In Berkshire Hathaway's iconic investors' meet this year, Warren Buffett directed his blunt criticism at hedge funds (and consultants) that think investors can maximise returns by constantly jumping from one asset class to another. Here's what he said: "Supposedly sophisticated people, generally richer people, hire consultants. No consultant in the world is going to tell you 'just buy an S&P index fund and sit for the next 50 years'. You don't get to be a consultant that way. And you certainly don't get an annual fee that way. So the consultant has every motivation in the world to tell you 'this year I think we should concentrate more on international stocks', or 'this manager is particularly good on the short side', and so they come in and they talk for hours and you pay them a large fee, and they always suggest something other than just sitting on your rear end and participating in the American business without cost."
Buffett was making the point that buying just one asset class - American stocks - and sitting on it for the long-term has created enormous wealth for American investors. Therefore, there was no need to shell out hefty fees to a hedge fund to shuttle frequently between asset classes.
Outlook for the year
The advice given above is something that Indian investors need to heed, too.
India may not have a thriving hedge-fund industry. But tactical calls, where market experts tell you what asset, sector or theme will outperform in the immediate future, have become quite fashionable. Just take a bunch of 'outlook for the year' reports that assail you at the beginning of each year. It has become the norm for every big-name brokerage, fund house, television channel and financial paper to tell investors at the turn of the New Year how equities, bonds, gold and sundry other asset classes will do in the year ahead. But the last couple of years are enough to tell us how badly wrong those forecasts can go.
At the beginning of 2014, most outlook reports talked of 'political risks' due to the upcoming Lok Sabha elections and how foreign investors would invest big time in Indian stocks only after the 'event risk' of elections was well and truly over. This was a cue for tactical managers to ask investors to sit on cash so that they could invest in equities after this risk was out of the way. There were also admonitions to stay with blue chips and avoid mid and small caps as they could experience very high volatility.
But investors who followed this advice would have had a good reason to kick themselves after Modi's landslide win. The BSE Sensex closed 2014 with a 30 per cent gain. The BSE Midcap index trumped it, with a 58 per cent gain, and the BSE Smallcap index did even better, with a 64 per cent gain. To actually enjoy those returns, you should have been invested in equities right from September 2013, when valuations were at their lowest. Jumping in post elections would have meant losing out on a good portion of those returns.
Cut to the beginning of 2015, when market experts were all bullish about a big bond rally. With crude oil beginning to fall and inflation moderating, debt-market experts predicted that 2015 would be a great year to go long on debt. The logic was that as the RBI cut its interest rates aggressively, long-term gilts and corporate bonds would rake in big gains from a bond-price rally. By end of the year though, it turned out that this category of funds managed just a 6 per cent return. It was short-term bonds and mid- and small-cap stocks that fared better.
Year 2016, so far, has proven to be a year of surprises, too. Hardly anyone could have guessed at the beginning of the year that gold would prove to be the best-performing asset for Indian investors, posting a gain of 18 per cent by end April. Equities are lacklustre this year, with mid- and small-cap stocks correcting sharply after two years of gains. But with market rates correcting all of a sudden, returns on long-term gilt funds have seen an unexpected recovery!
Clearly, investors who went by the 'outlook for the year' reports in 2014, 2015 and 2016 to switch their bets between equities, debt and gold would have had a terrible investing experience.
Tactical funds
This unpredictable and often irrational behaviour of financial markets works against the new breed of tactical funds, too. In the last few years, Indian markets have seen the launch of a new class of 'asset-allocation' funds, which promise to switch between equities, debt, cash and gold (in some cases) based on quantitative models. Some of them also adopt a fund-of-funds structure to implement this strategy.
These quantitative models use variables such as the market's price-to-earnings multiple or the gap between earnings yield and bond yield to decide on the funds' allocations. But a look at the five-year record suggests that plain vanilla balanced funds have delivered superior returns to these funds. While balanced funds (with 65-35 per cent allocation between equity and debt) have managed to average three-, five- and ten-year returns of 15 per cent, 11 per cent and 10 per cent (as of May 2, 2016), asset-allocation funds managed 13, 9 and 9 per cent, respectively. And these category averages hide a huge divergence in returns between different asset-allocation funds. So you need to know which asset-allocation strategy to choose, too!
This is not to say that the quantitative models used by fund houses are wrong. They are obviously based on empirical data. But the truth is that liquidity factors such as foreign-institutional-investor buying or selling and domestic flows have today become as important a driver of stock and bond prices (see the cover story on debt funds) as fundamental factors such as earnings and valuations. Therefore, tactical-allocation calls that rely heavily on fundamental triggers may fail to pay off.
Overall, when it comes to asset allocation, as with stock or fund selection, the simplest strategy, it turns out, is also the best. Arrive at your own fixed asset allocation (say, 60:30:10 between stocks, bonds and gold) based on your age, risk appetite and investment horizon. Simply stick to this 'steady-state' allocation until you get to your goal.
As for worrying about the direction of equity markets, bond yields or gold prices, leave that to hedge funds.
This article was originally published on June 09, 2016.
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