearful when others are greedy.
While most investors are dreaming about this bull run and how it will create wealth for them, ones time is better spent in learning how to reduce risk in ones portfolio.
The key aspect of investing in volatile instrument is not gains but preservation of gains.
All well to the ride the bull and enhance portfolio value. If the market corrects, your folio should correct less – much less.
That is the secret to wealth building – reduce the volatility in portfolio returns but at the same time keep the net return well above expectations.
Accomplishing this is easier than you think or anyone might lead you to think!
Here are some simple steps to de-risk your investment portfolio

1. Start investing early 

Boring as it may sound, there is no better way to lower risk than beginning early. The more time you have in your hands, the more time you will have to recover. So start investing asap.
In the simple compound interest equation,
Value = investment x (1+ return) ^duration,
Duration and quantum of investment (not returns) are responsible wealth creation. So ensure you maximise both.

2. Expect less 

This is the most important step in de-risking. The lower your return expectations, the lower the risk.
Investors who want a minimum of 20% return from their equity portfolios will have to take a lot more risk than investors who only want 10%.
The long term return from Indian equity markets  is not the 15% that everyone says it is. That number is heavily influenced by the Harshad Mehta scandal.  If no such scandal occurs, the long term return drops to 10% (see how here).
So we need to be realistic in our expectations. This is vital in keeping us calm.
Remember we pose the biggest risk to our folios! So the calmer we are, safer the folio.
Most investors become jittery because they fail to understand how equities ‘compound’. We expect 10% long-term returns from equities. This means one should not expect 10% year after year in investment.
Some years will be good, some excellent and some terrible. What you get is the net effect:
Value = investment x [(1+ good return) x (1+ terrible return) x (1+ excellent return) x…… ]^duration
So the key is to stay the course.

3. Asset allocation

Naturally, one cannot afford to be in 100% equity. The terrible return would then negate the effect of the good returns, and one would be left with nothing.
The only logical solution is to limit the fluctuations in the portfolio returns due to swings in equity return.
Therefore, one must include safer assets like (debt instruments) bonds to reduce the overall risk to the folio.
Here safety  refers to the poor correlation between the movements of equity markets with debt markets. Fluctuations in one will little affect the other.
How much should the equity:debt proportion be depends entirely on the goal duration and nature. Here is an example

Returns indicated are before taxes!

4 Choose wisely

Conservation asset allocation and return expectations are important but about to nothing if the right kind of investments are chosen.
The simplest and most important measure of risk investors must understand is thestandard deviation – a measure of how much a set of returns deviation from their average.
Lower the standard deviation, lower the risk.
The first step is to choose the right category of instruments. Here is a step-by-step guideto help you do that.
As a general thumb rule, lower the investment duration, lower should be standard deviation of the instrument.
For example, choosing an equity oriented balanced fund for a 5-year investment duration is madness.

 5 Diversify

Asset allocation represents diversification across asset allocation. One should also diversify within an asset class. For example equity holdings should be spread across market cap, sectors, nature of stocks and geography.
Diversification is the second most important step (expecting less is the first). Use this toolto find out how diversified your equity mutual funds are.
A well-diversified portfolio with reasonable expectations will significantly reduce downside risk.
These are mandatory requirements of any investor.

 6 Rebalancing

One can do a little better. You start with some asset allocation in mind. With time gains or losses in individual instruments will skew the allocation and it begin to deviate.
For example, a 60:40 equity:debt investments started a year ago could easily be 65:35 or 70:30 because of the upward swing in the equity market.
If this skewed allocation is reset to 60:40 by pushing some amount from the equity folio to the debt folio, the gains made in a volatile asset (equity) are shifted to a less volatile asset (debt) thereby preserving them.
This is known as rebalancing. There are several ways to do this. Learn more here.
Check out this volatility simulator to understand how rebalancing can be used to de-risk a folio and enhance gains.
Rebalancing requires no special know-how. All it requires is discipline. The discipline to shift capital from a well performing asset class to a safer one!
Rebalancing is not  profit booking.

 7 Tactical asset allocation

All of the above mentioned points can be (and should be!) implemented by all retail investors on their own.
The following, although not difficult to understand is recommended only for experienced investors with big folios.
When markets rise, they will soon become overvalued. Stocks will be priced higher than they are worth and one can expect prices to fall … sooner or latter.
A simple indicator market valuation is the P/E ratio or the price/earnings ratio.
Tactical asset allocation can be implemented many ways. For example,
1) when PE value is high, say > 22, stop investments, accumulate them and invest when the PE value becomes lower, say < 18. Read more about this here
2) when PE is high, say >22, stop investment and shift to debt. Move back and resume investment when PE value become lower. Read more about this here
This requires even greater discipline than rebalancing and extra-ordinary level headedness.  For example, the markets could increase after we pull out. If we are ones who tend to regret and lose focus, this is not for us.
Tactical asset allocation is for those who are focussed on the net portfolio returns.
Tactical asset allocation is not  profit booking.

8 Quit while ahead

Equity holdings should be decreased gradually as the goal approaches. Two – three  years before the deadline, the portfolio should be in pure low volatile debt instruments with no equity.
This means the last two years, the returns would be much smaller than your overall expectations. A simple way to account for this while planning for goals is to reduce the duration by two years.
If your child’s education goal is 14 years away, assume it is 12 years away. Therefore, two years before the actual goal date, much of the corpus is accumulated, and can be kept away safely.
There is no need to this while  planning for retirement, provided one started early and invested enough. Do you know why?

~~~~~~~~~

With these simple guidelines –most of which is commonsense – one can de-risk the portfolio effectively, remain calm and focused, paying little or no attention to the current state of the market.