"Only 12%? That’s kind of low, isn’t it?” said the distinguished looking person to whom I had been explaining the arbitrage returns from the Indian markets. We were at a social gathering, and I did not really know him that well. I could only guess from his mannerisms and sophistication in social etiquette that he would also be well-educated about financial matters.

“I really look for returns of at least 20-25%. Itna to real estate mein hi nikalta hai”, he concluded with the confidence of a seasoned buyer of several apartments.

I could not bring myself to point out right then that the volatility of any fund was only 2.5% annually (based on various market researches), whereas real estate prices can stay flat or go up 25%. I could bring to his notice that a mutual fund can be liquidated at any time, whereas converting an apartment into cash is no mean feat. Suffice to say that I could have gotten into a debate with him, but I let it pass as the poker table was waiting. Neither was the place nor the moment right to delve into the details of returns adjusted for risk, liquidity and total costs. APRIL 2015 l The Finapolis 19

Kitna Milega?

Insha Javed, a thirtysomething professional and an avid investor believes returns should be the only criteria while making an investment. “After all, this is what we invest for,” asks she.

Often, Indians tend to focus a lot on the returns and not on the other characteristics of their investments which is certainly not the right approach.

The obvious primary concern besides returns should be the risk attached with the investment. Risk and returns actually go hand in hand. We all understand that 10% returns from a bank fixed deposit is not directly comparable with 20% returns from an investment made in an ELSS. Risk is typically measured as the variability of returns. Thus, a bank fixed deposit with sure shot 10% returns versus an ELSS that could return 30% or lose 10% have very different riskreturn profiles.

Arvind Sethi, MD and CEO, Tata Asset Management says, “Investing discipline and sticking to your goals go a long way than merely ‘timing’ a return. That said, the return expectation determines in some ways the risk an investor will have to be willing to take. Having an aggressive return target, but investing in debt funds is unlikely to work. It’s always best to settle for realistic “return goals” and plan your investments accordingly. Such a strategy is likely give investor’s peace of mind, which would allow him/her to unwaveringly stick to the investment strategy.”

However, the problem is that the risk and returns for risky investments are not known up front, and have to be estimated. Most of us do not really do a good job of correctly estimating the risks and the expected returns. As the famous saying (variously attributed to Niels Bohr, Albert Einstein or Mark Twain) goes, “It is difficult to make predictions, especially about the future”.

Noted researchers, Tversky and Kahneman, had shown way back in 1974 that people tend to make major errors in estimation. First of all, they are heavily ‘anchored’ in their expectations. In the area of investment, anchoring can be to the most recent returns. That is to say that if a fund went up by 20% last year, we start with an assumption that the returns will be about the same in the current year too. We are incapable of making sufficient adjustments to the anchored estimate based on the information that we have or can easily get. For example, we would tend to expect the returns to be plus or minus five percent, even though historical records may show that the actual range may vary from -30% to +70%.

The Total Cost

Finally, we come to the total costs. We need to take care of the transaction costs (for example the stamp duty in the case of real estate) that are involved in our investments. What look like attractive returns can quickly become mediocre or even poor returns once you consider the total costs of transaction. The normal costs of brokerage, transaction and stamp duties must be considered. Even more important are the market impact costs. Market impact costs refer to the cost of getting out of a position.

Let us say you own an apartment and want to sell it in a hurry to raise some cash. The price you will get will certainly be lower than the price you would get if you had some time to wait for the right buyers. The difference in the realised price versus the fair price is the market impact. Similarly, when selling stocks, if you have to sell in a hurry and the stock does not trade a lot of volume, the price will fall as you start selling. This risk is particularly significant in Small-Cap and some Mid-Cap stocks. Finally, there are the taxes to be considered. Whether you are going to pay long or short term capital gains or even business income can make a huge difference to your post tax returns.

Create Alpha And Not Merely Returns

The desperation for higher returns often encourages people to overlook certain other key parameters. A major problem investors tend to overlook is the ease of liquidating their assets. Most investors are only concerned with the absolute returns, and assume that the money will be available as and when required. Only in times of crises do they re- 20 The Finapolis l APRIL 2015 alise that having a lot of illiquid investments does not do you much good if you do not have the cash required to meet your obligations.

For example it is true that real estate investments may have returned 20% on an average over long periods of time, consider what your realised return would be worth if you needed the cash in a hurry. A lot of real estate developers have discovered, much to their dismay, that assets do not equal cash.

Keshav Walecha, a Delhi-based salaried employee and a father of two learnt this lesson the hard way.

