Emotion

Posted on by Devesh Deepak Asset Allocation, Diversification, Investment, Mutual Fund, Risk

Diversification – A lesson from Cricket

Indians treat Cricket not just a game but we eat, sleep and breathe cricket.  Cricketers are as popular as a movie star and every victory in the field is a festival for the masses. Since cricket is so much entrenched in our psyche that we think there is no better way but Cricket to explain the benefit of diversification in your investment portfolio. The cricket is the most watched sports in India and every other Indian claim to be the bona fide expert of the game. Even the youngster will tell, “I know my cricket as my mamma knows her household.”

But for few tyro, Wikipedia explain the game as – Cricket is a bat-and-ball game played between two teams of eleven players on a cricket field, at the centre of which is a rectangular 22-yard-long pitch with a wicket (a set of three wooden stumps) at each end. One team bats, attempting to score as many runs as possible, whilst their opponents field. Each phase of play is called an innings. After either ten batsmen have been dismissed or a fixed number of overs have been completed, the innings ends and the two teams then swap roles. The winning team is the one that scores the most runs, including any extras gained, during their innings.

So what are the basics, there are eleven players on the field for each team during a match and every member of the team has an assigned role to play. The top order players are the batsman, the middle order consists of wicket keeper and all-rounders and lower order players are bowlers. The team has to score runs and restrict the opposition team to score as many runs as they have scored to win the match. The players who score runs are called batsman and the players who restrict the opposition team to score are called bowlers. Hence the reward is to score as many as runs you can and risk is the rival team can score more run than what you have scored.

If scoring the runs is the most important aspect of the game then why we can’t have a team with eleven specialist batsmen to maximize the rewards or eleven specialist bowlers to minimize the risk? If you ask this question even to somebody who wasn’t a big cricket fan, they could probably tell you that everyone has a job to do during any given match. If you don’t have a bowler in your team, your risk will magnify and it would be difficult for your team to restrict opponent to score more run than your team. Similarly, the team consisting of only bowlers can’t expect to score many runs and thus lose out to the opposition. This exactly explains the reason for having a diversified portfolio – as in cricket, every asset class has a specific job to do within the portfolio.

So if you are an investor trying to build a portfolio, let see what Cricket can teach you.

Go for Diversification

Holding several investments in a single asset class doesn’t mean a portfolio is well-diversified. Generally, diversification may lower risk when investments are negatively correlated, meaning their prices typically move in opposite directions. Your portfolio should be diverse enough to weather all sorts of markets – a mix of aggressive and defensive assets, such as stocks and bonds, may reduce the general risk of investing in the market. Dividend-paying blue chip stocks or mutual funds could be the core of your portfolio, while smaller growth stocks can give your portfolio speed and agility.

Diversification doesn’t mean sacrificing return

A well-balanced cricket team with six specialist batsmen and five specialist bowlers will have greater chance to win. A good all-rounder only adds the strength. Similarly, diversification may boost returns while lowering risk when compared to a single asset class. It’s possible at times that a portfolio holding separate asset classes produces a total return greater than the respective returns of each individual asset class. Since the portfolio is not subject to the volatility of a single asset class and covariance among the assets also lower the portfolio risk.

Build a core for Long Term Success

A team works best when they are built for a long period of steady success rather than a single, brilliant season. The best teams build a talented core group of players and only make changes when they need to address weaknesses in the team. M S Dhoni and Saurav Ganguly was the most successful captain of the Indian cricket team and both back their players to the hilt and gradually built a core which remains constant throughout their captaincy.

It’s the same in your portfolio. Rather than constantly rebalancing your portfolio and guessing the next winner, find some mutual funds that you like and plan to hold them for long time period. You should not obsess over whether your portfolio is up or down on a given day. Plan for the long-term; it’s better to have your portfolio perform above average over years than to have a few big years but performing sub-optimally in most of the other years.

Identify and stick with steady Manager

In the first decade of this century, we have two very successful coaches – John Wright and Gary Kirsten. In between, we also have Greg Chappell. The records of these coaches speak for themselves. Rather than firing the players after disappointing performances, the successful coaches kept faith in their long-term ability to win and stuck with them, even in the bad times. Whereas, Greg Chappell’s firing policy proves a disaster for Indian cricket team.

