When opting for actively managed funds, go for the ones that have delivered an occasional outperformance.
According to a study by Moneylife Foundation, 23 stocks hit an all time high in 2011, out of a sample of 1,295 regularly traded stocks. We may want to discount two initial public offers (IPOs) - Aanjaneya Lifecare and Flexituff – on the basis that the “lifetime” is less than a year.
Three of those, namely, Hindustan Unilever, Sun Pharma and Ultratech, were available in the derivatives segment. Seven were micro-caps, including Ahlcon Parenterals (India), Cochin Minerals & Rutile, Golden Goenka Fincorp, Luminaire Technologies, Mudit Finlease, Pro Fin Capital Services and Tricom Fruit Products. The remaining 13 were small-to-mid-cap. Most of these don’t have much institutional coverage. I am not making any comment on the specifics of any of these. Instead, focus on the “strike rate”. How likely is it that a random lottery draw would have picked up any of these 23 stocks? A ratio of 23:1295 translates to roughly 1.8 chances per 100. In the large -cap derivatives segment, the ratio is less than 1.5 per cent.
Few analysts will admit to basing stock selection on random methods and of course, many stocks gained between January to December 2011 without hitting all-time highs. But the ratio of all gainers to all losers was roughly 1:9 - that is, nine stocks lost ground for every gainer.
There are very few with the requisite skills to beat those odds, and pick winners consistently in bearish conditions. In fact, the performances of mutual funds through 2011 suggests this is, in practical terms, impossible. Very few funds beat their benchmark indices.
Does that mean investors should give up on equity? No - share prices have in-built volatility and a broad bear market is eventually followed by an equally broad recovery. If you’ve stuck it out through a bad year or two, the chances of a positive return in the near future is high. So, there’s no sense in suffering capital erosion and then dissolving a portfolio.
However, should investors give up active investing, trying to pick outperformers, and just rely on index funds instead? The argument for passive investing seems powerful and it’s backed by these numbers. In bearish conditions, an active investor would have to beat 1:9 odds to pick stocks that score positive returns. This is very difficult, even for institutions with major resources and intellectual horse-power.
However, if we focus on longer timeframes, some mutual funds do beat benchmarks. They may not do it every year - but they do it say, three years out of five. Importantly, funds can also occasionally churn out big outperformances that over-compensate for poor years. That is evidence in favour of investing actively.
I have some suggestions for the active investor to consider. The first is, by and large, stick to passive index-based investments if you don’t want to do the stock-picking yourself. The passive investor suffers less volatility and uncertainty.
The second suggestion, following from the first is that, if you really like active investing, do it yourself, rather than via a set of actively-managed funds. An individual’s chances of hitting the jackpot is perhaps, as high as an actively-managed fund. While the fund has more resources, an individual may find micro-caps that funds will be forced to exclude. An individual can also short, unlike a fund.
A third suggestion is unconventional. If you do invest in actively managed funds, look for the ones with extra volatility of return. Most fund investors look for the exact opposite - the active funds with the least volatility of return.
My point is, an active fund that scores an occasional extraordinarily positive return could significantly boost the portfolio, as and when it scores. It’s like a cricket team carrying a batsman who scores the occasional big century, in place of a guy who consistently gets acceptable scores. Use passive index funds to deliver consistent, acceptable returns. If you go with active funds, look for the ones with a track record of delivering occasional extraordinary outperformance. Of course, if you find a fund that delivers consistent, extraordinary outperformance, that’s even better. But those are not thick on the ground.
There is an iron law in investing – higher returns can only be targeted by higher risks. The above methods of picking volatile funds, or volatile stocks, leave the investor exposed to potentially higher losses. The results through bull and bear markets suggests that this is a high-beta strategy.
If you want safety in active investing, go with dividend-based methods. Stocks with consistent dividend records and high current yields possess safety. The theme is unglamorous. But dividend-based portfolios seem to beat the index over the long-term.=
