Will This Be Robo Advisory Firms’ Achilles' Heel?

Robo advice has become a buzzword in the financial services domain, and robo advisory firms are mushrooming at a furious pace in India. A combination of factors—growing financial literacy among investors (especially in urban areas), internet penetration, and enhanced awareness about mutual funds, among others—has contributed to this phenomenon. It can be safely stated that robo advice is an idea whose time has come.

As the name suggests, robo advice eliminates human intervention. Instead of an adviser, the investor is guided by algorithms run on a website. Typically, the investor feeds in information about his age, risk-taking ability, income and expenses, current assets and liabilities, financial goals, expected inflation et al. The robo adviser uses the data to produce a suggested asset-allocation and a list of mutual funds that can aid the investor achieve his financial goals while adhering to his risk appetite. Furthermore, robo advisory firms also enable investors to make online mutual fund investments thereby acting as distributors too.

To my mind, several of the robo advisory firms do a decent enough job when it comes to risk-profiling and arithmetic calculations. Likewise, it is evident that some have paid due attention to areas such as user interface. It is the last mile—recommending mutual funds—where most err.

It is commonplace to see funds being recommended based solely on performance. Typically, the three-year period is considered, and top-performing funds make it to the robo adviser's list. Recommendations are also offered in the form of a portfolio of mutual funds. Yet again, the three-year showing is the primary factor for picking funds from various categories. Given the strong showing posted by small/mid-caps in the recent past, it comes as no surprise that at present several recommended portfolios have a strong small/mid-cap bias.

A rule of thumb approach is perceptible in the recommendations. For instance, investors with a moderate risk appetite are offered large-cap funds. However, no thought is applied to the nature of the fund. For instance, a large-cap fund wherein the manager aggressively churns the portfolio, and draws on factors such as news flow, market sentiment and momentum while investing might not be suited for a moderate risk-taker. Yet such funds make the cut thanks to their performance and large-cap classification.

Not only is making recommendations based solely on performance a fundamentally flawed approach, it also reveals a poor understanding of the basics of investing. When the present top-performers are replaced by others (as it can and does happen in the case of market-linked investments) will investors be expected to churn their portfolios? Robo advisory firms can’t take refuge under the premise that their advice is bound to be ‘formulaic’. There is a difference between formulaic advice and flawed advice.

Don’t get me wrong. I’m not questioning the utility of robo advice. For first-time investors and those with uncomplicated investment needs, robo advice can be the way to go. But robo advisory firms must realise that there is more to investment advice than just running calculations. Indeed, flawed advice can significantly hurt investors' interests.

Robo advisory firms have a huge opportunity at hand. If tapped well, robo advice can prove to be a game-changer for both the mutual fund and distribution industries. However ignoring the ‘advice’ aspect of the business will prove to be a costly miss.

Stupid Portfolio Manager vs. Ignorant Portfolio Manager

Aggression seems to be the flavour of the season. Several politicians routinely breathe fire; at present, students at a New Delhi campus are in a belligerent mood. No discussion on Indian cricket is complete without the mention of aggression; likewise, a bespectacled newscaster known for his confrontational demeanour tops the TRP charts. And just when one thought it couldn’t get any more interesting, aggression has reached the mutual fund industry.

Recently, the promoter of an asset management company published a piece insinuating that competing portfolio managers are stupid. His contention is that since the NDA government assumed charge at the centre, bogus/hyped earnings estimates have been doing the rounds. Hence, equity portfolio managers who believed in and acted on the same are stupid. Furthermore, portfolio managers who didn’t fall for the hype, but failed to communicate their misgivings (on lucrativeness of equities) to investors are dishonest.

Apart from a touch of arrogance, the piece also reveals a poor grasp of how investing works. Investing is a personalised activity i.e. each investor pursues an investment philosophy and strategy that works for him. This principle holds good for portfolio managers as well.

For instance, while some managers pay more attention to top-down factors, others rely on bottom-up analysis. Some invest with a growth-bias, while others have a value-bias. There are managers plying research-oriented strategies and others who deploy a sentiment and momentum-driven approach. Even the investment horizon can vary significantly. Admittedly some strategies are more efficient than others, but that doesn’t take away from the fact that investing isn’t a one-size-fits-all activity, as the article erroneously suggests.

Equity investing isn’t a pure science. When a manager evaluates a business, factors such as his investment philosophy, interpretation and biases (among others) come into play. To suggest that every manager should have (or did) read the macroeconomic environment in a uniform manner is oversimplification. More importantly, is it apt to evaluate managers based on one event? Prudence demands that an equity manager be evaluated over the long-haul spanning a market cycle.