An investor should do well to analyse the performance of the fund house instead concentrating on a single scheme. One should not quit a fund if it is going through a rough patch. A steady, successful fund management team always pull out of rubbles and steer the fund back to its winning way by adhering to winning strategies, putting up good numbers in the long run. The track record matters and investing in a hotshot new manager with no track record can be risky.

Conclusion

The great team doesn’t build in a jiffy; it takes years and load of patience. Even the best team loses sometime hence one should not lose sleep if your portfolio gives negative returns when market capsizes. We all are well aware of the history of US stock market crash of 1929. Some investors must have first-hand experiences during market meltdown in 1999 and 2008. The reality is that some market crashes are so sudden that even the most diversified portfolios suffer. Risk can only be minimised, can’t be wished away. However, portfolio diversification may stabilise risk to help lower a portfolio’s sensitivity to market volatility.

 

 

Posted on by Devesh Deepak Equity, Hedge Fund, Long-Short strategy

Why to Invest in Hedge Funds

“Higher the risk, higher the return; lower the risk, lower the Return”. This is the first concept of Investment you come across whether you are a seasoned investor or a newbie while talking to any adviser or participating in any investors’ education programme.

For many years, investors have been told that risk and return are correlated. Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk/return trade-off is the balance between the desire for the lowest possible risk and the highest possible return. This whole idea is graphically illustrated here and we are sure each one of us must have seen this graph at least once in our lifetime.

risk-return

This graph depicts the idea beautifully but there is one flaw. The Risk-Return trade-off line is not a straight line in real life. That is, the return per unit of risk is not constant. More risk will not necessarily bring you more return and the return per unit of risk start diminishing as you take more and more risk. This is the second concept of Investment called Law of Diminishing Marginal Utility.

‘Utility’ is a term used in economics to describe how much value or happiness one derives from a good or service. Marginal utility refers to how much additional value/happiness is derived from one additional unit of the good or service. Most goods and services are said to have “diminishing marginal utility.”

‘Diminishing marginal utility‘ can be understood by this simple example – If you are hungry, you will relish your first dosa, you may eat your second dosa but very few of us will enjoy the third one. As our hunger satiates after the first one, our urge to eat another dosa diminishes though the taste of each dosa is the same.

More risk can’t generate a proportionate higher return and it’s a fact of life that markets fluctuate and unpredictable. But occasionally markets experience bouts of extreme volatility and declines, which can wreak havoc on portfolios. Statistics over the last 20 years show 5% pullbacks typically happen about two to three times a year, 10% to 15% corrections every one to two years and 20% bear drops every three to five years and over 50% once in a decade.

It’s easy to ride out small fluctuations given a long time horizon. But with rare large declines, most investors get perturbed by the mark to market loss and allow the behaviour aspect rode over the fundamental aspect of investment. It would be better having a bit of protection or hedge — either for peace of mind or for performance. This concept of Investment is called Hedging, which can be achieved by buying derivative to protect your long position. This cost reduces your return in an up swinging market but protect you from draw downs and generate better risk adjusted return.

Hedging risk has been an integral part of the financial markets for centuries. One of the more notable early successes came in the 17th Century when commodity producers and merchants devised a way to protect themselves against unfavorable price changes through a system of ‘forward contracts’.

Another aspect of hedging is Arbitrage. Arbitrage is a strategy where you try to capture the price difference of stock, commodity, etc in two different markets by buying in one and selling in another simultaneously. This is a market neutral strategy and you are not concern about the market direction. In India, you profit by exploiting the price differences by buying in the cash market and selling in the future market. Subsequently, you square up the trade on or before the expiry of future contract to realise the gain.

The term ‘hedge fund‘, however, dates back only to 1949. At that time, almost all investment strategies took only long positions. Alfred Winslow Jones, a reporter for Fortune, published an article arguing that investors could achieve far better returns if hedging became an integral part of an investment strategy. Jones launched a small investment partnership to test his belief. He incorporated two investment tools into his strategy – short selling and leverage – to simultaneously limit market risk and magnify returns.

