galatime.com - Kaushik Gala

Note: The views & opinions expressed in these essays are strictly my own, and not those of any entity I may be associated with as an employee, consultant, promoter, investor, etc.

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Technology Venture Investors in Pune

 

Technology Entrepreneurship in India - Teams

Entrepreneurial traits

Picking cofounders

 

Technology Entrepreneurship in India - Generating Revenue

Is your business model well-defined?

Your industry's value chain

What is your value proposition?

Which distribution channels will you use?

Who will drive business development?

 

Technology Entrepreneurship in India - Raising Capital

Venture capital & venture capitalists (VCs)

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Angels & angel networks in India

Government support for Indian startups

Proof-of-concept funding

Do you need a business plan?

How much money should you raise?

Startup valuation

Pitching to investors

Figure out the term sheet

Negotiating with investors

Due diligence - A necessary evil

Time to sign the investment agreements

 

Equities, ETFs, F&O

› Oct 2011: Equity Risk Premium for India

› Jun 2011: Investing in Indian equities

 

Technology Enterprises in India

› Nov 2010: Technology investment in India - WATER

› Aug 2010: Technology enterprises in India - 3 avatars

 

Risk Capital for MSMEs

› Mar 2010: Risk mitigation for investors in MSMEs

› Mar 2010: Why don't (Indian) MSMEs get risk capital?

› Feb 2010: Angel investing - Will it work for Indian MSMEs?

› Feb 2010: What's so special about innovative MSMEs?

› Feb 2010: Where do Indian/NRI (V)HNIs invest?

› Feb 2010: Funding options for innovative MSMEs in India

› Jan 2010: Innovative MSMEs in India

Investing in Indian Equities

Last revised 28-Jun-2011. Send comments to galatime@gmail.com.
HT to @deepakshenoy for inputs.

This essay explores the creation of a (quantitative) investor-friendly fund that invests in Indian equities. As a 'hedge' fund, it will also put a fraction of its capital in call and put options, typically based on the Nifty-50 index and on the INR:USD exchange rate. Option strategies overlaid on an equity portfolio may enhance returns and/or reduce risk. Investors' interests play a central role in the design of this fund.

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Q: What's the fund management philosophy?

Time-frame

Most global studies point to 5-7 year periods as optimal investment horizons for equity portfolios. This suits Indian markets well, given poor short-term liquidity, high trading costs, impact of sustained FII flows, tax considerations, etc.

Stock selection

Indian markets exhibit strong power-law characteristics - a few stocks contribute to a very large % of total revenues, profits, turnover, etc. At a portfolio level, it is important to capture a large enough chunk of the economy - concentrated portfolios are likely to do better.

Style

For long-term market-beating returns, it's best not to restrict the fund to any specific 'style' - small/large cap, growth/value, sectors, etc. That said, capital allocation strategies should take into account the mean-reverting tendencies of such categories.

F&O

Markets oscillate between extremes of valuation, volatility and 'trendiness'. During range-bound markets, option strategies can be used to enhance returns. During bull/bear market extremes, they can help reduce risk and/or boost portfolio leverage.

Risk

Given the sensitivity of Indian markets to government actions, global markets, exchange rates and FII flows, risk management is critical. Position selection and sizing must avoid outsized losses/drawdowns - leverage (if any) must never lead to blowups.

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Q: What's the fund management strategy?

Investment Approach

› Invest with a 5+ year horizon - measure performance accordingly.

› Deploy capital into NSE-listed equities, equity ETFs, index options and currency options.

› Develop proprietary, quantitative, macro-economic & market-level analytics for capital allocation.

› Aim for portfolio drawdown not more than 2/3rd the Nifty drawdown.

› Bonds, commodity ETFs and currency options to be explored.

Equity Strategy

› No equity/ETF position should be more than 5% of portfolio capital. Alternatively, if stop losses are an integral part of the strategy, position sizing can be defined in terms of % of capital at risk.

› Each equity/ETF position should be less than its average daily traded value on the NSE.

› Equity portfolio should account for at least 15% of cumulative revenue - as well as profits - of all NSE-listed equities.

› Do not invest in equities with annual revenue < Rs 450 crore / $100M (avoid micro/small caps).

› Do not invest in equities with market capitalisation < Rs 450 crore / $100M (avoid micro/small caps).

› Prefer equities that are high in 'quality' and low in volatility - of both price and performance.

› No penalties for holding cash!

› Develop proprietary, quantitative, back-tested metrics for equity selection, selling strategy and position sizing.

