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I hate diversified equity funds. And I specialize in equity funds. Confusing? Not really. My clients have been very happy with their equity fund portfolios over the last 5 years, when most of their friends fretted and fumed about equity markets and equity funds going nowhere. And, their portfolios did very well, only because I worked hard to ensure that I create smart portfolios and not just a bunch of diversified equity funds put together in the name of a portfolio. My AuM of over Rs.90 crores is made up almost entirely of equity funds. I specialize in mutual funds - no other products, and I maintain a sharp focus on continuously honing my skills in this one area of specialization.
My clients are all HNIs - busy and successful professionals, who are smart in their areas of competence - which is why they have become HNIs. When they seek the services of an advisor, they have a simple goal : they want to make money. Period. I tell them that my job is to make them smart investors and help them make money. I tell them that just as they are confident about their area of competence and like to do things their way, I too am confident about how I think equity portfolios should be constructed and managed, and would like to do things my way. Straight talk helps, especially when you are dealing with smart people.
My way
There are 4 principles that underpin my entire investment philosophy. Let me take you through the principles first, before explaining how I construct portfolios for my clients.
1. Think out-of-the-box. Think independent
The primary task of any advisor, in my view, is to become an expert in his field - and not to rely on other people's expertise. I believe that if your objective is to help make money for clients, among the asset classes available to you, equity is clearly the one for this purpose. And, if you want to differentiate yourself, if you want to excel, which asset class offers you that opportunity more than others? Clearly equity.
I spend a lot of my time studying equity markets, understanding sectors, understanding companies, understanding market cycles, understanding how sectors behave across market cycles. I am passionate about research, I constantly keep learning, keep reinventing myself. I am 56 today, and my enthusiasm for research is just as high today as you would probably find in a budding new equity analyst. You got to be passionate about learning.
There are a lot of views from fund managers and experts that are readily available. By all means, hear them out. But, for you to truly get your own convictions, you will need to think independently. It is only when you do your independent research that you will develop strong convictions in your strategies. I don't believe in merely communicating a fund manager's convictions to my clients - I believe in thinking independently and communicating my convictions to my clients. Clients trust my judgment - I better ensure that I have done my homework well.
I also believe that true wealth is created when you think out-of-the-box. If you develop an ability to question conventional wisdom, if you try to look beyond the obvious, you are more likely to come up with ideas and strategies that truly make money for your clients.
2. Protection is as important as creation
This is an aspect I put a lot of emphasis on. You need to find ways to protect client money during downturns. Nobody likes losing money. Client confidence gets badly dented when they see a large part of their gains of an upcycle evaporate in a downcycle. I find very few diversified equity funds doing anything significant about wealth protection. They mirror the markets, on the way up and down, albeit with some degree of outperformance, at least in one of the two phases. I believe our skills as advisors lies in creating portfolios that do well in bull markets, and also help preserve capital in lean phases. And this can be done by remaining in equity markets. When I research equity funds, I pay equal attention to alpha generation by the manager on the upside as well as risk mitigation on the downside.
3. Understand what true diversification is all about
Diversification is a very important tool to mitigate risk. But, putting together a portfolio of 3-4 diversified equity funds in the name of diversification is not going to get you very far. The key in diversification is to put together a portfolio which has the least possible commonality in underlying stocks. Take a look at most diversified equity funds, and you will find a striking similarity in large portions of their portfolios. They are, by design, aligned quite closely to their benchmarks and cannot afford to deviate too much. As a consequence, when you buy 3-4 diversified equity funds, you get 3-4 portfolios that are likely to behave broadly the same way. All you have done is manager diversification, but not true portfolio diversification.
When I construct equity portfolios, I take a lot of effort to put them together in such a way that I minimize, to the extent possible, commonality of stocks between funds. This gives my portfolios the actual benefits of diversification as risk mitigants.
4. Understand where true wealth creation actually happens
This is actually at the heart of all my research. I look for themes that generate wealth over long periods of time. I have done a lot of research on market cycles, on how sectors perform across market cycles and how sector leadership changes over time. I have looked closely at sectors that have built wealth over time and those that have done this only sporadically. Very often, market attention gets focused on sectors that are sporadically doing well - but these are the same sectors that eventually cause more pain than gain.
