Subramoney

this article by Suraj of moneycontrol.com first appeared on ibnlive.com - i have reproduced it here as it contains my quote and reasonably explains what is an etf. So here it is as a part of my tutorial…

Hovering at around 9,000 levels, the Sensex has shed more than 50 per cent of its value, since the beginning of this calendar year!

By now, we all know the oft-repeated ‘buy low sell high ’ mantra. So, with equity prices beaten down badly, it does not take rocket science to decipher that now is perhaps indeed the right opportunity to buy good quality stocks at low prices.

However, as a layperson, how do you define a good stock? How would you know which stock will give you good returns once the markets take a ‘U’ turn?

Instead of laying your bets on a single stock (and not being sure if it will do well), wouldn’t it be better to simply invest in the index? This way, once the market shoots up, so does your investment and therefore, your returns!

Is it possible to invest in the index? Yes, one way to do this is through an Exchange Traded Fund, or ETF, as it is popularly known.

What are ETFs?

ETFs, like index funds, are mutual fund schemes that invest in stocks in exactly the same proportion as that of a given benchmark index. For instance, the Nifty BeES ETF from Benchmark Mutual Fund invests in the same stocks that the S&P CNX Nifty Index is comprised of.

As the name suggests, they are traded on the stock exchange. This means, you can buy and sell ETF units anytime during market hours. This is where they differ from index funds which also invest in index stocks but cannot be traded.

To invest in ETFs, you need a trading as well as a demat account.

Why choose ETFs?

ETFs are a good bet for more reasons than one.

1. Market linked returns

Statistics show that in the long term (all blocks of 5 years for the past 25 years in India), equity returns have surpassed that of every other asset class. Since ETFs invest in securities that form a part of a particular index, their returns are more or less in line with index returns. So, if you have invested in a Sensex based ETF, once the benchmark zooms up, you can be sure that your Sensex based ETF will go up too!

With diversified equity funds, your returns may or may not exceed market returns, that is, your equity fund may not outperform the index.

2. Low costs

ETFs are generally passively managed. This means that the ETF merely invests in index based stocks and does not deviate into investing in other stocks. Since the ETF does not buy or sell its stocks often, it has lower expenses than that of an actively managed fund. For example, the Nifty BeES has a cost structure of around 0.50 per cent, much lower than what conventional mutual funds levy (around 2.5 per cent).

3. Low tracking error

Tracking error is the difference between ETF returns as against that given by the index it tracks. The lower the tracking error, the better is the performance of the fund. Index mutual funds as well as ETFs aim to achieve a tracking error close to zero. ETFs have been seen to have maintained a low tracking error.

4. Real time buying and selling

Other mutual funds can be bought and sold only at the day end’s net asset value (NAV). However, you can buy and sell ETFs just like stocks, that is, during trading hours, which also makes them more liquid.

ETFs offer the best of both worlds – they are mutual funds but are traded like stocks.

PV Subramanyam, financial domain trainer strongly recommends index based ETFs in an investment portfolio. When the markets recover, ETFs that mimic the index will be the first to come up and give attractive returns over the long term.

I would have called this a million dollar question. However, thanks to this great meltdown, let me call it the Trillion dollar question.

The Optimistic view: the world loves a bull market. The world loves a winner. The world loves to see the “good” man win - that is why we pay millions of rupees / dollars to see movies. So speaking optimistically:

1. India is growing at 7% if you believe the pessimists and 9% if you believe the optimists. Anyway it is way above the world average, so investments will flow in.

2. Oil will hover around 90$ to the barrell and that is good news.

3. Our working population is huge, and has a fantastic capacity to earn, save and spend.

4. Our domestic investors have put a small amount of money in equity markets, as they invest more, markets can only go up.

5. Rakesh Jhunjhunwala says markets will go up. He cant be wrong, can he?

Now, sadly for the other side:

1. We are nowhere near the beginning of the American problem. Credit cards, Home loan defaults, Pay day loans, - we have not begun to touch the tip of the iceberg in the American problem.

2. Indian IT companies will have a huge drop in earnings - thanks to the American problems.

3. The turmoil in the banking/ investment banking / financial services industry world wide will ensure that less money comes into the markets.

4. Down turns could be for short term - say 18 to 24 months, but secular bear markets can keep the index same for long periods. Remember the Dow remained at the same level from 1970 to 1982.