As an Indian, we have historically invested in long-only strategies, be it Stocks, Mutual funds, PMS or Insurance. Since the naked short sale is not permitted in any of these investment avenues, we never benefited like global investors and fund managers who take advantage of mispricing, overvaluation, and euphoria in the markets to make investment returns by shorting a stock. This strategy yields sizable returns in bearish markets, where the share prices take a plunge.

A long-short strategy is used primarily by hedge funds, seek to deliver positive returns with low correlation to equity markets by taking long positions in stocks whose prices are expected to rise and short positions in stocks that are expected to decline.

The fund manager take a long position in a stock by buying it: If the stock price rises, the fund will make money. For shorting a stock, fund either uses the derivatives or borrows the stock they don’t own, sell it and then hoping it declines in value and then buy it back at a lower price and return the borrowed shares.

The Indian equity market is more volatile than US, European and other major Asian markets. Higher Volatility in the market couple with Lower Correlation and Higher Dispersion among Indian stocks provides an opportunity to generate alpha through active management of long and short positions.

Hedge funds profit from winners and losers both by taking long positions in winning stocks and short positions in losing stocks; it reduces the volatility and limits max draw down.

Structure of Hedge Funds in India

Hedge Funds in India are category III Alternative Investment Fund governs by SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”).

Alternative Investment Fund or AIF are privately pooled investment vehicle which collects funds from sophisticated investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors.

Specific exclusions include family trusts, employee stock option trusts, employee welfare trusts or gratuity trusts, holding companies, special purpose vehicles not established by fund managers and regulated under a specific regulatory framework (eg. securitization trusts), and funds managed by registered securitisation or reconstruction companies.

An AIF under the SEBI (Alternative Investment Funds) Regulations, 2012 can be established or incorporated in the form of a trust or a company or a limited liability partnership or a body corporate. Most of the AIFs registered with SEBI are in trust form.

Category I AIFs

AIFs which invest in start-up or early stage ventures or social ventures or SMEs or infrastructure or other sectors or areas which the government or regulators consider as socially or economically desirable and shall include venture capital funds, SME Funds, social venture funds, infrastructure funds and such other Alternative Investment Funds as may be specified.

“Angel fund” is a sub-category of Venture Capital Fund under Category I Alternative Investment Fund that raises funds from angel investors and invests in accordance with the provisions of AIF Regulations.

Category II AIFs

AIFs which do not fall in Category I and III and which do not undertake leverage or borrowing other than to meet day-to-day operational requirements. Various types of funds such as real estate funds, private equity funds (PE funds), funds for distressed assets, etc. are registered as Category II AIFs.

Category III AIFs

AIFs which employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. Various types of funds such as hedge funds, PIPE Funds, etc. are registered as Category III AIFs.

There is no exact definition for the term “Hedge Fund”; but it is generally accepted that any investment fund that used incentive fees, short selling, and leverage are hedge funds. However, there are many category III AIF which are not utilizing the hedging and arbitrage strategies and are engage in relatively traditional, long-only strategies.

The eligibility criteria and conditions for Hedge funds in India are:

  • Investors can be Indian, NRI or foreign.
  • Only spouse, parents and children can be a joint investor.
  • Minimum corpus should be Rs. 20 Crores for each scheme.
  • Minimum investment by each investor should be Rs. 1 Crore.
  • The Maximum number of investors can be 1000 for each scheme.
  • Category III AIFs can be both open and close ended.
  • The manager or sponsor shall have a continuing interest in the respective AIF, (a) of not less than 5% of the corpus (in Category III), or (b) Rs. 10 Crores (for each scheme) whichever is lower.
  • Leverage of a Category III AIF cannot exceed 2 times the NAV of the fund.
  • Units of close-ended AIFs may be listed on stock exchange, subject to a minimum tradable lot of Rs. 1 Crore and such listing of AIF is permitted only after the final close of the fund or scheme.