“Once I sold some ancestral property and had excess cash in hand. A friend suggested that I should invest this money in a particular scheme which will also give me tax benefits. Although I was not sure but still went with his advice. Few months later my son fell ill and I needed immediate cash for his treatment. However, my fund had a minimum block in period which I got to know when I went to encash my fund. Fortunately my wife had some savings which we used for my son’s treatment.

Walecha says that moment made him realise that one should have a sound investment policy and not be blinded only by the rate of return.

“Alpha is sometimes misused to indicate “short bursts of outperformance”. These bursts are difficult to sustain and replicate. To us Alpha is achieving above average returns sustainably over long periods of time. To this end investors need to have a clear understanding of their return expectation giving it sufficient time to fructify,” says S Naren, CIO, ICICI Prudential AMC.

“It is advisable that for any immediate obligations, a person should plan a Contingency fund and dip into that, rather than disturb a well thought out investment plan. And should the immediate need be such that the person has no choice, then withdraw those funds in a manner which do not disturb the asset allocation or, if the time frame is long enough, withdraw funds in a manner which is biased in favor of equity,” adds Naren.

Portfolio churning is part of any investment manager’s strategy. But churning in itself is no guarantor of outperformance or alpha. A good financial plan is an iterative process in which a person’s goals are defined and then an asset allocation is determined to meet those goals. So if a person needs 5 crore to retire, and given their level of income it would need 70% equity and 30% debt (with some assumptions of course about the long term return on both asset classes) then they would need to be comfortable with it.

We need to take care of the transaction costs (for example the stamp duty in the case of real estate) that are involved in our investments. What look like attractive returns can quickly become mediocre or even poor returns once you consider the total costs of transaction.

However, given the volatility in equity markets the person is not comfortable and would be psychologically happier with a 50:50 allocation – then they would have to go back to the drawing board and see – well shall we lower the target of Rs 5 crore or shall we see if we can find ways to save more. This is why one needs a good financial advisor to help take you through these iterations and then come up with a plan which helps you navigate the uncertainties ahead – whilst ensuring that your current needs, both financial and psychological, are also taken care of.

“The future is an unknowable unknown. This is easy to say but very difficult to accept, which is why people keep trying to time markets. So the challenge is to truly understand and accept that – and believe that over a 10, 20, 30 year time frame you will get a certain return, say 15% compounded from equities and 7% compounded from Debt. And then stick to those investment rules and not get shaken out when markets are bad or even when they are good. If you are able to follow this method, maybe with some minor modifications in asset allocation when things are very volatile – that is the best chance which you have of securing your future,” says Sethi.

Top 5 Equity Funds

The Near Perfect approach

While dealing in mutual fund or for that matter equity, what people should ideally be looking at is a combination of cycles, sector, industry and company valuations. Equities have the potential to outperform all asset classes over the longer term. However, equities tend to be a volatile in the short-term. Thus, investors allocating towards equities should have a buy-and-hold strategy to ensure a good investment experience.

If investors foresee an immediate obligation, they may invest for a horizon of three months to one year in products like liquid funds, ultra short-term funds and monthly income plans to ensure liquidity.

Investors should decide their asset allocation (i.e. how much of his wealth should be invested in which asset class) basis their risk profile and investment horizon. Having said this, it’s true that an investor would find it cumbersome to invest in debt and equity securities and then monitor them regularly.

“The market volatility depends on investors’ current asset allocation strategy. If they are under invested in equities, they may look to invest lump sum in equity strategies which are defensive (or have cash) as equity markets have run up and if the markets offer opportunities over the course of next few months or one year, these strategies will have enough cash to buy equities,” says Naren.

It may be a prudent strategy, thus, to add flavour of funds in the balanced advantage or dynamic asset allocation category. These funds seek to increase allocation to equity when the markets are cheap, and book profits in equities when markets are rising thereby reducing volatility and boosting returns.

Naren further adds, “If investors are well invested in equities, it is recommended to invest in a staggered manner through equity mutual funds over the course of next 6-9 months. The outlook for equity markets is very positive for the next 3-5 years. With the current price of crude and good growth prospects, India is the most attractive emerging market in the world and therefore, it is an opportunity to invest for the long-term in Indian equities.”

Looking at the last year’s performance is like looking at the rear view mirror to drive the car. Therefore, one may look at the long-term performance record of the fund. The need of the hour is to move away from selecting products based on shortterm/ previous year’s performance and look at other important parameters like pedigree of the fund house, consistency in performance and risk management.

So, the next time someone tells you that a particular investment idea is going to generate 25% returns don’t forget to ask them about the risk involved, the liquidity constraints and finally, the total transaction costs.