5. Shankar Sharma says the sensex will not reach 100,000 in his life time. Assuming he lives for another 35 years, it means the Indian markets will grow at a rate LESS THAN 5.8%. Now if you provide for inflation at 7%, you will get a negative return. Shankar Sharma cannot be wrong, can he?

So, which view would you want to take? Optimistic or Pessimistic? Make your choice. All yours!!

A few hundred calls from friends, relatives, readers….have all had the same question on their lips. “What should I do now?”, “Will the index touch 9000?”, “Should I stop my SIPs?”, “When will the market recover?”

Frankly I have no answer to some of these questions. I realise that the real good fund manager (by whatever name called) KNOWS that he cannot predict the direction of the market, and even in case he can predict the market direction, he cannot predict the slope of the curve - how fast will it fall. It reminds me of Late Sir John Templeton’s remark “the Dow will surely reach 100,000 I do not know when!

So let us see what causes us to behave in such a manner? Well human beings know that in case of a dangerous situation they have to do something. Monkeys also behave in the same manner. Who knows this? Tigers know this. So when a tiger wants to catch a monkey it goes to the trunk of a tree and roars repeatedly. In fear the monkeys start jumping from one branch to another. Monkeys can jump well, can they not? Well they can, but in fear they crash against each other and fall prey to the tiger!

So know you know why most of us are like monkeys and Buffet is like a tiger.

So to let your portfolio to do well, just stay in your place…of course some of the basic structure has to be in place - that will be a different post!

At the India Equity show there were many speakers. One of the good speakers was Mr. Nilesh Shah, CIO, and Deputy Managing Director of Icici Prudential asset management company. He of course is a good speaker from the understanding point of view - his examples are always related to food though :). When he talks of inflation, he talks of the price of masala dosa, when he talks of a asset allocation he talks of a “thali” for a balanced diet, and true to form this time he spoke of how mutual funds are like Udupi hotel! Surely he likes his food - but his body does not show it. Lucky him!

This is what he had to say at the India Equity Show, 7th June, 2008 at Worli Mumbai:

He gave a nice, new version of the ant and the grasshopper story. As is known this is a old story about thrift. The ant toils in summer and creates a warehouse for itself for the winter. However, the grasshopper which has been playing all summer has no larder from which to eat. When the grasshopper asks the ant for food, the ant tells the grasshopper if you have sang all summer, you should now go and dance!

Nilesh’s take was “people like us” - I guess he meant the middle class, educated Indians do not vote and therefore we get the politicians we deserve. However, he ended on an optimistic note. He said if politicians are in a performing mode, they will get re-elected (like Gujarat and now Bihar), otherwise they will get thrown out.

His version of the ant and the grasshopper story is:

Once upon a time there was an ant and a grasshopper….However in the winter when the grasshopper did not have any food, the situation changed.

There was a round-table discussion on cnbc, zee, bbc and cnn on how to save the grasshopper. 4 activist groups had gathered data on how ants had more food to eat and that it could get spoilt. Soon there were dharnas and protests held all over the country. Kerala, West Bengal, Tripura announced a state wide bandh protesting against the ants keeping all the food to themselves - so what if they had earned it themselves. Under pressure from UP, Kerala, and some more votes in the West of the country an ordinance was pushed through : “Prevention of terrorism against grasshoppers”.

This was followed by IT raids which took all the food and gave it to many people hoping it would reach the grasshoppers. End of story.

Nilesh then went on to talk about “rahu” and “ketu”. Now he felt that it is rahu kalam because of oil prices. He felt that if oil prices are not brought down, the market is headed down. He felt that higher oil prices would lead to inflation, would lead to higher interest rates, and thus a higher deficit. We will all end up paying for the quality of politicians we vote for (or as he says do not vote for).

Unlike the earlier oil spike we will not pledge our gold, but clearly our momentum of at least one year is lost. He felt that politicians will ensure a de-rating of India story. He had something sinister to say about the Index being in 4 digits if oil hits $ 200.

So go out and invest….!

If you read what John Templeton says, you will believe that you need to create a diversified portfolio - a little of Japanese stocks, lots of American, some emerging markets, etc. in equity alone. Apart from this some debt - short term, long term, etc.

Warren Buffet on the other hand says you should concentrate your portfolio if you wish to create wealth.

Whom should you listen to?

Both!

