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Asset Allocation is Key

Vetri Subramaniam, Head, Equity Funds at Kotak Mutual believes that asset allocation is key to successful equity investing. His equity funds have a mandate of going 40 per cent in cash. In an interview with Mutual Fund Insight, he elaborates on this style and its implications.

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Vetri Subramaniam took over as Head, Equity Funds, Kotak Mutual Fund, in 2002. His previous background in portfolio management has shaped his view that protecting capital is of paramount interest even in equity funds. In an interview with Mutual Fund Insight in April this year, he explains among other things how this philosophy is being implemented at Kotak Mutual.

Could you please tell us something about your background?
This is my second stint with the Kotak group. I joined the group in 1992, straight from the IIM campus. I worked in the group's car finance business in the early years. From 1994 I became a part of the team which looked after the company's proprietary portfolio and from 1995, I was heading this team. From there on I, along with two analysts, was managing this portfolio. In late 1996 I moved to SSKI, a large institutional broking firm. I was there for about two years, mostly interacting with foreign instituitional investors, and it helped me develop a more global perspective. When you are selling to a foreign client you realise that there is so much happening across the world that an Indian company can be compared to that enables you to tell a story. By mid-1998, I moved to SSKI's retail business, which was known as Sharekhan.

I was part of the core management team at Sharekhan and my specific responsibility, besides being part of management, was to head the research function for the retail business. At SSKI, I had also managed the firm's proprietary portfolio but had to discontinue it because when you are selling as well as managing a portfolio then clients always have a suspicion about the honesty of your recommendations.

I moved to Kotak Mutual Fund in September 2001. My mandate was to take a look at the fund's performance, evaluate the past performance and try and see if we needed to revamp. And in January 2002 we took a call and changed our investment philosophy and said that capital preservation needs to be a second-level objective, and that we will use asset allocation in our portfolios. We wrote about these changes to our unit holders and got their approval. The changes were introduced in February 2002 and by May I had taken over as the head of equity funds.

You were part of the entire decision cycle that led to these changes...
Yes, I was. This was pretty much the main thing I started working on when I joined. My mandate was to look at the philosophy and the strategy of the fund and take a call on the changes that had to be made.

The approach that you finally settled for is not a common thing in the industry. What drove this thought process? Was it in response to something investors were saying or did it happen internally?

Investor feedback has always been there. Most investors ask AMCs that if they knew something bad was going to happen then why didn't they do anything about it. But in our case, it was also driven by my own background in proprietary trading. In proprietary trading what matters the most is absolute returns rather than benchmark returns.

That was one factor that drove this thought process. The other was what were the key factors driving this market since economic liberalisation began. We have seen a market in which the overall market represented by the Sensex number may not have gone anywhere, but yet there have been significant trends in the way things keep happening. And although many of these trends are liquidity-driven... there are some, which are driven by structural changes in the economy. The capitalisation of the market may have to be the same from point-to-point but companies that make up that market capitalisation have undergone a dramatic change. And there's no reason to believe that this will change any time soon.

We need flexibility in terms of asset allocation as capital preservation is key in ensuring that investors make money. If you study the philosophy of some people known to be great investors—even though they don't talk of asset allocation—their philosophy is clear... clear-cut not just in terms of timing (of when to buy) but also in terms of showing patience. They would say that 'I'm going to buy when the price is right, when I find stocks valuable. I am not under any compulsion to be in the market at all times. I will wait for value to come to me.' And that was also part of decision-making.

If you are going to wait for value to come to you then you can't be beholden to any mantra of staying fully invested at all times. You have to have the patience to wait for the price to reach a level where the price-value equation makes sense to you. If valuation is science and you can produce 50 charts and a 100-page report that proves that the market is a buy, then it must be equally possible to produce a document that the market is not attractive. And if the market is not attractive then there must be some way to act on this... say that I will cash in my portfolio, I will use asset allocation in my portfolio. So, it was a combination of all this. Our own experience, the environment, investors and looking at what great investors did outside India, led us to this decision.

When you explain this, it all seems so self-evident. Yet, why is this attitude to investing so rare among fund managers?
In every industry there are some holy cows that everyone takes for granted and no one dares to question. Also, in many ways, we have blindly adopted whatever it is that appears to have worked abroad in the recent past and blindly copied whatever has been the holy grail of US mutual funds. More importantly, all this got biased by the fact that in recent memory—and for most people 1982 till now is their entire memory, not just recent memory—a very simple, stay-fully-invested model has been the only way to go.

This is the period in which the change was made from being one of the ways of investing to being the only way to invest. Look at what Warren Buffet says. He says that you have to wait for the market to reach your stock. He means that you have to wait for the value to come to you rather than force yourself to be in the market at all times.

I think at some point the fund industry just accepted the stay-invested formula as the holy grail. However, the bear market of the last three years has thrown open the debate again. Of course the debate was always there but anyone who argued against accepted wisdom was put to shame by all the arguments that seemed to work.

I think people are beginning to realise that if you do experience markets of the kind that the US experienced between 1965 and 1982—when the market went nowhere for 17 years—you need a flexibility of strategy to tackle that. And then you look at examples like Japan and you start wondering what exactly do people mean by long-term investing. A London School of Economics study, 'The Triumph of the Optimist', studied stock market returns across a number of markets and they confirmed that equity as an asset class does give you higher returns over a long period of time. But the period that they found long-term was, in most cases, between 15 years and 25 years.

This made us ask a question: does this really match the kind of period our investors think is long term? Most people in our markets talk of long-term as being one year. If you really push them, a handful will be willing to look at three or four or even five years. When we studied the Sensex's entire history and looked at every five-year period on a rolling basis, there was still only a 45 per cent chance that you got returns in excess of a basic threshold of 20 per cent. So, we wanted to come up with a strategy to improve these odds. And an important part of that is the flexibility to be able to say that yes, capital preservation is important.

