Will this data now make you re-think your strategy?
Aashish Somaiyaa, MD & CEO, Motilal Oswal AMC
19th January 2017
In a nutshell
Late last month, we carried an interview with Aashish (Every advisor should re-think his fund selection strategy) where he discussed the merits of a focused investing approach and also shared some of his concerns on over-diversifying with diversified equity funds. Some advisors expressed doubts on whether indeed holding 6-8 diversified equity funds meant tending towards market returns, as Aashish suggested. In response, here is some number crunching that Aashish asked his team to do, which reaffirms his conviction that owning 7-8 diversified equity funds is an extremely expensive way of trying to beat the market, as you pretty much land up owning most of it.
Recently our Chairman MrRaamdeo Agrawal published the 21st Wealth Creation Study titled Focused Investing. On the occasion, explaining the findings and some of our learning I shared my thoughts on WF through this interview. http://wealthforumezine.net/CEOSpeakMotilalOswal261216.html
There was some disbelief and there were a few observations, queries, doubts, concerns raised with regards to one of my observations reproduced as below:
BSE 200 is 82% of total market capitalization. Always remember this number. Why? On an average equity mutual fund schemes have anywhere between 40 to 70 stocks in their portfolios. Even if one assumes an average around 50 stocks per fund, 7 equity funds would end up holding 350 stocks. If you de-duplicate for common holdings, one would still end up owning in excess of 200 stocks. If you buy the market you cannot beat the market. Owning 7-8 widely diversified equity funds is a very expensive way of trying to beat the market by pretty much owning most of it. With this kind of diversification I am pretty sure investors will end up getting index plus a few percentage points at best. But the benefit of stock selection and serious alpha generation definitely cannot flow to you if you own almost everything that's trading in the market.
Considering some questions that were raised, we decided to churn out some actual numbers and see whether this hypothesis holds up and as per the title of the interview, do advisors really need to re-think their advice.
We went back in time and starting 2009 for each year we took the top 10 diversified equity funds by size. So there's a bucket of top 10 funds for 2009 and then 2010 and then 2011 so on and so forth. We put an equal weighted 10% allocation into each of these funds and just held on without any rebalancing. And then we took the performance of each bucket of money as on December 31, 2016. This performance, assumed to be what an investor with 10 funds in her equity allocation would fetch, was then compared to broader indices i.e. BSE 200 and Nifty 500.
The results are as below:
Data as on 31st Dec 2016
If you see the heat map of alpha you will be surprised to note that our initial hypothesis pretty much holds up. The biggest funds picked as of Dec 14 and Dec 15 are the only ones showing slightly more alpha and that too over 3 years plus holding periods. Everything else is in the vicinity of 2-3% and lower. Just imagine the entire commission pool being paid is being paid for asset allocation and fund selection and we invest in so many funds we are charging nearly 50% of outperformance produced by us as commission. There is nothing wrong with the whole pattern, except that by being a little more discerning and choosy we can increase the outperformance. In the US, it's not without similar reasons that ETFs are gaining popularity.
And if we are drawing solace by seeing the outperformance for holding periods over 3-4-5 years then the below chart is worth keeping in mind.
Somehow I feel the title of that chart should have started with the word "only" - but that's that.
I would just to leave one final thought - at the cost of repeating - "you can't beat the market if you buy the market". And hence "If you buy the market you cannot beat the market. Owning 7-8 widely diversified equity funds is a very expensive way of trying to beat the market by pretty much owning most of it. With this kind of diversification I am pretty sure investors will end up getting index plus a few percentage points at best."
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