We all want to pick stocks; after-all, successful stock pickers like Buffett, Klarman etc are romanticized and their returns are the stuff of legend. But should you pick stocks? And here, I am talking about picking individual stocks vs investing in a mutual fund.
Here is a small explainer on stock-picking and its relationship with active management. Let’s quickly get through what these terms mean, and what I’m trying to convey in this post.
What is active management?
There are two styles of fund management: active fund management and passive fund management. Read more about active and passive funds here.
Before we go any further, it’s important to understand what a benchmark is and why you need a benchmark. A benchmark serves as a point of reference for measuring performance because you cannot look at the performance of a mutual fund in isolation. Every mutual fund benchmarks itself to an index like the Nifty 100, Nifty Midcap 150, Nifty Smallcap 100, etc depending on the category it operates in. Benchmarks also give you an idea of the returns you would’ve made if you had done nothing and just bought the index.
Now, the job of an active fund manager is to beat the benchmark. There are various strategies they use to try and do this. Some avengers might be value-oriented, meaning, they try to identify underpriced stocks compared to their fair value. Some managers might be growth-oriented, they don’t worry too much about valuations. Some managers employ systematic quantitative strategies such as factor investing. Some popular active funds are HDFC Top 100 managed by Prashanth Jain and PPFAS Flexi-Cap fund managed by Rajeev Thakkar.
An index fund on the other hand just tries to copy an index and deliver the returns of the index. For example, a Nifty 50 index fund, just tries to deliver the returns of the Nifty 50 index before costs. It’s that simple.
Active management is when a money manager or a team of professionals is tracking the performance of an investment portfolio by regularly making buy, hold, and sell decisions about the assets in it. Active management is always in pursuit of returns that exceed the performance of the overall markets.
An example in the US of this would be Fidelity. Fidelity Blue Chip Growth Fund uses the Russell 1000 Growth Index as its benchmark. Over the five years that ended June 30, 2020, the Fidelity fund returned 17.35% while the Russell 1000 Growth Index rose 15.89%. Thus, the Fidelity fund outperformed its benchmark by 1.46% for that five-year period.
Actively managed funds charge higher fees than passively managed funds. The investor is paying for the consistent efforts of investment advisors and for the potential for higher returns than the markets as a whole.
Active management involves traditional stock picking. Traditional stock picking is when you invest using a systematic or a discretionary form of analysis to decide that a certain stock will make a good investment, which is why it should be added to your portfolio.
Why stock picking is hard for everyone to choose
Stock picking is equal parts an art and a science and it’s notoriously hard. Learning how to pick stocks requires a deep understanding of a business, it’s management, the economy at large, business cycles, valuations among other things. And all this knowledge is no guarantee of success. The stock market is probably the only place in life where effort and results aren’t correlated. The stock market doesn’t give a rat’s ass about how hard you worked.
Millions of people try their hand at picking but most fail. This image shows the number of active funds that beat their benchmarks around the world. Most of them fail and these highly paid, ridiculously smart fund managers that have insane tools and research budgets.
The other issue is that stocks returns kinda mimic the Pareto Rule - 80/20. A small number of stocks are responsible for most of the market returns. Professor Hendrick Bessembinder looked at the market returns of US stocks between 1927 and 2019. $47 trillion of shareholder wealth was created relative to a treasury bill (fixed deposit). Guess how many stocks were responsible for most of this wealth?
Just 83 stocks were responsible for $23 trillion of wealth. It took 25,584 stocks to create the other $23 trillion!
Read more on this here.
This isn’t just a US phenomenon, it’s the same across the world.
Came across this interesting article. The long-term creation of shareholder wealth is concentrated in very few stocks. Top-performing firms tend to be older and do not have particularly volatile returns.
Not just stocks, it’s the same with mutual funds. Very few funds beat the index and of the top performing funds, most end up as the worst performing over the next few years. It’s like a game of musical chairs. Picking a top performing manager in advance is incredibly hard.
So why do active managers fail?
The markets are more efficient than ever and alpha (excess returns) is limited. There’s more competition for than ever.
Active fund managers charge too much. If a Nifty Index Fund charges 0.10% and an active large-cap fund charges 1.5%, the fund manager first has to generate enough excess returns to cover the expense ratio and then deliver additional returns over the benchmark. Sounds simple to just deliver additional returns of 1-2%, but 80% of large-underperform Nifty 50.
