Monday, January 26, 2015

Institutional (short term) performance derby

I got this phrase from the Seth Klarman book on value investing - "Margin of safety". My attempt here is to put this into context of the Indian markets.

Market participants

Overall a large percentage of the Indian markets are owned by FIIs. The number has been steadily rising since 1992 making the markets more and more linked with the global financial system. The percentage of volume on the exchanges is now over 22%. So the gyrations of the market are similar to the global system.

Mutual fund penetration in India seems low at 9% of urban households versus 46% in the US. But that is probably because of much lower investment money available to most households and lower banking penetration.

The FII volume in India as of Jan 2015 is about 3 times the DII (Domestic Institutional investor) volume which basically means that the institutional activity is driven by FIIs. Overall FII + DII constitute about 80% of the total volume

This 80% of market activity drives the institutional performance derby.

Short term index beating performance rat race

What makes an asset management company successful? NO the answer is not returns. The answer is assets under management. Given that around 80% of the market trade is in with institutional investors it is not necessary for the largest institutional investor to be the one with the best returns. Returns are the marketing key for each institutional investor. This is why most asset management companies (AMCs) have several funds. The idea is that some fund or the other will be outperforming and that will be used by the sales force to market the product. 

This means that all fund managers working for the AMC will be given a key result area to deliver better than market returns year on year, quarter on quarter, month and month - and YES day on day. The most rational way to do that is for the fund manager to play the momentum trades - buy the fad of the day. So instead of investing the manager has pressure to become a fad picker.

The investors also have a choice to go in and out of the funds (with a fee ofcourse) which makes capital highly mobile thus increasing the pressure to be ahead of the fads.

Roadblocks for sound institutional money management

Too much information is available and with the advent of the internet it is not possible for a money manager to know everything about even 10% of their portfolio. Most fund houses own several stocks making the task even harder.

Research is typically provided by brokerage firms which also have investment banking arms. The research team, although is supposed to be walled off from the investment banking team, has incentive to write reports that favor their clients over others' clients. This makes research highly biased from brokers and should always be taken with a pinch of salt.

Given high liquidity requirements of investors - illiquid but high quality assets often get ignored.

Most funds are under pressure to be fully invested at all times. This is because there is a fear of under performance if the market rallies. So even when stocks are trading at absurd prices funds are forced to buy. Secondly many managers believe that market timing is the job of the investor putting money into the fund - and their job is to pick companies/stocks.

All these factors lead to managers ignoring the fundamentals.

Indexing - invest without thinking

Many a financial literature has recommended investing in index funds as the cost is low and because the average performance of the mutual fund industry is index return minus fees. While this is true if too many people participate in indexing (which they probably are) the stock picking job becomes that of the index maker. Now most index companies will invariable carry a premium to ones outside the indices when there is a bull market and a discount when there is a bear market.

Why is this good for value investing?

This institutional short term performance derby is responsible for an overreaction of the markets in both directions creating opportunities for the astute value investor sharply focused on fundamental value. The pitfall is that several value investors start feeling the pinch when they are sitting on cash and the market is rallying. There is a strong urge to follow the fad and get out before the peak - this is a very dangerous urge and needs to be avoided at all costs.