Coffee Can Investing: the low risk road to stupendous wealth

by Saurabh Mukherjea

Over time, however, a second category of equity funds with lower expenses have emerged. These funds do not need a fund manager and thus do not incur fancy fund management charges. These funds are called passive funds. Active versus passive funds

Outperformance, which is also called ‘alpha’, is the incremental performance that the fund manager generates vis-à-vis a benchmark (such as the Nifty or the Sensex).

There are ETFs, or exchange traded funds, which fully replicate a benchmark. For example, a Nifty ETF is a fund that invests in all the fifty Nifty companies in the same proportion as they are in the index. This ensures that the value of the fund moves exactly like Nifty.

ETFs as a rule have very minimal expense ratios since they do not offer ‘active’ fund management and hence do not have to employ highly paid fund managers. An ETF is almost like a technology platform. Since an ETF does not have to pay a fund manager, it is able to charge fees which are lower than actively managed funds. Most index ETFs today charge fees ranging from...

Passively managed funds come in two types: funds with brains and funds without. In the former (also called ‘Smart Beta’ funds), the fund is run based on a preset strategy or an algorithm. For example, there are mutual funds which invest in a mix of Nifty and government bonds. The weightage of each asset class is determined by the Price/Earnings (or P/E)7 of the Nifty. In other words, based on an allocation table, the fund invests more in the Nifty when markets are cheap and less when markets are expensive.

The second category of passively managed funds is index funds (just like Index ETFs). They are simply built to replicate an index like the Nifty or the Sensex and have minimal human input.

funds. Then, as that market becomes more competitive, more perfect, it first becomes more difficult and then almost impossible for funds to outperform the broader market. That is when passively managed funds and ETFs (with low expenses) start gaining market share. Let us understand what a perfect market is.

No market can be absolutely perfect or imperfect. But the developed markets in the US and Europe are nearly there after over two centuries of evolution. As a result, in these markets, actively managed funds have no edge over index ETFs. According to Morningstar’s July 2017 report, only 10 to 20 per cent of active US equity funds beat their benchmarks over the ten-year period ending December 2016.

shows the outperformance of the large-cap equity funds between January 1991 and December 2009. Large-cap funds have given meaningful outperformance in this period. On a median basis, there is an Alpha of 4.7 per cent per annum in the five-year and 1.1 per cent per annum in the ten-year rolling periods.

However, when we did the same exercise for the period January 2010 to February 2017, the script changed dramatically (Exhibit 25). In this seven-year period, there is hardly any alpha left. Given that the index does not carry the effect of dividend returns, actively managed large-cap equity funds in India have actually underperformed the index between 2010 and 2017. So there is actually a negative alpha!

We can thus conclude that not only has the outperformance of large-cap equity mutual funds as an asset class more or less vanished, but there is randomness even in the relative performance of mutual funds. The inconsistency in the mutual funds’ relative performance also shows us why the past performance of a fund does not indicate future outperformance. All this is compelling evidence that the Indian market is becoming more efficient. In such a scenario, it is difficult to see how these funds will be able to keep attracting investors if they keep charging such high fees.

Even within active funds, the outflow is not uniform. American investors have taken out the maximum monies from high-cost funds. According to Morningstar, if we were to divide the active funds into two categories—the cheapest 20 per cent and the remaining 80 per cent then, from year 2007 to 2016, the cheapest 20 per cent have seen net outflows only once while the remaining 80 per cent have seen net outflows on six out of ten occasions.

Thanks to these tectonic shifts in investor preference, passive funds have gained significant AUM from active funds. From less than 10 per cent at the turn of the century, passive funds today command 37 per cent of the total fund industry AUM in the US.

In 2009, SEBI abolished entry loads, which meant that the fund houses could not charge the client any upfront fees.

In response, SEBI, through AMFI—the mutual fund industry’s trade body—introduced the ‘best practice guidelines’ in 2015. The guidelines stated that the upfront commission that a fund pays to a distributor cannot be more than 1 per cent. The guidelines also placed

A direct scheme of a mutual fund has the least expense possible because mutual funds cannot give commissions to any broker. Direct code investments give investors an option to deal directly with the fund house without any intervention by intermediaries like distributors, agents, financial planners, banks, etc. The

Then, in 2013, SEBI mandated that all mutual funds had to have a direct option for all schemes. This meant that an investor now did not have to limit his/her investment universe if they wanted to go direct.