They trade too much which adds to the costs.
SEBI recategorization exercise has clearly defined the investment universe of the funds. This has made it even harder for funds to beat their benchmarks even in the mid-cap segment which has been traditionally thought of as less efficient.
It’s a game of relative skill. The more relative the skill is, the harder it becomes.
Even in mutual funds, year after year, it gets harder for schemes to beat the index. And even if the top stock pickers hit high marks one year, it always seems like they fade to mediocrity in the following year. There are, of course, high fees associated with mutual fund management; at the same time, some of the largest mutual funds consistently underperform the market.
There’s no real buy and hold in the markets. I think everything is a trade, be it for 1 day or 10 years. Some companies survive, some don’t. The advantage of an index fundit overweights the winners and underweights the losers. In a way it has that momentum effect—not in the strictest academic sense.
And when I say index fund, I am talking about the classi market cap weighted funds. The way a market cap index works is that stocks which have the highest free float market cap have a higher weight. That means as companies keep growing, they become a big part of the index and vice versa. So, the beauty of index funds is that you get more exposure to good companies and the terrible ones become smaller and eventually get kicked out of the index. Nifty 50 is an example of a market cap weighted index.
The other advantage of the index funds or ETFs is that they are extremely low-cost. A Nifty index fund costs just about 0.20%. Direct active funds charge up to 1.50%. And index funds have low turnover, which means over a period of time they do better than 70-80% of active funds.
- Almost all the stock market gains come from a small set of stocks, so stock picking is extremely difficult. As the below graph explains, around 54% of individual stocks under perform the benchmark.
- Most stocks let you down. As the below chart illustrates; Between 1983 and 2006, around 73% of the stocks had a draw-down of larger than 50% and for the period 2007 - 2014, this number is 82%. During the same period, the S&P 500s MaxDD was around 44% and 50%.
Costs are the biggest drag on performance. Most active funds charge too much and trade too much. Whatever alpha the manager generates mostly becomes the AMCs margin and the investors under perform the index.
Markets have become a lot more efficient. There is very little information asymmetries-insider info that managers can capitalize on.
Markets have also become increasingly professionalized. Imagine the number of PhD’s, physicists, mathematicians, CFAs, CMTs, who are constantly trying to find an edge in the market.
So should you avoid stock picking?
I’m not saying that, I’m saying it’s hard. But even if you want to, the ideal way to do it is to have a bulk of your portfolio in low-cost index funds like Nifty 50 and Nifty Next 50 and some decent debt funds. Allocate a small amount of money to picking stocks and see if you are cut out for it. Don’t go all in with your portfolio.
Index funds only deliver market returns, aren’t they mediocre?
That’s not incorrect. But think of it this way, just market returns are enough to beat over 80% of all active funds and other investors over 10-20 years. Moreover, most of your returns come from asset allocation. Asset allocation means having a good mix of equities, debt, gold, and real estate.
Also, if you want a chance to beat the index, you can maybe have some small allocation to a decent active fund if you can pick one. If not, you can have some allocation to smart beta funds. These are rule-based systematic funds that seek to exploit certain factors that drive stock returns such as value, momentum, quality, and low volatility. Sounds complicated but check this post.
So you use the core and satellite framework to build a portfolio. You can include these in the core:
- Market cap weighted low cost index funds such as Nifty 50 & Nifty Next 50. Together you get access to the top 100 stocks. These stocks represent 77% of the total free float market cap of all NSE listed stocks. It’s like you are buying the entire market. And moreover a 50% Nifty 50 and 50% Nifty Next 50% outperforms 70-80% of Large and Mid-cap funds. Nifty Next 50 is like a Mid-cap index
- In the debt part of the core you can have simple funds like ultra short funds or some really well managed corporate bond funds or banking PSU funds. You can also check out PSU and PSU + SDL/GSEC index funds.
- In the satellite portion of the equity, you can have a good active fund if you manage to pick one or allocate to smart beta funds.
- The satellite portion of debt is meant for taking credit calls, tactical calls on interest rates with Gilt funds etc. This is extremely risky and advanced and not for lay people.
Keep it simple
Investors don’t realize how important keeping costs low in investing is. High costs slowly eat away your returns. By using the simple framework I outlined above you can invest for all your long term goals above 10+ years like retirement,
For any goals less than 5 years, investing in equity is risk and frankly stupid. It’s better to invest in a liquid fund for short-term goals.