Reference

  1. AIF Regulation
  2. AIF FAQ
  3. Registered AIF
  4. The Indian Association of Alternative Investment Funds (IAAIF)
Posted on by Devesh Deepak Risk

Are we Loss averse or Variance averse?

How many times you have compromised on return and invested in a relatively safer instrument; or fretting about the potential loss before making an investment, or worst sold the investment whenever there was the slightest dip in the value of the portfolio. This impulse to protect you is called the safety first principle or “loss aversion.”

The influence of emotions on decision-making is widely accepted. Neurophysiology evidence suggests that loss aversion has its origins in relatively ancient neural circuitry (e.g., ventral striatum). This evidence also helps us to understand while modern finance theories tend to see risk as related to variance in expected returns; the psychology literature tends to link risk to probability or size of potential losses.

The assumption of modern portfolio theory about the efficiency of market and rationality of investor is long been nullified. Individuals do not tend to act rationally when making decisions in a risky environment. Most of the times individuals have little information, process such information using simplified routine, and are influenced by the way in which information are presented to make a decision.

Before the advent of Modern Portfolio theory (MPT), the investment risk is measured in terms of absolute loss or relative loss vis-à-vis of a market index. Variance as a measure of Risk was first introduced by Economist Harry Markowitz in MPT in a 1952 essay, for which he was later awarded a Nobel Prize in economics. This idea of variance as a measure of Risk is so new that it never percolated in the psyche of investors, despite the fact that all the subsequent development in Risk Management – Risk-adjusted return, Value at Risk, EWMA, Downside Deviation or GARCH – uses variance as a building block.

The significance of standard deviation (the square root of variance) can be gauged by the fact that 68.2% of the time your return of the investment will lie between one standard deviation above and one standard deviation below the mean value, 95.4% of the time your return of the investment will lie between ‘2’ standard deviation above and ‘2’ standard deviation below the mean value and 99.7% of the time your return of the investment will lie between ‘3’ standard deviation above and ‘3’ standard deviation below the mean value.

We don’t have empirical evidence to conclude whether individuals are loss averse or variance averse but our experience in the field of investment suggest that individual is more loss averse than variance averse.

Dan Ariely, James B. Duke Professor of Psychology and Behavioural Economics at Duke University, and the author of ‘Predictably Irrational’ and ‘The Upside of Irrationality’, both of which became New York Times bestsellers opined that “People hate losing much more than they enjoy winning. How happy are investors when they make 3% on their investments and how miserable are they when they lose 3%? There is a tremendous asymmetry.”

The asymmetrical behaviour of the individual under the fear of losing money tends to make these common mistakes:

First, they ‘overweight’ the lesser probability and ‘underweight’ the higher probability and sometimes totally ignore a minor event.  Their response to a loss is more extreme than the response to a gain of the same magnitude. Instead of cutting loss, they try to recoup the loss by liquidating their profitable assets—that could run counter to their long-term investment goals.

Secondly, they often increase their risk-taking in order to try to escape losses and fall victim to the sunk-cost fallacy. The sunk-cost fallacy is behaving as if more investment alters your odds, believing the more you put in, the more it will pay off.

Third, they fail to distinguish between a bad decision and a bad outcome. Individual regrets bad outcome of a good company like a weak quarterly result or low returns over a period, even if they have chosen the investment for all the right reason. In such case, regret can lead them to make a decision to sell. This means selling at the bottom instead of buying more.

Lastly, they justify holding the safe investment by comparing the alternatives with respect to a specific point of time, that is, they always evoke Internet bubble of 2000 or Lehman Brothers collapse of 2007 to justify not investing in stocks – thus losing the chance of potential return.

It is interesting to note investors – amateurs and professionals alike, regardless of intelligence or skill level – act intuitively under risky and uncertain condition forgetting that today’s uncertainty won’t likely last forever.

Risk aversion is important. This is natural check and balance – keep us away from financial fraud and also keeps our expenses in control, and helps us to save for a rainy day. But loss aversion is short-sightedness. It happens when we lose sight of our long-term goals, and focus too much on short-term events.