An element of bragging rights is perceptible too. Over the last year or so, equity markets have experienced a fair bit of volatility. The flagship equity fund (from the author’s AMC) takes cash calls based on valuations, and has expectedly fared well in a peer-relative sense. The portfolio manager and strategy deserve credit for the showing. However, that doesn’t diminish the credibility of competing managers who don’t take cash calls; expectedly, such funds have fared poorly in the recent past.

   

On the dishonesty bit, yet again the author displays his ignorance by mixing up the roles of an adviser and a portfolio manager. The latter is responsible for running the fund to the best of his abilities and in the investor’s interest at all times. However, offering the investor asset allocation-related advice, or managing the investor’s portfolio is not the manager’s role. That’s what advisers are engaged for.

In the competitive asset management industry, the need to celebrate and spread the word about one’s success is understandable. However, branding the competition as stupid and dishonest on untenable grounds reeks of ignorance.

Investment Lessons from Yuvraj Singh’s T20 Innings

On Sunday, I watched the third T20I between India and Australia. Chasing a stiff target of 198 runs, India seemed on course until the third wicket fell. The next batsman Yuvraj Singh, was making a comeback to the national team. In the initial part of his innings, Yuvraj struggled, scoring just five runs in nine balls. As the required run-rate rose, the buzz on social media and the views of television commentators weren’t particularly charitable.

Then something interesting happened with India needing 17 runs to win in the last over. 11 runs were scored from the first three deliveries which Yuvraj faced – including a four and a six – putting the run chase back on track. With India winning the match, Yuvraj was hailed as a 'hero' all over.   

To my mind, the reaction was a classic case of circular logic; in other words, the result was used to selectively determine the cause. I have no doubt that had India lost, the focus would have been on the first half of Yuvraj’s inning wherein he struggled; furthermore, he would have been painted as the villain of the piece. However a win meant that the focus shifted to his impressive performance in the last over.  

Now let’s draw a parallel with the world of investments. Investors often rely solely on the performance to draw an inference about an investment avenue’s worthiness. For instance, if a mutual fund clocks a strong showing, investors infer that the portfolio manager must be skilled, the investment process must be robust, and so on. However such ‘analysis’ is fundamentally flawed. 

To begin with, in a rational approach, one or more causes lead to a given result, and not vice versa. Also, the performance-based approach fails to separate luck from skill. Consider, a mediocre fund helmed by an incompetent portfolio manager who got lucky with his stock picks. On account of the positive performance, the manager will be considered to be skilled. Likewise, a skilled manager whose investment style is currently out of favour will be given the thumbs-down on account of a poor showing. Investors’ woes will be further worsened if they choose to focus on near-term performance in an asset class like equity. 

A prudent approach would be to identify and evaluate factors that will influence performance. The results of this evaluation must then be compared with the fund’s long-term performance. If the two are in sync, then the analysis can be considered to be accurate.

Market-linked investing is inherently risky. Investors who base their decisions on performance, further accentuate the risk borne. While adopting this approach in cricket-related matters is harmless, doing so while investing could be a recipe for undesirable results.

Let Portfolio Managers Eat Their Cooking, But Don’t Force-Feed Them

It has been reported in the media that Kotak Mahindra Asset Management Company (AMC) has ruled that its employees who wish to invest in mutual funds, shall henceforth do so only in the AMC’s funds. The reports also suggest that employees will be penalized if they make fresh investments in funds from other AMCs after the policy comes into place. 

The rationale behind the move is to introduce the concept of ‘skin in the game’. The concept is far more common in the West, than in India. For instance since 2005, the U.S. Securities and Exchange Commission has required AMCS to annually disclose how much portfolio managers invested in the funds they run. 

To clarify, Kotak Mahindra AMC is not the first Indian AMC to institute a ‘skin in the game’ policy. While some AMCs pay (a part of) bonuses to their investment teams in the form of mutual fund units, others pledge that their top brass invest in funds from the AMC. What differentiates Kotak Mahindra AMC’s guideline is that perhaps for the first time, employees across the board who wish to invest in mutual funds, have been told to compulsorily do so, in the AMC’s funds. 

Why ‘skin in the game’ matters 

From an investor’s perspective, is Kotak Mahindra AMC’s guideline necessarily a positive one? I don’t think so.

To clarify, I have been a propagator of portfolio managers eating their cooking i.e. investing in funds they run for a while now; also, I believe there is a case for disclosing managers’ investments in funds they run. To understand why I am not convinced of the guideline in question, let’s delve further into the ‘skin in the game’ concept. 

At its core, portfolio managers investing in mutual funds they run is all about inspiring confidence in investors. Portfolio managers who invest alongside their investors show a conviction in their investment approach and a confidence in their investment acumen. It’s a classic example of putting one’s money where the mouth is.

