In his latest book “Freefall”, Nobel prize-winner Joseph Stiglitz points out why subprimes were a cause of global markets turning inefficient. Market efficiency depends, among other things, on participants having equal access to information. Information flow about subprimes was not symmetrical: some participants knew more about them. As subprimes infected other assets, financial markets suddenly became less efficient. But the underlying logic of passive investment was reinforced by the crisis. In efficient markets, it is tough for an investor to beat the indices. In inefficient markets, it is only possible to beat the indices with the help of “inside” information.
Passive investing is the average Joe's best bet
For the average investor, staying passive and investing systematically remains the best strategy. The discipline of buying during downturns lowers average cost of acquisition. Indeed, investors who continued buying systematically through the crisis are now sitting pretty.
A purely passive investor will stick to systematic investments in index funds, or in well-diversified equity funds. There's nothing wrong with this tried and tested approach and it beats over 90 per cent of active market strategies.
Passive-plus strategies
But some tweaks to standard passive investing methods may help generate better returns, without taking excessive risks. Many “semi-passive strategies” involve sticking to the same assets but tweaking portfolio weights. One well-known method is to be overweight in scrips with higher dividend yields. This is mechanical. Every year, after receiving dividends, calculate current dividend yield. Buy the 15-20 per cent (five-six stocks in case of the Sensex) of the index with the highest dividend yield (and when rebalancing in year two, sell the lowest-yield stocks you own) .
The stocks with the worst price performance over the previous year will usually offer the highest yields. One variation is a portfolio split at about 80:20 between an index fund (80 per cent of your corpus) plus 20 per cent in the five highest-yield stocks in the index. This method is tax-efficient for Indians since dividend is tax-free and the sales from year two onwards will be taxed as long-term capital gains. The dividend also provides a cushion against capital loss. At the same time, the risk is relatively low because you are not moving outside the index population. Some studies say this offers a small but sure premium over pure passive index-investing.
Another semi-passive method is rebalancing indices by turnover rather than market-cap. Most stock indices weight constituent stocks in the ratios of market capitalisation (free float or full float). This common method favours high PE companies over larger companies with lower PE.
Some investors have experimented by switching weights to the ratio of respective corporate turnovers (actually to a combination of various fundamental factors like turnover, profits, etc) . In this “fundamental index” strategy, the portfolio will depend on the value of the larger businesses catching up. Studies suggest that this is a reasonable strategy and it could yield slightly higher returns in the long-term. But in practice, this is difficult for an individual to execute.
Another method is to vary investment corpus according to a formula. SIPs operate on the concept of EMI (equated monthly installment). But in a strategy borrowed from gambling, some investors increase investment installments if the market falls. Say, if the market falls 20 per cent, they invest 10 per cent more per EMI, and if the market falls 50 per cent, they invest 25 per cent more. The theory is fine. In practice, there could be many variations. If you can keep such a strategy going through a long bear market, the results may be very rewarding since average cost of acquisition will be lower than an SIP. Tweaks based on portfolio-theory and efficient frontier (EF) analysis also exist. Portfolio theorists look at the covariance of various assets. By combining two or more assets in various ratios, it's possible to vary risk and reward. The efficient frontier is the point of maximum return for a given risk level. EF analysis may be used to combine a basket of index funds. Again, some studies suggest this method generates higher returns while keeping risks under control.
Whatever you do, don't stop investing. The Budget has put a little more money in your pocket. Pranab Babu would like you to go out and spend it. That way he gets some revenue back through excise and corporate tax while stimulating economic activity. A lot of people will indeed go out and consume more. If you refuse to go with the herd and invest instead, you are likely to outperform.
This article was originally published on May 01, 2010.
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