If you look at all the sectors in the market, there are 5 key sectors which constitute 65% of market cap, and which stand out as genuine long term wealth creators. These are financials, IT, auto & auto ancillaries, FMCG and pharma. Then there are a host of other sectors - oil & gas, metals, capital goods, media, power, cement and so on. If you study them over long periods of time, none of them stand the test of long term wealth creators. They have their days in the sun, their brief moments of glory. But, these are certainly not the buy-and-hold varieties. Holding them in downturns causes a lot of damage to client portfolios.
Take the infra pack. A great story no doubt. Huge pent up demand. But there are just too many problems in the sector that prevent them from becoming consistent long term wealth creators. Politics, red tape, numerous clearances, land acquisition challenges - the list is endless. When the environment is conducive, they do well. When the environment turns challenging, they destroy wealth. Your attitude towards infra must always be to make a quick buck when the going is good, but never take a long term view with a sector that has so much Government influence.
Consider pharma on the other hand. It's a phenomenal story with domestic and export growth helping drive long term business momentum. I've spent a lot of time understanding the business, understanding the global scenario and the opportunity for Indian players, understanding balance sheets of key pharma companies. On that basis, I strongly believe that the pharma story is going to remain a great long term wealth creator, just as it has been over the last 10 years. You shouldn't get carried away with short term sector rotation plays in the market, when looking at long term wealth creators. Understanding what to buy-and-hold and what to punt in is key to long term wealth creation.
Always look for structural stories, not daily news flow. And, in structural stories, look for ability of the structural story to actually create shareholder wealth. Where you find both, stick with them. Else, look at them only opportunistically.
Let me give you a simple example. A couple of years ago, I got my clients to invest in the UTI Transportation & Logistics Fund. It's a great theme, with a lot of focus on auto and auto ancillaries. It was languishing due to poor near term news flow on the sector. Nobody was recommending it, few were tracking it. I did my homework, built my conviction and got it into client portfolios. Its made a lot of good money for my clients. You need to think out-of-the-box to really make money.
Contrarian portfolio construction strategy
Conventional wisdom suggests that you put diversified equity funds in the core of any equity portfolio, and then look for sectoral and thematic plays as satellite positions. My thinking is completely different. The core according to me should be consistent proven long term wealth creators. My research suggests that 5 sectors qualify for this tag : financials, IT, auto & auto ancillaries, FMCG and pharma. Therefore, sector funds that invest in these 5 sectors are my core long term holdings.
At the next level, I look at market cap rotation. There are phases when large caps do better than midcaps and vice versa. If I want to add large caps, I typically choose only 1 large cap fund. The universe is so small that 2 large cap funds are likely to be very similar with each other. When looking for mid and small caps, I look for a couple, from managers whose thinking is quite different from each other. That's not to say that there won't be common stocks, but the universe is much larger and therefore allows for more portfolio diversity.
Then come the thematic plays. Based on my views on medium term prospects for particular themes, I add the relevant thematic funds into client portfolios. I do my independent homework on themes and develop my own convictions on them. There is, as you can see, little place in my portfolios for diversified equity funds.
To conclude
What works for my portfolios is the natural hedge that's built in due to the way they are constructed. In the last 5 years, whenever markets and diversified equity funds dipped 20% or more, my portfolios rarely saw a dip of more than 5%. And, while diversified equity funds struggled to make money until this year, my clients made significant returns from their equity fund portfolios.
I would strongly recommend to all advisors to spend time on developing your own independent thinking, your own independent views. Don't get swayed by market talk. Do your homework, create your own investment strategy, back test it to gain conviction, and stick to your philosophy and strategy. Don't be afraid of thinking differently. Train yourself to think out-of-the-box. That's the key to really make money for your clients - and through that, eventually for yourself.
All articles in the Sell Well - Grow Well section are created by Wealth Forum. These are not to be construed as opinions given by SBI Mutual Fund.
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