F&O Strategy

› Cumulative option positions should be less than 5% of capital.

› Only Nifty-50 or INR:USD option positions; especially near-dated contracts that tend to be more liquid.

› Test & manage correlation between equity/ETF portfolio and index option portfolio.

› No leveraged naked short options - ever. Cash secured naked puts are OK.

› Develop proprietary, quantitative, back-tested metrics for option strategy selection and position sizing.

Fund Mechanics

› The minimum investment amount is Rs 25 lakh.

› The investment strategy must be able to easily deploy Rs 100+ crore of AUM.

› The fund should not charge any entry loads, but should levy a heavy exit penalty (subject to fund performance) for early withdrawals.

› The fund should charge a management fee of not more than 1% p.a., payable at the end of each quarter.

› The fund should charge a success fee of not more than 15%, above a hurdle rate of 15% (compounded over the investment period), payable at the end of each year.

› The fund should implement a high watermark policy.

To align incentives even further, the fund manager should invest at least 60% of his/her liquid, investible net-worth in the fund.

Fund Reporting

› On a weekly basis, the fund would report - from inception till date - its NAV, comparisons with benchmarks, hurdle rate curves, and high watermark.

› On a monthly basis, the fund would provide market commentary, new metrics/analytics under investigation, and a compilation of interesting readings for investors.

› On a quarterly basis, the fund would report expenses, fees paid/due, analysis of performance and updates on investment strategy, if any.

› On a yearly basis, the fund would provide its expectations for future performance, risks to the performance and insights into new assets/strategies under consideration.

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Q: What do the Indian markets have in store for such a fund?

Price Performance

› Since 1991, the compounded annual growth rate (CAGR) of the major indices (Nifty, Sensex) is ~ 16%, excluding dividends. Since 2002, it is ~ 20%, excluding dividends.

› From the 2003 trough to the 2008 peak, the CAGR of the major indices reached almost 40%, excluding dividends.

› The best performing mutual fund(s) have gained 30% p.a. over a 7+ year period (with special thanks to the 2003-08 bull run).

› The majority of mutual funds have lagged the indices over most 7+ year periods. Don't even mention ULIPs. Or PMS-es.

› For the 1996 - 2005 period, the CAGR of the major indices dropped below 10%, excluding dividends. For 2006 - 2011 (and counting), it has done the same.

Economic Performance

› Since 1950s, the CAGR of nominal Indian GDP is 11.5%; for the 1991-2010 period, it rose to 13.5%.

› Since 1999, the CAGR of the Nifty-50 EPS (alas, a horribly flawed measure) is ~ 13%. This is the nominal (not real) rate.

› Since 1999, the Nifty-50 dividend yield has ranged between 0.6% and 3.2%.

› Since 1999, aggregate cash margins (cash profits / net sales) of Nifty-50 stocks have ranged between 8% and 11%.

› Since 1999, aggregate PAT margins (profit-after-tax / net sales) of Nifty-50 stocks have ranged between 3% and 8%.

Liquidity

› Since peaking in 2008-09, the turnover on the NSE - especially for equities - has steadily declined.

› Even in the Nifty-50 index, there are stocks that sometimes trade ~ Rs 10 crore/day. That's a paltry Rs 10,000/tick, on average.

› F&O turnover hasn't collapsed, but most of it is Nifty-50 F&O trading.

› Bid-ask spreads for most option contracts remain terribly wide (i.e. the contracts are highly illiquid).

› Brokerage commissions, STT, taxes on capital gains, impact costs, etc. - all severely penalize high-turnover investment operations.

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Q: What are the risks?

There are various risks to fund performance - many of them are common to all equity funds in India. If the Indian markets go through a secular bear phase, the fund may lag even Fixed Deposits in performance. If government regulation (eg. FDI, taxation, etc.) changes for the worse, the fund will suffer. If financial and corruption scams continue at the current pace, equity markets will remain weak. Small and mid-caps are subject to risks arising from margin funding, promoter pledges, FCCBs, etc. High/rising inflation, volatile exchange rates, poor macroeconomic environments - all tend to punish equities.

Fund-specific Risks

› The fund's equity selection strategies might fare poorly - the various proprietary metrics might turn out to be duds.

› The fund's capital allocation strategies might be suboptimal.

› The cost of the fund's option strategies might result in a drag on performance.

› The fund might go through an extended period of sub-par performance, requiring more than 3+ years to catch up.

› The fund might attract investors with mismatched performance expectations and/or investment horizons.