You should have a concentrated portfolio - which means in the Indian context, if you have a Rs. 25L portfolio you may not need more than 6 companies. However, once you have created some wealth, you need to protect a portion of it from the vagaries of the market.

Let us take an example. In case you had invested Rs. 10,000 in Wipro in the year 1980, today it would be worth Rs. 350 crores (assuming you consumed all the dividends). However, at various stages you would have sold some part of your wipro shares to invest in other companies too - now if WIPRO had not done well, but some other company in which you invested (say Silverline) had done well, you would have looked smart (but actually you were lucky, simply, lucky).

However if you are still holding on to ALL the shares of WIPRO, it makes sense for you to sell a portion of WIPRO and invest in a simple index fund, some real estate, some rbi bonds, etc.

There are many companies which have given fantastic, scorching returns. Microsoft, GE, Berkshire Hathway….are some examples. Berkshire Hathway, well er is a fund..or so you thought. Let me tell you, it is not. Mr. Buffet is a brilliant businessman, fantastic stock picker, (fantastic bargain picker - look at the recent offer to pick good bonds at bargain prices), a great human being, a great philanthrophist, BUT not a fund manager.

He runs a big, huge 800-pound gorilla of an insurance company, where people like Mr. Jain can buy an risk -at the appropriate premium. In fact Mr. Buffet can buy a small stake in a company, can buy more stake, can merge it with Berkshire Hathway - things which a normal fund manager cannot even think of doing.

Berkshire Hathway is a fantastic company with a great 28 year track record. However over the past 2-3 years it has underperformed the index. Yes you read right, it has underperformed the index. How come it is not there in the index - well it is not traded enough, so perhaps the impact cost could be an issue.

So in my finance class if I ask you to name a great fund manager, you will get a zero if you said “Warren Buffet”. However if I asked you to name a great businessman, a great philanthropist, or a great business communicator and you said “WB” you would get a 10/10.

When Jeremy Siegel speaks you listen! Author of the book “Stocks for the long Run” Jeremy is surely one of the investment gurus. He has said a few things in his latest comminque. This is worth listening to. I am producing it as it is, and (1) is not even relevant to you and me if you are also not in the US of A. So read on….

1. Investing abroad is essential. “Sticking only to U.S. equities is a risky strategy for investors.”

2. Don’t be too optimistic. With the increasing popularity of foreign investing, Siegel predicts that today’s globalized world will result in higher price-earning ratios, but as a result, average returns are going to be lower for foreign stocks. Hey that means us (!). You have to look at equity returns to be better than debt returns. So if your equity returns are about 12% p.a. thank your stars. Forget 30 and 40% returns that the market has pampered you with.

3. This technical system works! The only technical system that has really worked to beat the market over the long run is the “Dogs of the Dow” strategy, picking the top 10 highest-dividend-paying Dow stocks. No system works every year, but Siegel found that this Dow 10 technique has staying power. Please remember Siegel is talking about the past, I am not too optimistic about this theory. I am more convinced that the greater the success of such theories the greater the chance of failure. No comments.

4. Stay away from this popular stock category: tech and biotech (with few exceptions). “Most technology stocks have greatly under performed the market.” The few winners (such as Microsoft or Merck) can’t make up for the huge number of losers. Siegel calls this “The Growth Trap.” Cannot agree more. Look at Biotech, Mindtree, ..you have a graveyard out there. Keep it simple – do an SIP in a index fund.

5. Avoid most, but not all, IPOs. According to a study by Siegel of IPOs between 1968 and 2001, nearly 80% of new stock issues under-performed the stock market index. Ha ha ha…Indian markets have not been researched but there are a few stocks available at 40% discount to the issue price.

6. Dividends are a better indicator of future stock performance than earnings. Earnings can be manipulated by depreciation schedules, sales of assets, and other hidden factors. But dividends don’t lie. According to Siegel’s studies, the best way to beat the market is to invest in high-dividend “value” stocks with low P/E ratios. “These high-dividend strategies have provided investors with higher returns and lower volatility over the past five decades.” Sorry I do not know how to find such stocks in the Indian market. Surely it is not a “value” market it is a “growth” market. Surely not a dividend yield market.

7. Use Exchange Traded Funds (ETFs) to increase and protect your profits. Siegel calls ETFs “the most innovative and successful new financial instruments” since stock options and commodity futures were created in the 1970s.