Coercion versus free will

The trouble with Kotak Mahindra AMC’s policy is that there is an element of coercion. Employees (including portfolio managers and analysts) who wish to invest in mutual funds, will invest in funds from the AMC because they are being forced to do so, not because they want to. For an act to inspire confidence, it must be voluntary and not compulsory. Even if managers claim that they have invested in funds from the AMC voluntarily, that argument is unlikely to find many takers, given the existence of a policy which dictates such investments.

What AMCs must do

  

If Indian AMCs are serious about building investor confidence, they must adopt the ‘skin in the game’ concept in letter and spirit. Apart from voluntary investments by portfolio managers, AMCs can explore avenues such as offering a part of the compensation in locked-in units from the AMC’s funds, or periodically disclose investments made by managers in funds they run. 

Most importantly, AMCs must appreciate the importance of free will for ‘skin in the game’ to have the desired effect.

Of Sangakkara, Yuvraj, and Prashant Jain…

In the recent World T20 final, southpaw Kumar Sangakkara’s blistering knock helped Sri Lanka triumph over India. Playing his last international T20 match, Sangakkara had had a rather indifferent run coming into the final. But on the day, his batting display meant that all skepticism surrounding him vanished and the clichéd maxim “form is temporary, class is permanent” was back in circulation.

In the same match, another southpaw Yuvraj Singh had a bad day at the office. To put it mildly, he was woefully out of sorts with the bat. As a result, he found himself at the receiving end of a barrage of criticism; even as I write this post, critics are busy writing his cricketing career’s obituaries. Though Yuvraj has proven credentials as a match winner, not many seem willing to offer the “form is temporary …” defense in his favour, at present.

To my mind, the diverse reactions can be attributed to a recency bias. The accolades for Sangakkara and criticism for Yuvraj have more to do with their performance in the final match, rather than an accurate evaluation of their cricketing prowess. Both Sangakkara and Yuvraj are unquestionably talented batsmen with impressive careers to show for. But for now, most believe that Yuvraj is a 'has-been', while Sangakkara is a 'class act'. And what’s driving this belief—the players’ showing in the most recent match.

The recency bias can manifest itself in investments as well. If markets have been on an upswing in the recent past, investors are more likely to believe that they will continue to move northwards going forward as well, rather than otherwise. Likewise, a stock or sector which has hit a purple patch lately will often inspire more confidence in investors rather than one that has underperformed recently.

O Prashant, Where Art Thou?

In the latter part of 2013, I was addressing a gathering of mutual fund distributors, advisors and investors. Things became interesting when the conversation veered towards funds run by portfolio manager Prashant Jain i.e. HDFC Top 200 and HDFC Equity. To clarify, I thought (and continue to think) highly of those funds and the manager in question. But then, I was in a minority. The funds were having a terrible run in 2013, underperforming both their respective benchmark indices and comparable peers. The audience was at its vitriolic best: Theories such as the manager doesn’t churn the portfolios enough, the funds are too large to perform, and the manager is a spent-force were put forth by the audience to rationalise the underperformance.

Prashant Ahoy!

Oddly, at present (i.e. roughly six months later), Jain and his funds are being eulogized by the same set of distributors, advisors and investors. And what has changed between then and now–the funds have clocked a strong showing and emerged among the best performers in a peer-relative sense. Is that surprising? Not really. Broadly speaking, the manager has been betting on a turnaround for a while now and had positioned his portfolios accordingly. Expectedly, while the funds struggled for a better part of 2013, they staged a comeback of sorts in the present market upturn.

Is it Heads or Tails?

Here’s what makes the funds tick: Jain easily ranks among the best portfolio managers in the country; he plies a robust investment process and is backed by a fund house which has a reputation for safeguarding investors’ interests.

The aforementioned factors existed when the funds were underperforming, and they continue to be present now too, when the funds are outperforming. All things being equal, a year or so of underperformance doesn’t turn a good fund into an inferior one; likewise, outperformance over a six-month period doesn’t convert a mediocre fund into a superior fund.

Yet, we have seen the manager and his funds go from vilification to glorification in a six-month period. This is irrational behavior at its best which can be attributed to the recency bias. I shudder to think of the reactions that will follow, if Jain’s funds were to underperform over the ensuing six months.      

What investors must do

Resist succumbing to the recency bias while investing. Think about it: you might exit a sound investment avenue with solid long-term prospects because of short-term underperformance. Conversely, by blindly chasing an investment which has fared well you may run the risk of making an overpriced buy or even one that is unsuitable for you. Maintain a long-term orientation while investing; it will help you block out all the noise which prevails in the near-term.

Also, learn to look beyond just performance while making investment decisions. Rather focus on what makes the investment avenue tick to better understand when it is likely to fare well and otherwise. This in turn will help you make informed investment decisions, independent of recent performance.

On a lighter note, a word of caution for those writing off Yuvraj based on one poor showing—the humble pie isn’t particularly palatable!