High brokerage and fees hurt active investing

The active versus passive investing debate cannot really be resolved academically. In theory, a perfectly efficient market offers an advantage to passive index players. However, perfection is as unattainable in financial markets as in other spheres of life.

The efficient market hypothesis suggests that, given equal access to information, equal ease of trading, and so on, all news is immediately absorbed by the crowd. Investors take individual actions. Price swings more or less randomly in response to the combined effect of their buys and sells.

In an efficient market, the optimal investment strategy is therefore, to stick to the index. However, access to information is rarely equal. Nor do all participants find it equally easy to trade – for one thing, brokerages are skewed. A third condition is also rarely if ever, met – there shouldn’t be any participants who have overwhelming influence. If we include “non-playing captains” such as policy-making institutions, this condition is never met.

So markets are to varying degrees, imperfect. These imperfection help to explain the small but significant number of investors who consistently outperform indices. Some are plain lucky. Some have access to better information, or deeper pockets, or both. Finally some are perhaps genuinely gifted at forecasting trends and manage their money more efficiently.

However, the available data suggests that most active investors get it wrong. Markets may not perfectly efficient but they are efficient enough to make a strong case for index-investing. An easy basis for comparison is the performance of index funds versus actively managed funds.

Apart from anything else, active funds pay more brokerage and they usually charge larger fees. The global data clearly suggests that there isn’t much percentage in paying for active fund management. The performance of Indian mutual funds mirrors global data to a certain extent. But it also suggests that India is more imperfect than most large markets because there are more outperformers.

S&P (and Crisil) has a global methodology, SPIVA (S&P Indices versus Active funds), which generates scorecards of performances of funds. The India SPIVA which covers most categories like equity, debt, ELSS, hybrids throws up some interesting points, which investors could bear in mind.

First, if you must buy actively managed equity funds, you should buy into the diversified equity segment (DE) rather than large-caps. Large cap focussed funds tend to underperform their respective indices more consistently.

Roughly one in three large cap active funds beats the benchmark, over five years. ELSS has similar levels of underperformance despite the lock-in periods, which ensure that fund managers don’t have to worry about unexpected redemption pressures. Diversified equity funds also tend to underperform but there are more outperformers in the DE segment. About 45 per cent of DE funds beat the benchmark over five years and half the DE universe beat the benchmark over three years.

A second learning seems to be, buy into bigger funds. Funds with more assets under management tend to be better performers. This could be some sort of effect caused by selection bias. Investors put more money into better performing funds and this means the better performers end up with more AUM.

Third, unlike equity, speculation in debt actually seems to offer rewards for active investors. Quite a few pure debt funds outperformed benchmarks. Despite the significant structural risks of Monthly Income Plans, hybrid MIPs with a higher debt component have done well.

Debt funds that focussed in corporate debt also tended to beat the benchmarks. This is interesting because it implies that fund managers made the right calls in assessing the relative risks of different corporate debtors. Given that the interest rate environment went through two full cycles, it is quite impressive. Conversely gilt funds didn’t do so well, which means that fund managers are more liable to misjudge policy rate moves.

If we look at highly evolved markets, such as the US, roughly one in ten equity-oriented funds beats the market over a 5-year period. The ratio is also skewed against actively managed debt funds in the US. That is more understandable because the US bond markets is much broader, and deeper and more liquid. So where does that leave the Indian fund investor? There’s evidence that, unless you’re great at equity fund selection, going with indexation is sensible. However, though it’s odds against, it’s not really too bad at 1:2 for large caps or 9:11 in the case of DE.

The data confirms that the debt market, especially corporate debt, is very inefficient . Here, active management definitely has the edge. However debt fund managers are better are judging the credit-worthiness of corporates than second-guessing the RBI.

Source: http://www.business-standard.com/india/news/high-brokeragefees-hurt-active-investing/466631/

Uncertainty over market rally as intra-day trades increase

The stock market rally this year has led to a jump in trading volumes on Indian bourses, but the proportion of delivery-based trades has been lower than in the previous year due to increased intra-day trades, indicating uncertainty over the current rally.

