Mr. Portfolio Manager: It’s About Conviction, Not Guarantees

Over the years, in my several interactions with portfolio managers most have claimed to be big investors in funds they run. Perhaps it was politically correct to do so. Then again, there was no way to independently verify their claims. However, with market regulator SEBI mandating that investments made by managers and the fund company's top brass be disclosed, the scenario has changed.

The disclosures have been startling to say the least. Several long-tenured managers running large diversified funds have nominal investments to show for, while others have chosen not invest in their funds. It can be safely stated that the principle of having ‘skin in the game’ hasn’t been embraced by many managers.

Recently, a manager who has no investments in his funds came up with a novel justification. He stated that a ‘manager investing in his own fund doesn’t guarantee performance’; hence, his investments (or lack of them) are immaterial. To clarify, he isn’t the only manager to have taken that stand. In my opinion, this line of thought is both naive and flawed.

Given their market-linked nature, mutual fund investing entails taking on risk. While the degree of risk may vary depending on the kind of fund chosen, risk is pervasive nonetheless.

So how do investors mitigate risk? By performing an evaluation. For instance, some may focus on quantitative parameters such as past performance, risk-return showing, while others emphasize on qualitative factors—manager skill, investment process et al. It isn’t uncommon for investors to combine the two either.

The portfolio manager’s investments in funds he runs is yet another evaluation tool. A manager investing substantial monies in his funds demonstrates conviction in his investment approach and acumen. It’s a classic example of putting one’s money where the mouth is.

None of the evaluation parameters can guarantee performance. But that in no way diminishes their relevance. Of all people, a portfolio manager should be aware that there are no guarantees in his domain. Investing in markets akin to a business of risk, not a business of guarantees. Does the fact that there is no guarantee of returns, prevent the manager from exhorting investors to invest in funds he runs?

I have no doubt that some managers will continue to steer clear of investing in funds they run. But they would do well not to trivialise the importance of having ‘skin in the game’ using inane arguments. As for investors, I am certain that like me, most will be wary of the chef who doesn’t eat his own cooking.

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.

What happened to close-ended funds?

Circa 2006-07, close-ended funds were the season's flavour. Fund houses were busy convincing investors to get invested on the premise that close-ended funds furthered the cause of 'long-term' investing. Investors had a plethora of options to chose from since close-ended NFOs (new fund offers) of every conceivable kind were launched i.e. mid-cap, flexi-cap, thematic, fund of funds and tax-saving.

The genesis of close-ended funds
When equity markets hit a purple patch in 2003, fund houses capitalised on the same by launching equity fund NFOs. Most NFOs were of the open-ended variety. Fund houses were permitted to charge initial issue expenses (6% of corpus) to the fund and amortise the same over a period time. Initial issue expenses were largely used to meet marketing and distribution expenses. As a result, distributors were handsomely rewarded for their efforts in asset mobilisation.

A spanner in the works came in the form of a SEBI guideline that scrapped initial issue expenses on open-ended NFOs. Now, fund houses were required to meet NFO-related marketing and distribution expenses from the entry load; the norm was 2.25% of the sum invested. But close-ended NFOs were out of the purview of this ruling. While fund houses were permitted to charge initial issue expenses on close-ended NFOs, the trade-off was that they were prohibited from levying an entry load. The choice between initial issue expenses and entry load was a no-brainer. The result was a deluge of close-ended NFOs.

It would be unfair to paint all fund houses and close-ended NFOs with the same brush. Some close-ended NFOs did offer a truly innovative investment proposition. However, ignoring the marketing aspect would be naive.

The present scenario
It can be safely stated that close-ended funds are a forgotten breed now. Maybe, it had something to do with a subsequent guideline (January 2008), wherein SEBI decided that close-ended NFOs be treated on par with open-ended NFOs i.e. they would be permitted to charge an entry load and the provision to charge initial issue expenses was scrapped.

While close-ended funds may not feature on the priority lists of fund houses, it's a different scenario for investors. Several investors got invested in close-ended NFOs and continue to hold the same in their portfolios. Also, since then, markets have had quite a journey - an ascent to record highs, followed by a sharp downturn, and a recovery of sorts. It would be interesting to study how close-ended funds have fared so far.

The performance
Of the several close-ended funds launched in the 2006-08 period, 4 have a 3-Yr track record now. The following table shows how they have fared vis-à-vis comparable open-ended offerings from the same fund house and their respective benchmark indices.

	3-Yr (%)
Franklin India Prima	8.2
Franklin India Smaller Companies ©	6.6
CNX Midcap	16.8
HDFC Premier Multi-Cap	14.1
HDFC Long-term Equity ©	9.1
S&P CNX Nifty	15.2
ICICI Prudential Dynamic	18.2
ICICI Prudential Fusion ©	6.5
CNX Nifty Junior	18.7
Tata Tax Saving	12.6
Tata Tax Advantage 1 ©	14.3
BSE Sensex	14.6

(NAV and index data as on July 24, 2009. © indicates close-ended fund. NAV data sourced from www.amfiindia.com. Index data sourced from www.bseindia.com and www.nseindia.com. All data in CAGR terms)

As can be seen in the table above, close-ended funds have failed to match their benchmark indices over the 3-Yr period. Furthermore, with the exception of one fund, others have failed to match comparable open-ended funds from the same fund house. Even a cursory glance at performance of other close-ended funds (ones that have been in existence for less than 3-Yrs) will reveal that largely their performance is nothing to write home about.

It ain't over, till it's over
Critics might argue that the aforementioned funds need not be a representative sample of the entire close-ended funds category. Fair enough. But few would dispute that close-ended funds have failed to impress so far.

Fund houses are likely to justify the mediocre showing posted by close-ended funds on the grounds that these are early days. Given that most close-ended funds have a 5-Yr tenure, passing any judgement at this stage would be premature. Also, several funds have a provision for conversion into open-ended funds on maturity. Hence, should they fail to deliver in their close-ended avtaar, investors can continue to stay invested and exit the same at a more opportune time. While there might be some merit in the former argument (early days for funds), the latter certainly doesn't hold good.

Here's why - investments in close-ended funds were made on the premise that they would enable fund managers to make long-term investment decisions i.e. fund managers would not be weighed down by factors like redemption pressure and short-term market occurrences, that typically plague open-ended funds. When investors agreed to forsake liquidity (make a 5-Yr commitment) and bear initial issue expenses, the trade-off should have been a superlative performance. The least investors would expect is for close-ended funds to deliver a better showing than open-ended funds. And should close-ended funds fail to deliver, investors have every right to feel aggrieved.

What investors must do
Investors would do well to appreciate that not every promising proposition translates into a sound investment avenue. On paper, a close-ended fund with a defined maturity horizon and corpus sounds like an interesting idea; however, with the benefit of hindsight, it can be safely concluded that not every close-ended fund will live up to the promise. This underscores the importance of seeking diversification and a track record while making investment decisions.

Also, investors must keep track of their close-ended fund investments. Be patient and give them adequate time to prove themselves. Despite this, if they fail to deliver, don't hesitate to exit them after taking into account factors like the exit load. Perhaps an alternative fund with a similar investment proposition might be a better bet.