› The fund's avoidance of IPOs, micro/small caps, equity/index futures, etc. might lead to underperformance.

› The fund's (conservative) focus on longer investment horizons might lead to underperformance.

The list goes on.

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Q: Who should invest in the fund? Why?

The fund is suitable only for investors who have a 5+ year investment horizon - this requires both patience and enough reserves of liquidity elsewhere. Ideally, investors should deploy not more than 25% of their liquid, investible net-worth in the fund. While the fund seeks to beat the major indices by a wide enough margin (and with less risk), it does not promise out-sized returns. Investors in the fund must use the historical performance of the Indian economy & markets to set future expectations.

The chart above shows how Rs 100 might grow over a 15 year period, under CAGRs of 14% (~ nominal Indian GDP growth rate), 18% (~ long-term Nifty performance, including dividends) and 25% (a number that only a handful of investors in the world have beaten in the long-term).

Never underestimate the power of compounding! However, those expecting a return of 3% per month, every month, should look elsewhere.

Why?

› The use of quantitative, back-tested metrics - instead of real-time human discretion - is likely to result in better investment decisions (and hopefully better outcomes).

› Index option (hedging) strategies are likely to help fund investors avoid large losses.

› Wise position sizing (not too much, not too little per position) and capital allocation can lead to strong portfolio performance.

› The ability to hold large amounts of cash - instead of always being fully invested - will provide the capital (and courage!) to buy panic-priced equities.

› The hurdle rate of 15% incentivizes the fund manager to work hard, and perform well, in order to earn substantial fees.

› The fund manager is required to have 'skin in the game'.

› The fund will never have a broking / sub-broking arm; there are no incentives to needlessly churn the portfolio.

› The fund will be available to investors only via direct purchases, thus removing distributors - and their perverse incentives - from the picture.

The list goes on.

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Q: How does one structure such a fund in India?

Regulatory laws in India do not make it easy to structure such a fund. Some of the options include:
  • Mutual fund, Exchange traded fund (ETF)
  • Portfolio management service (PMS)
  • FII (eg. a Mauritius listed entity)
  • LLP
  • Private limited company

Each structure has its own challenges and is not suitable. Mutual funds and PMS' can't trade naked index options or currency options. The costs of setting up a FII entity can be prohibitive for a young fund. LLPs do not allow pass-through of capital gains/losses. More importantly, an LLP solely in the business of investing will have to instead operate as an AMC/NBFC and aren't designed for easy entry/exit.

One solution is to operate this as an investment advisory. The fund is thus not a fund, in the sense that it does not collect assets from investors. Instead, the fund 'advises' its clients on what investments to make in their own accounts. The fund would of course have to abide by SEBI guidelines, but the operating burden is much lower than that for an AMC.

Obviously, this poses many issues for the fund manager investment adviser. The inability to directly deploy funds is a severe constraint; each investor needs to be disciplined enough to diligently execute each transaction as advised. The relationship between the adviser and the investor needs to be reliable enough for the performance-related clauses to be effective. What if the investor declines to pay the performance fees? What if the investor applies his/her own discretion before executing each transaction? What if the investor is not entirely honest about the quantum of capital being deployed?

Clearly, the adviser model is ill suited to a fund that seeks to tap a large number of retail investors. However, most of the above issues wouldn't arise if the fund catered only to a small number of investors - mutually chosen on the basis of relationships and trust. For example, instead of 'managing' Rs 10 lakh each for 1000 retail investors, the adviser would instead be responsible for Rs 2 crore each for 50 HNIs. This would in fact be a good match with the fund strategy, fee structure, investment horizon and F&O trades. Quarterly payment of management and performance fees, combined with a 7+ year horizon, could well align adviser and investor behavior.

In fact, tons of such informal fund managers currently operate in India. The model is essentially based on trust - or lack thereof, during bear markets!

PS: See Deepak's detailed post on the pros and cons of various options.

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Q: What next?

One of the biggest determinants of fund performance is 'initial conditions' - the market environment in which a fund is launched. Imagine a dot.com equity fund launched in the US in April 2000 and you'll get the idea.

The current market environment in India is not suitable for the above fund. Valuations are rich, but not bubbly. Liquidity is dropping, volatility is relatively low, prices are range-bound - it is just a big grind. Future prospects aren't all that rosy, given steady declines in valuations (P/E ratios) vs. rising corporate earnings. The fund would have a great launch opportunity if when the Nifty-50 index drops below 4500.

Now is the time to raise capital, keep the gunpowder dry and wait. Patiently.