Direct plans are much cheaper, by 0.5 to 1 per cent per annum in equity and 0.05 to 0.5 per cent per annum in debt. These fees were almost half the expenses charged by conventional mutual funds, which remain in the vicinity of 2 to 2.5 per cent in equity and 0.5 to 2.25 per cent in debt. The difference in fees is obviously due to the distributor or broker being disintermediated by direct schemes.

The results have been game-changing (see Exhibit 28) and SEBI deserves a lot of credit for that. Already, 38 per cent of the industry’s Rs 20 lakh crore of assets under management is in direct code (...

Why? Because the client now invests in direct schemes and the distributor does not get any commission from the product he is recommending. He then naturally advises the investors to buy the funds most suitable for them.

Fund expenses are often ignored but are deceptively important. Given their compounding over long periods, they have the ability to drag down investor returns drastically. For example, Rs 1 lakh invested for forty years and assumed to grow at 15 per cent per annum becomes Rs 1.11 crore and Rs 2.58 crore at annual expenses of 2.5 per cent and 0.1 per cent.

Unlike earlier years, the alpha (or outperformance) in large-cap equity mutual funds is now negligible. In this scenario, it makes much more sense to invest in passive funds or ETFs. Already, in the US, active funds have started seeing massive outflows, which are becoming inflows for passive funds.

A broker suggesting funds to an investor leads to a conflict of interest. Driven by SEBI, the country has already moved on to an ‘only advisory’ or ‘only broking’ model. Thus, an investor is better off paying a certain percentage as advisory and investing in the most inexpensive funds (as opposed to the tradition...

‘He is not a full man who does not own a piece of land.’ —Hebrew proverb

Investment size: You can buy a stock for Rs 500 and a mutual fund for Rs 5000, but you need to have a few lakhs with you for investing in the cheapest of properties. This makes real estate a rich man’s asset class where high ticket sizes prevent widespread adoption of the asset class.

Liquidity: Compared to financial assets such as stocks and bonds, and even compared to physical assets such as gold and silver, real estate is an illiquid asset class. You can sell a stock on the exchange, sell gold to buyers, or even barter a goat, but it is very difficult to sell a plot or a house. It takes several months, sometimes years, to arrange a buyer. In fact, as sellers in many parts of the National Capital Region and Mumbai have discovered after 2014, finding a buyer can be impossible at times.

Stamp duty, registration and other transaction charges associated with buying property now exceed 10 per ce...

Added to that the taxation—short-term capital gains taxes on real estate are at the marginal rate for the income-tax payer and the long-term capital gains tax is 20 per cent. This implies that most of the gains from investing in real estate are lost via transaction costs and taxation.

An ounce of 24-carat gold will appreciate at the same pace in your hand as it will in the hands of another investor. An Infosys stock will give you the same appreciation as it will to anybody else who holds it. However, real estate is very non-standard. It varies across macro markets (like Mumbai versus Delhi), micro markets (Bandra versus Lower Parel) and even across streets and neighbourhoods. This makes it a very unpredictable asset class and returns are driven as much by luck as by thought-out investment decisions.

A head start: Until the stock market came to the fore over the past decade, buying a house, buying land or buying gold was the only known way to save and invest money. Compared to the familiarity of buying land or gold, investment in any form—either in mutual funds or in stocks or bonds—is alien to most Indian investors (see the exhibit below). According to the RBI’s Household Finance Committee Report (2017), only 5 per cent of India’s household savings is invested in financial assets as against 77 per cent in real estate.

‘House prices only go up’: Unlike other asset classes like equity and debt, which can have

cycle of three to five years (i.e. price movements change their trend every three to five years), real estate runs into super cycles of more than ten years. So, most people who made significant profits in the bull cycle of 2003–13 don’t have any experience or memory of a downward cycle. As a result, they get caught in the belief that real estate prices can only go up.

The lure of magnificent returns: One of the reasons even the most hardnosed investors find it hard to ignore real estate is that the asset class made a tremendous amount of money over 2003–13 as house prices in most locations went up by as much as five to ten times. For example, property prices in Gurugram’s Sector 49 rose 6.4 times from Rs 1360/square feet to Rs 8670/square feet during this golden decade. Elsewhere, in Lower Parel (Mumbai), a flat selling for Rs 4500/square feet in 2003 sold for Rs 35,000/square feet in 2013, going up 7.7 times.

