Don't Emulate The Big Boys

Many investors buy or sell certain stocks because fund managers are doing so. These investors swear by fund managers’ actions. For them fund managers’ actions are the equivalent of insider information in stocks and a pointer to where prices are headed in the near term. Such investors spend their entire day watching the bulk and block deals on Bombay Stock Exchange (BSE) to pick up information of this kind.

At first glance, this might appear to be a sound approach. Fund managers are supposedly most knowledgeable about happenings in the equity markets. They have got considerable resources at hand for analysing companies before they invest in their stocks.

Fund managers’ participation also, to a large extent, allays the fear among retail investors that there might be something fishy going on inside the company.

More importantly, these institutional investors are the only ones who can decide whether a stock will be tomorrow’s Infosys. It is an accepted fact that institutions are the primary drivers of the equity markets. Investment by retail investors alone will not drive up the price of a stock. For that to happen institutions must invest in these stocks. So which stocks they are investing in is at least worth a second look.

That’s exactly what we did. We tested the validity of the follow-the-fund managers approach. We looked at BSE 500 index stocks and identified those stocks where fund managers had increased their net long position in each of the previous four quarters. We then examined the performance of these stocks in the subsequent quarters. What we found was surprising: there was absolutely no correlation between fund managers’ purchases and the subsequent performance of those stocks. While there could be temporary spikes in the prices of stocks due to purchases by mutual funds, there was absolutely no near-term impact. Rather, in the case of a couple of stocks like Sasken Communication Technologies and Jammu & Kashmir Bank, we observed the complete opposite happen, i.e., funds consistently increased their positions in these stocks, but instead of going up their prices spiralled downward thereafter. In case of Sasken Communication, mutual funds’ shareholding went up from 6.59 per cent in March 2010 to 10.42 per cent in December 2010, while the stock price over the same duration fell by 21.85 per cent. This raises the question: what’s wrong with the approach of emulating fund managers’ actions? Many, as we shall see.

(Remember, however, that we examined data for only the short term. Over the longer run, this approach could possibly prove more fruitful than in the short run.)

Why being a copycat doesn’t work
One, these fund managers are not quite Warren Buffet, who buys a company out of choice, often after years of research, and then holds on to it for a lifetime. Fund managers do not enjoy the luxury of choice. Together with managing the portfolio they also have to manage the inflows and outflows of money from their funds. When investors exit with their money, fund managers are forced to offload some of the stocks in their portfolio, sometimes even their favourite holdings. Conversely, when there are inflows, they have to perforce quickly deploy the assets. Sometimes they even have to invest in stocks about which they do not have a high level of conviction. This is part and parcel of managing a fund. If fund managers are not constantly vigilant in dealing with inflows and outflows, their funds’ returns would get hit. Hence, many of the investment decisions fund managers make are the outcome of compulsion rather than choice.

How does a fund survive if a stock performs badly? Remember that a fund manager manages a portfolio of stocks. He can take risk with a particular stock because it constitutes a tiny percentage of his overall portfolio. The diversified nature of his portfolio helps absorb the downside risk of individual stock selections.

Thirdly, a fund manager might buy a stock in order to meet his sector allocation. For example, an IT fund may have some exposure to all the IT stocks in the BSE IT index, or else its sector exposure will not be complete. In some of these stocks the fund manager will have higher conviction and will go overweight on them. In case of others, where his conviction level is low, he will be underweight. Nonetheless, the latter stocks will still be part of his portfolio. If you blindly emulate a fund manager’s actions, you would unknowingly purchase many of the stocks regarding which he has low conviction.

Further, a fund manager has at his disposal a number of tools for minimising the downside risk of buying a stock in which he has low conviction. He could partially or fully hedge the stock by going short on the stock or on the index in the derivatives segment. A fund manager at times undertakes a series of transactions to hedge his long positions. And buying into a low conviction stock may be a part of such series transaction.

As you can very well conclude from the above, buying or selling of a stock by a fund manager should not be looked upon as a standalone action; it should be looked upon as part of a larger strategy. A retail investor would not be privy to that larger strategy. Buying a stock without knowing why you are buying it means you also won’t know the purpose that the stock is meant to serve in your portfolio. You will also not know when to sell it. If the stock outperforms, you will not know when to book profits. And when it underperforms, you will not know when to cut your losses.

Unlike a fund manager, you do not enjoy the luxury of owning a highly diversified portfolio. As explained earlier, a fund manager with 50 to 60 stocks in his portfolio can afford to buy a one-off stock in which he doesn’t have a high level of conviction. If you blindly emulate him and buy the same stock, it could constitute a major holding within your much smaller portfolio. Hence, a follow-the-fund-manager strategy amounts to nothing less than asking for trouble. You might get lucky at times, as you can see in the table alongside, but when your luck runs out your losses will outstrip your gains.

That’s why at Value Research we always stress that one should have a clear goal in mind before investing. Investors should also do their own research instead of blindly following fund managers. If you make random purchases based on fund managers” actions, then after a few years your portfolio will resemble a flea market and its returns will also be poor.