Last Updated on September 27, 2018 at 10:30 am
In this guest post, SEBI registered fee-only advisor Avinash Luthria who is part of the freefincal list of advisors and fee-only India suggests that investors should minimize costs through index funds and not waste energy fighting the law of no-free-lunch, instead use it as a tool for thinking, to avoid mistakes and also.
Avinash Luthria is Founder, Fee-Only Financial Planner & SEBI registered Investment Adviser at Fiduciaries and was previously a Private Equity & Venture Capital investor; Views expressed here are of the author and do not necessarily reflect the views of freefincal. He had earlier written about real investment returns will be zero!
Turn no-free-lunch from an opponent to an ally
The most fundamental and inviolable law of finance and investing is that there’s no such thing as a free lunch (technically ‘no-arbitrage’). As long as one aims to earn the market return, the law of no-free-lunch is an ally. However human nature tempts us to crave for higher returns which is often from alpha—and this is more so due to the relatively high valuations and low expected return over the next decade. But the law of no-free-lunch ensures that the potential for alpha comes with an equal amount of pain. Let’s see how in two of the most common approaches to earn alpha in equity investing.
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
Stock-selection alpha: Standard & Poor’s (S&P) Indices Versus Active Funds (SPIVA) India report shows that there is no net-alpha (i.e. net of fees/costs) over a long period of time by the combined group of active mutual fund managers as a whole. This is generally true across mutual fund categories in India, but it is easiest to understand in the context of large-cap equity: The weighted-average net returns (i.e. returns after deducting fees) generated by Indian large-cap active equity mutual funds over the 10-years ending 31st December 2017 was only +0.24% p.a. more than the ‘total returns’ (i.e. returns after including dividends) of the relevant stock market index. Further, the nuances indicate that one cannot rely on getting approximately +0.24% p.a. For example, the same 10-year metric measured as of 30th June 2017 was minus 0.53% p.a.
Since this does not match the conventional view, one could go about explaining all the important technical aspects that SPIVA accounts for and many other studies do not account for. These include survivorship bias, style inconsistency, using the correct benchmark, factoring in dividends, correct weights etc. Since the SPIVA report mentions all these points in a brief manner, lets instead focus on the equally important aspect of grasping some of the intuitive reasons for this empirical reality.
An exceptional investor (probably, one in a ten-million people on this attribute), using the Munger-Buffett-style of value-investing, may hope to earn a small statistically-significant net-alpha over a long period of time. But this comes with the pain of potentially underperforming the market for a decade or more. A visible sign of this is that the US Russell 1000 Value Total Return index has underperformed the broader US market over the last 10 years by a cumulative 16.6%. Tangibly, the pain is ‘career risk’ for the professional investor and a reduction in lifestyle for the individual investor.
Intuitively, stock-selection net-alpha (i.e. net of costs) is so difficult because firstly, competent investors are competing not just against laymen. They are also competing against promoters of companies who will also try to personally benefit from their company’s stock being temporarily undervalued or else, talk it up to prevent it from being undervalued. Secondly, in financial markets, the crowd as a whole is, more often than not, smarter than even the smartest member of the crowd. This is because members of the crown typically err on either side and the errors cancel each other out. Finally, costs are a critical aspect in the intuition. On this aspect of costs, an interested reader can simply read William Sharpe’s brilliantly elegant and concise logical proof of this which cannot be made any more concise (‘The Arithmetic of Active Management’ is a 2-page article which was published in 1991).
Of the people who accept the difficulty of stock-selection net-alpha, a large number feel defeated by the fact that it is so difficult to earn stock-selection net-alpha. But several others recognize that it frees them up from having to constantly worry about selecting the right active fund manager.
Asset-allocation alpha: Aiming for asset-allocation alpha typically requires holding more equity when the market is relatively cheap, and less when the market is relatively expensive. But to aim for material asset-allocation alpha, one has to vary one’s equity allocation in a wide range e.g. 30% to 70% of net worth. Let’s say that at some point one thinks that the market is not expensive and one’s equity allocation is 70%. Even if one thinks that the market is not expensive, there is nothing to prevent the market from falling by 50%. If the market does fall by 50%, then one’s total net worth would reduce by 35%. This is difficult for almost anyone to stomach.
Our experience from 2009 leads us to believe that even in case of a large crash, the stock market usually bounces back fast. But history shows that it could take decades for the market to regain its peak value. For example, around the oil-shock in 1973, after the US S&P 500 fell 48% from its peak; it took 7.5 years to regain the same peak nominal value and 14.6 years to regain the same peak real value (ignoring dividends). A couple of months after regaining the same peak real value, the market crashed 20% on a single day (Black Monday in 1987).
