The Chase for Alpha

Much has been written and publicized by the investment managers about their ability to generate Alpha – above market returns. Most of the Mutual Funds offer documents and advertisements talk about how the fund has consistently beaten the market over the past years. And surprisingly, using very carefully chosen time frame as well as parameters, most of them have data also to substantiate their claims.

So, does it mean that these managers actually beat the market? Well, very unlikely – and if one adds the entry load (1-2% for most schemes), management fees (~2% annually), and exit loads (0-1%), there is very very miniscule chance that an investor would be better off by investing in a fund as against directly in the market index. Assuming an average all-expenses of 3% for a fund, you need the manager to beat the market by more than 3% to be actually able to generate alpha to his end clients. Add to it the fact that alpha is strictly a zero-sum game, and for every manager who beats the market, there would be another one who has been beaten by the market.

I’m strictly against use of Mutual Funds, atleast by people who can understand the basic nuances of stock market, and have the resources/skills to invest directly in the market. Most of the time we are afraid of losing money in the market – a fact compounded by frauds like Satyam, and we always run the fear that we may be caught on the wrong foot. However, the reality is that the same is true for a professional fund manager as well, and in fact I would like to think that they would have a larger tendency to take risks. And most of the fund managers in reality were caught napping during the Satyam fiasco.
So where does this leave an average retail investor? There are two choices for generating the market returns - (a) Using Index Futures, and (b) Using ETFs. I tend to prefer the latter over the former as futures are by their very nature a short term betting instrument, and if one plans to have an investment horizon of atleast an year, then futures would entail rolling the contract at every expiry – a costly as well as cumbersome exercise. ETFs are nothing but essentially a basket of all the stocks in an index, and have a small ticket size (currently INR 500 for Nifty BeES). Much goes behind the scenes with regard to how they are structured, and how they are able to track the Index. However, for a small investor, it would be sufficient to understand that they would tend to trade very close to the actual index value, and the management fees are much lower (0.50% or so) for these funds. So, if one just wants to have a plain exposure to the market, ETFs present a much better option compared with the mutual funds.

Why there is no word called ‘Bear-sh*t

To start with, let me put the disclaimer first:

I have a very strong belief that most of the asset classes in the world always trade at a premium over their fundamental value – defining fundamental value as what people would earn if they indeed keep the asset till perpetuity. I have a term for it as well – the ADR phenomenon. It goes like this – any ADR can anytime be converted into the underlying stock, and hence the value of an ADR will seldom fall below whatever an investor can earn by buying the ADR and then immediately converting that into stock. So, ADRs most of the time trade at a premium to the intrinsic price of the underlying share. The price of the stock here is the ‘Opportunity Value’ of the ADR – which could be derived any time the investor wants to. The same rational goes for the stocks or any other asset class – they always trade at a premium over what people can earn by holding them to perpetuity (their “Opportunity Value’). Only in times of deep recessions and market crashes do they trade below their values. So, more than 80%-90% of the times there is a bubble in the market.

Now building on my belief about the perpetual asset bubble in the world, any rational person would most of the time expect the market to correct (looking deeper into the terminology here – market falls are called ‘correction’, while the rise in markets are given terms like ‘bubbles’, ‘frenzy’, and ‘euphoria’). So, there is an inherent bias in the market where more people always believe that markets should fall. Whether they expect the fall to happen immediately or later is where the opinion differs, but they are all united in their belief that they are over-valued. There seems to be slight sophistication in thinking ‘Bearish’ – anyone who thinks markets would keep on rising is termed a naive retail speculator, whereas anyone who can substantiate a market fall is an ‘Economist’ or a ‘Trader’. So much are the professionals in the field biased against the bulls that they have named the ultimate description of crap as ‘Bull-sh*t’.

So, little wonder that all the ‘E’s and ‘T’s of the world are united in terming the latest rally as overdone, and are predicting another crash to happen ‘any moment’. No one likes a rising market – anyone can make money there. The dumbest of people end up making the most mullah in a bull market – as they don’t have the slightest of fear about a market fall. If one was born in US in the last 1970s, and discovered their senses in mid-1980s, then he/she saw was an ever rising market. How on earth would someone explain him/her that markets could fall as well. They were living in a ‘fool’s paradise’. NNT also warned against the bull markets, and bought deep OTM options – in the full knowledge that markets one day would fall big, and he would make a killing. He did make it, but that came after years of painfully watching the market move up, and seeing all his options expiring worthless (he did get all his money back, but that was from the sale of his books, rather than from the markets). No one ever loses everything in the market – either you make money, or you learn.

In the end, everyone is right about it – but seems that if you do not think about it too much, you are right on more occasions than the rational thinkers. You might lose everything you made in just one bad year, but then, its the same with the other side as well. So next time an expert warns you against a crash, just tell him that you would rather lose money in a couple of crashes, than being worried about it for all your life. And for all the ‘bears’ in the world, there is one simple answer - ‘Ignorance is Bliss’.