Your Portfolio Needs Patience, Not Helplessness

If you have any money in equity, you have repeatedly been advised by your wealth manager, market experts and the media to be patient; that markets are cyclical and before you know it, we will soon continue our positive trajectory. They are not wrong. However there is a difference between being patient and being helpless. The way we see it, a market crash brings clarity and tends to embolden or highlight weaknesses in the portfolio, which otherwise are overlooked in a bull market. In good times, most portfolios do well regardless of fundamentals or the fund manager’s ability. Investors need not (but should) dwell on the little details of strategy since positive sentiment drives returns. There’s little difference between the great and good, or even the great and bad. However, as we inevitably approach a downturn and the euphoric blur ends, the distinction becomes more and more visible.

‘Only when the tide goes out do you discover who’s been swimming naked’ – Warren Buffett

What’s the difference between a patient investor and a helpless one? A patient investor is cognizant of what’s in their control and what isn’t. They understand that recovery is inevitable, but discussing when it’ll come and how long it’ll take is futile. They proactively sift through the portfolio and look to eliminate weakness (that was ignored earlier) to limit further loss, and align the portfolio for a speedier recovery. A helpless investor on the other hand freezes and becomes dormant. The quantum of loss makes them uneasy and remaining status quo seems to be the best option. Our advice is be patient, not helpless.

After studying several portfolios and the reasons of vast difference in their performance during subdued markets, the ‘errors’ have become fairly apparent. Following is a comprehensive list of action items from our observations. In our opinion, investors should use this opportunity to reflect whether their portfolios are symptomatic of these errors and take corrective measures. These measures should increase the probability of a speedier recovery with lower volatility and limit further downside (if any).

1. Having large cap funds with high expense ratios – Large cap funds are mandated by SEBI to have 80% of their assets in the top 100 stocks of India by market capitalization. Naturally, their portfolios greatly overlap with the much followed index of Nifty, thereby reducing their alpha (out-performance) generating ability. This is why every decimal percentage that’s charged counts in the large cap category. Yet on average this category charges an expense ratio of 2.30% . Unsurprisingly, only a handful large cap funds are able to beat their benchmarks. Check your portfolios for consistently under-performing large cap funds with expense ratios upwards of 2%. Consider a change in fund unless your advisor can justify its high cost. Chances are that the high expense ratio alone is dragging the portfolio’s performance.

2. Having excess number of stocks/funds – Clients are often surprised when we tell them that they are holding over 500 stocks via their mutual funds, direct equity (shares), and ULIP policies. Frankly, taking into account promoter integrity, ingenuity of financial statements, and quality of business, the Indian stock market barely has 70-100 stocks even worth considering. Buying 20 mutual fund schemes is like blindly casting a large net in a tiny pond. You might catch some fish but you’ll also end up with a lot of trash. Data from the crashes of 2000 and 2008 shows that it took broad based markets (Indian and global) years to recover. In fact it took BSE 500 almost 4 and a half years to hit previous peak after the 2008 crash. US Index S&P 500 took around 4. A lot of corporate fraud and business unsustainability will come to light in the near future. To avoid the resulting permanent damage, there’s no doubt that consolidating holdings is a must for a sharper and sooner recovery. The general rule is to not have more than 5-6 funds.

3. Thematic funds – Thematic funds by law have to invest 80% of their assets in a particular sector/theme. As established, during a bull run most things work. This is why taking a sectoral call via a thematic fund in a bull run may not be as punishing as holding it in a downturn. COVID-19 has brought complex and precarious circumstances that have a multitude of long term effects on several industries, some which we’ve envisaged and some which are not so obvious. It would be prudent to eliminate exposure to thematic funds at this stage and move to a far more open ended high quality multi cap strategy. Why restrict your money’s flexibility?

4. Stuffing the portfolio with large caps / ‘blue chips’ – The biggest myth in investing is that large caps are safe and mid/small caps are risky. Yes bank was once a Nifty stock. In fact the best performing mutual fund (excluding thematic funds) in the last one year is axis mid-cap fund as on 31st May, 2020. It has 80% in mid cap stocks. Marcellus Little Champs PMS has delivered 8% from 30th August, 2019 to 30th April, 2020 even though all their stocks have a market cap of less than 3,500 crores (very small cap), putting most ‘safe’ large cap funds to shame. The common consensus right now seems to be that since liquidity will come back in large cap stocks, they will be the fastest to recover. Liquidity first returns to quality, market leading, and clean businesses (which may be large caps but don’t have to be) Don’t assume that holding large caps i.e. ‘blue chips’ will protect you from further downside or help your portfolio recover any faster.

5. Buying cheap i.e. getting stuck in a value trap – Investing myth number two would probably be that a P/E of 10x is cheap and 50x is expensive. Or even worse, a stock price of Rs.50 is cheap and Rs.2,000 is expensive. Intuitively we like to think that if a stock has fallen 40%, it will recover much faster than a stock that has fallen 10%. This can be a very damaging thought process. Getting stuck in a value trap means holding onto something just because its cheap and waiting for a re-rating (e.g. many PSUs). More often than not, you’ll be left waiting for years facing permanent damage; there’s usually a reason why something is trading so cheap. If history has shown us anything, it is that market share gets further concentrated during a meltdown. Market leaders with strong and clean balance sheets in across industries emerge stronger EVERY TIME. A better bet would be to focus on finding them. In our blog ‘The Impact of GDP on your Portfolio’, we’ve explained in detail the what drives equity returns.

6. Investing in Close Ended / Lock in Products – In our experience, portfolios packed with close ended products almost certainly under-perform their open ended counterparts. A smart investor compromises his/her liquidity only for an additional return. For obvious reasons, in times likes close ended products can be extremely damaging to the portfolio. Avoid further investments that lock in your liquidity.

7. Remaining invested in funds facing redemption pressure- This is especially relevant to debt funds. Redemption pressure often forces fund managers to sell high quality securities as lower rated papers are far too illiquid. Naturally, inactive investors are stuck with the bad apples. In equity funds too, an inordinate amount of redemptions can interfere with the fund manager’s strategy. Check if you hold any funds that are fast losing assets, especially in the debt space. It may be wise to switch to a different fund. It may also be wise to check the levels of cash your funds are holding.

8. Ignoring Qualitative Factors – qualitative factors are those that can’t be measured with numbers (i.e. quantitative) but are just as important. Many times qualitative factors are a cue for the upcoming performance of a stock or fund. They can be predictive whereas looking at numbers is often reactive. For example how will a change in fund manager impact your scheme’s performance? Does the fund house rely on well defined processes or rely on a star leader? How often is there a change in the fund’s composition and is it deviating from its original objective? Is the fund house a PSU or private? Who are the promoters? What’s their integrity like? Similarly for direct equity a change in management, regulation, etc. can have far reaching impact on your returns. Ignoring qualitative aspects can have a drastic impact on your portfolio.

Behavioural finance teaches us that loss aversion is an extremely strong sentiment. Losing 10 lakhs hurts us a lot more than the joy we get from making 10 lakhs. It is therefore understandable that investors go into deep-freeze when a loss of this magnitude occurs. However, it’s important to actively and continuously consult our rationality. Our blog ‘Navigating Markets through the Corona Virus’ may be helpful. How can we go back from Rs. 70 to Rs. 100 again? Perhaps after reflecting you’ll find that remaining status quo is the best answer and by all means then, stay put. However if you find that your portfolio has any of the above symptoms, we would recommend that you take a look and fortify it.

Siddhanth Jain | Partner

BlueFort Financial