Even if someone with a high equity allocation had the superhuman ability to stay invested through those 15-20 years, they would still have experienced several sleepless nights, and have had to cut back on their lifestyle for those 15-20 years.
Using no-free-lunch as a tool for thinking
At the very least, battling no-free-lunch is not the best use of one’s energy. Instead, a good investor’s job is to avoid mistakes, and no-free-lunch, as a tool for thinking, helps us do that. No-free-lunch is the basis for index funds (which help us diversify at a trivial cost and with trivial personal effort); it makes us suspect that something that is too good to be true may be a fraud (e.g. the high return with low volatility that was offered by Bernie Madoff); pushes us to look for the catch in each investment or investment strategy (e.g. structured products and trend following, respectively); and encourages us to think out of the box about the risks we might be ignoring (e.g. often a higher expected return from an investment or investment strategy is due to a risk that may not be obvious).
This is one detailed illustration of how to use no-free-lunch as a tool for thinking: To maximize mutual fund returns over the long term, one should limit the fees to 20 bps p.a. using index funds or index-like funds. The 20 bps p.a. mentioned here is as of 2018 and this cost will hopefully reduce over the years.
These are a few good options cutting across equity and debt categories and, for the sake of brevity, a few important nuances have been skipped:
Nifty 50 Index ETF at a cost of 10 bps p.a.: The Nifty 50 covers 63% of the free-float market capitalization of the NSE i.e. it covers a majority of the Indian stock market. The relevant options are Reliance’s ETF (at a cost of 10 bps p.a.), UTI’s index fund (12 bps p.a.; Direct Plan, here and in general) and HDFC’s index fund (15 bps p.a.)
The only Debt Funds that (if one holds it for more than 3 years), can be relied upon to consistently beat high-quality Fixed Deposit post-tax returns: Please note that this previous statement is forward-looking, is about post-tax returns and is assuming a marginal tax rate of around 30%. The Quantum Liquid Fund (18 bps p.a.) is the only extremely low credit-risk Liquid Fund that exists. Naturally, it also has a proportionately lower expected return. Regulations does not prevent this fund from taking more credit risk, but Quantum has decided not to take more credit-risk and has consistently stuck to this policy.
While this is not an index fund, it is index-like fund in that, the fund manager does not have to make important active investment decisions. This fund invests in treasury bills, in the Collateralized Borrowing and Lending Obligation (CBLO) market and in fixed-income issued by PSUs. Also, it focuses on very low duration fixed-income investments, so there is no active management of duration. If you come across a one-star rating for this fund on fund comparison websites, in this particular case, that is the badge of honour of this fund. Since ideally, one should not invest more than 10-15% of someone’s worth in any one instrument, it would be good to have some alternatives to the Quantum Liquid Fund. However, there are no other extremely low credit-risk Liquid Funds. So, if one requires another extremely low credit-risk fund, one has to consider the category of Overnight Funds at a cost of 7 bps p.a. These again are index-like funds with almost zero credit-risk (i.e. lower credit-risk than all the other Liquid Funds), no duration risk and no liquidity risk. Naturally, it also has a proportionately lower expected return. UTI’s Overnight Fund (around 7 bps p.a.) is the lowest cost option and this category as a whole has a very low AUM.
Constant Maturity Gilt Fund at a cost of 10 bps p.a.: This index-like fund category holds 10-year average maturity Government of India bonds (G-Sec). So, it has zero credit-risk, but it has huge interest rate / duration risk. Hence, this Debt Mutual fund (even if held for more than three years), cannot be relied upon to consistently beat high-quality Fixed Deposit post-tax returns. Hence it is suitable only for investors who have a deep understanding of duration risk. The ‘Growth Option’ has the additional benefit of being more tax efficient than the underlying asset class of G-Sec. The ICICI Prudential Constant Maturity Gilt Fund (10 bps p.a.) is the lowest cost option and again, this category as a whole has a very low AUM. But, if one does not want to suffer the below average returns of the layman investor, then one has to think differently from the layman investor.
As a tool for thinking, no-free-lunch forces us to think rationally. And thinking rationally is what it takes to be a good investor.
Avinash Luthria is Founder, Fee-Only Financial Planner & SEBI registered Investment Adviser at Fiduciaries and was previously a Private Equity & Venture Capital investor; Views expressed here are of the author and do not necessarily reflect the views of freefincal. He had earlier written about real investment returns will be zero!
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 7000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 2,500 investors and advisors use this!
Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.Your Ultimate Guide to Travel
This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)