All investment decisions have to be considered relative to their opportunity costs.4 Most real estate investors are usually satisfied simply because they look at absolute returns in isolation. Thus, an investor may have a very fond memory of his property going up by five times in the last twenty years. But the compounded annualized return that property has generated over the last twenty years is just 8.3 per cent.

What they don’t realize is this is because of the inadvertent Coffee Can style of investing that they adopt in real estate as against the trading style in their stock portfolios, i.e. when it comes to real estate, investors are happy to buy and hold for long periods of time. As a result, they end up holding their properties through thick and thin, which is why they are able to see an appreciation in the value. In contrast, in equity, investors typically end up buying at the peak, trade frequently and then exiting at the bottom.

Commercial real estate also has two sets of buyers: the end-users and the investors. With end-users, it is a simple equation. For them, real estate is simply a capital expenditure or a cost which has to be incurred, and these costs have to be seen relative to the return that the business generates.

If businesses don’t want to incur the heavy upfront cost associated with real estate, they end up renting the premises or moving to a cheaper location.

For most affluent investors, investment in commercial real estate is in the form of shops, office units and small warehouses. This mimics their residential realty investment style in the size and locality of investments. Ultra HNW investors also have access to what are called the ‘Grade A’ office buildings.

Grade A offices are large, modern and top-of-the-line buildings, typically built in the most prime locations. These are typically occupied by blue-chip Indian corporates or multinationals and are the benchmark of commercial realty in any country.

In fact, foreign players are the largest investors in Grade A property in India with Blackstone alone holding 70 million square feet in the country. With even single floor plates at times costing upward of Rs 10–20 crore, only a few ultra HNWs have the capacity to invest in such projects.

Rental yields from commercial properties are a function of property prices and the underlying interest rates in the country. At 7 to 9 per cent today, these gross yields are far higher than the 1.5 to 3 per cent yields that residential real estate has to offer.

Whilst an investor in commercial real estate also hopes for capital appreciation over time, given that the capital appreciation associated with this asset class forms a lower proportion of the overall gains, commercial properties are far safer investments than residential real estate (where capital appreciation is pretty much the only source of gains).

Commercial real estate prices have been less volatile in India than residential real estate prices primarily because of the interplay between two forces. Firstly, the end-users of commercial real estate have been businesses. For these businesses, it is imperative to make profits and if the cost of a particular building or location is too high, they will consider moving to some other building or location. This rational frame of mind is very different to the mindset of the residential real estate investor...

it is baffling why commercial properties (which give rental yields that are five to six times that of residential real estate) should be selling at half the price. This again shows the absurdity in the residential real estate asset class and warrants extreme caution from investors.

Real Estate Private Equity funds give funds to developers in exchange for equity. The funding (and hence the equity) could be at the developer’s holding company level or for specific projects. When it is for a specific project, it is also known as SPV (Special Purpose Vehicle) funding. An SPV is typically a company that the developer incorporates only for execution of one or more specific projects. Since it is an equity investment, the investor gets full participation in the SPV’s/Fund’s profits. However, the flip side is that the equity investor has to bear the downside as well. While prices usually don’t crash, projects typically get delayed. This increase in the duration of the project means that the equity investor’s return plummets (as the return comes much later than the investor expected).

For example, an investor may get Rs 150 back on an investment of Rs 100. If the money comes back in two years, it is a compounded annualized return of 22 per cent. However, if the same money comes back in five years (maybe because the local government took longer than expected to give the ‘occupancy certificate’), the investor’s compounded annualized return drops to a paltry 8 per cent. Investors who get an 8 per cent return from investing in real estate will justifiably feel hard done by as they might have made more money from investing in a fixed deposit than in a high-risk venture like a real estate project.

These funds were typically of lower tenure than the private equity funds since they were investing in ready properties. In that sense, they also did not carry the development risk. These funds hoped to also earn capital appreciation apart from the annual rental yield which was supposed to make the overall internal rate of return (IRR) very attractive.

Again, like private equity funds, these funds also failed to deliver. To be fair, rental yield funds have had fewer disasters than private equity funds. While the thesis for rental yields played out, the lack of exit opportunities meant that these funds dragged on far longer than their intended tenures and sometimes had to sell their assets at a discount to the price to be able to give money back to investors.

Real Estate Non-convertible Debentures (NCDs) emerged, offering very high returns. NCDs are similar to bonds issued by borrowers which promise to pay a certain coupon along with the principal back within a predetermined tenure.

Unlike private equity and rental yield funds, there was no capital appreciation expectation and thus, technically, the