And this comes at a very opportune moment when one can get real-world data and relate this to customers, and create a product, which helps us, meet their goals.

Did you find that investors' maturity was at a level where they could relate to this?
Actually, we found that talking to investors about this wasn't hard. Intuitively, most of them catch on to this fairly fast. I haven't had a problem marketing this idea to investors. They say, yes, now you are making sense to us and if there are times when you think that the market is bad then you should act in our best interest and think of saving our money.

There's a simple story about Bernard Baruch, a legendary US investor of the early 20th century. He was addressing a group of students who asked him the secret of his getting wealthy. He started to talk by saying that first rule of making money is to ensure that you don't lose it. I give examples to investors that they intuitively understand. Take the game of poker. The basic rule is that if you want to win you've got to stay at the table. Staying at the table means having the chips to play. Having the chips means that you've got to ensure that you don't lose money. That is as important as trying to maximise your winnings.

It maybe a little premature to ask this, but isn't there a risk of the opposite happening? Markets can turn around pretty quickly and you may find yourselves out of the market during the better part of a rally.

As long as you work this within a clearly-defined risk-reward ratio, in terms of when it makes sense to take the risk of cash and what is your pre-defined threshold level which determines how much you are willing to live with. I don't believe that is a risky strategy at all. It is less risky than the other strategies of staying in there and hoping for the best.

During the boom of 1999-2000, many fund managers couldn't understand what was happening, didn't really believe whether these valuations were for real, yet stayed in the market for fear of losing out in the returns race. Missing out on part of a sharp rally could put you significantly behind other funds in the returns race. Won't this be of concern to you as well? There are clear pluses and minuses of this strategy but you should also look at one or two fund houses in our peer group, which have gained tremendous respect post-2000. A lot of this respect is attributed to the fact that these funds are examples of fund managers who stuck by their conviction. They said to themselves that, "I believe that these valuations are absurd and I'm going to stay out of this game for a while". This converted into some significant performance gains for these funds post-2000. I think the market realises that having the courage of your convictions and sticking to them is as important as maximising gains on a weekly or mon-thly basis. There is clearly pressure from the marketplace, from your own marketing people, from your distributors and from your investors who call you and talk about week-to-week performance. But I think over a period of time everyone will learn to differentiate bet-ween funds that have a conviction-based approach and the ones that are playing a momentum game.

To implement this strategy, you need to take strong calls on the direction of the market. How do you do all that?

There are two or three things that we've used fairly successfully to do this. Our overall process of deciding on how to use asset allocation and what should be the cash levels in the portfolio is partly based on fundamentals... at another level we also use technicals. We look at technicals to take a call on how overextended or low-risk the market is. We look at the F&O (futures and options) positions to see what kind of outstanding positions are getting built up. We look at simple technical measures to see whether the market is getting overbought or oversold. We look at how far away standard deviation is from the price. We also look at the 200-day moving average of the market as a whole. These and other basic tools tell us which side of the risk platform we are on.

Further from there we try to figure out which stocks we need to sell. Here, we use a three-tier process. Every month we look at portfolios of our peer group funds. Scanning 30 or 40 or 50 portfolios gives you a fair idea about where the money is moving in. We are able to correlate that with where the F&O positions are, and in combination with the trading volume data this gives us red flags about where the speculative activity is. I believe this is key currently because most runs in the Indian market in the last 10 years were liquidity-driven.

To give you an example, if you look at the market in June-July of 2001, you'll find PSU stocks occupied half of the top positions in most fund portfolios. The F&O positions were building up in PSU stocks, stocks that you hadn't heard of a few months before were topping trading volumes. These were red flags that clearly tell an investor that this is a high-risk situation.

Is this a monthly review where you take a call and look for red flags?
Well, sometimes the red flags go off at a whim but this is normally done at the end of a month, mostly because at that point we also have portfolio data to tally with everything else we know. But the groundwork of a sell decision starts when a stock is bought as then we have a target in mind. When the stock reaches that target, we compare the returns on that stock to the benchmark returns in the same period. One of my great experiences in the last 10 years is reversion to mean. Anything that pulls away too much eventually comes back to the mean. So, if my stock has moved up 40 per cent during the period when the benchmark gained 3 per cent, I would aggressively seek to book profits. However, if the stock is up 20 per cent and the index is up 20 per cent than I'll prefer holding on. This is a thumb-rule for us.

Tell us more about your research process, your team...
We have a lean team with just two analysts. Our view on research is that there is very little value addition to be done by researching large-cap companies all over again. I have already got enough research material from 15 sources on these companies. I get updates on them every 10-15 days. For these companies we rely largely on external sources. We try and participate when there are any company-organised sessions... when they are in town but we do not go out of our way to research them afresh.

The only time we start afresh is when we believe that a contrarian situation is building up, when our view of the company is divergent from that of others.

About 80-90 per cent of our exposure in K-30 in particular is in large-cap stocks which are either in the Sensex or the Nifty or have market capitalisation numbers that are similar to the Sensex or the Nifty companies. This gives us a universe of 70-75 companies. From these, we pick the stocks in which we would like to invest. We maintain a list of stocks which we think are close to the right price for buying and one of those that may be reaching the fair value for selling.

In K-MNC, the universe is fairly static and we have not found the volatility high enough to do any allocation calls.

What do think will make investors come back to the equity market?
I wish had an answer to that. I don't believe tax sops will make investors come back to the market. When I talk to investors I get the feeling that if they believed they could make good money on stocks they would gladly pay some of it to the taxman. The problem is that no one believes that they can make money in the markets...most investors believe they will lose money in the markets.