Moreover, although the long-term outlook for Indian equities appears marginally better now, compared with two months ago, uncertainty on events such as election results, the national budget later this month, and the direction of crude oil prices, which touched an 11-month high on Thursday, might make the markets volatile in the coming weeks, analysts said.

Riding on the back of easing liquidity in the West, foreign institutional investors (FIIs) have pumped in $7.4 billion net of sales in Indian equities so far this year, pushing the 30-stock Sensex index on BSE up 14%. The rise in the broader market has been sharper,with the BSE-500 index rising 18%.

The rally has led to increased trading interest, fuelling a jump in trading volumes. Average daily trading volumes reached a 16-month high of 1.38 billion in February.

This year, nearly 1.17 billion shares have been traded per session, 33% higher than the previous year, when average trading volumes had dipped to a five-year low of 872 million shares. Due to a weakening economy and policy uncertainties, institutional and retail investors largely stayed away from Indian markets in 2011 and the Sensex slumped 25%.

The drop in volumes had become a major worry for Indian regulators. When Securities and Exchange Board of India (Sebi) chairman U.K. Sinha in late December met various market participants including top mutual funds, FIIs, brokerages and investment banks, the drop in trading volumes dominated the meetings.

The Reserve Bank of India (RBI), in its financial stability report in December, flagged off the drop in cash volumes and the rising share of derivatives in the total turnover as a key risk to financial stability in the Indian equity markets.

A rise in global risk appetite since then has led to a surge in volumes, but trading has been dominated by day-traders. The average proportion of delivery-based trades fell to a 19-month low of 38.1% in January and rose only marginally last month. Delivery-based trades as a proportion of total volumes averaged 41.5% in 2011.

“The proportion of delivery-based trades has fallen as day-trading has become more common,” said Yogesh Radke, head of quantitative research at Edelweiss Securities Ltd.

The current trend is in contrast to the equity rally in 2010, when rising volumes were accompanied by a rising share of delivery-based trades. The average proportion of delivery-based trades had risen by 2 percentage points to 42% in the August-November period of 2010 over the first seven months of that year. The Sensex had rallied by 9.3% over the same period on the back of foreign inflows worth $18.5 billion, net of sales.

This year’s rally has been led by improved global liquidity, and lingering concerns on fundamentals have made many averse to taking long-term bets, analysts said. The recent rally is unlike the 2010 rally, when there was greater institutional participation and conviction in the strength of the bull run, said Radke.

“Economic growth is likely to bottom out in the current quarter, and the overall outlook appears marginally better compared to a few months back, but uncertainties on corporate earnings and over events such as the Union budget still remain,” said Prasun Gajri, chief investment officer at HDFC Standard Life Insurance Co. Ltd that manages around Rs.25,600 crore worth of assets.

India’s economic growth slid to a three-year low of 6.1% in the December quarter. The consensus earnings estimate for Sensex firms for the next fiscal year has dropped 13% since the start of fiscal 2012 to around Rs.1,298 a share, and it will be a while before the upgrade cycle starts, analysts said.

While the second round of monetary easing by the European Central Bank is expected to lend support to risk appetite globally, concerns over rising crude oil prices that adversely impact India’s fiscal and current account deficits, and uncertainties over the upcoming Union budget and the direction of RBI’s monetary policy could keep markets on tenterhooks in the coming weeks.

The fall in inflation and recent policy initiatives by the Prime Minister’s Office are grounds for optimism, but the current valuations appear to have priced in most of the positives and “March could see newsflow-driven volatility due to election results, RBI policy and budget”, Manishi Raychaudhuri, head of research at BNP Paribas Securities India Pvt. Ltd, wrote in a 1 March note to clients.

The Sensex trades at 14 times its estimated earnings for the next fiscal year.

Gajri of HDFC Life agreed that there are near-term uncertainties, but said current valuations appear reasonable from a long-term perspective.

Source: http://www.livemint.com/2012/03/04221337/Uncertainty-over-market-rally.html?atype=tp