Insider Information: The Source of Most Alpha

Extract from a blog post by Basab Pradhan, the founding-CEO of Gridstone Research - which largely serves the information needs of hedge funds. (His post was made soon after the arrest of Galleon Partners' CEO and others associated with the hedge fund. All emphasis mine).

Understanding companies requires time and application. At about twenty companies in one or two industries, you start hitting the ceiling of what is possible for one analyst to cover. Hedge funds often don’t have the assets to be able to afford that many analysts.

But I think the real reason is that it is too damned difficult to beat the index just analyzing companies based upon publicly available information. Everyone is seeking an informational edge over the market. Some of this edge is through channel checks and such legal but proprietary sources. Much of it is through rumors – legal but quasi-public. And some of it is through insider information.

Informational edge is a slippery slope at the bottom of which lies insider information – the most alpha-producing informational edge. If you are a high achiever like most hedge fund managers are, and you have profited from proprietary information in the past, it is almost irresistible to cross the line. It doesn’t help that the difference between the difference between a rumor and insider information is only in how the information was procured. A rumor very well could have started its life as insider information. On large caps, placing a bet that is significant for the fund but small enough to escape being noticed is not too difficult. My belief is that insider trading is far more common than what one major bust every few years will make it seem like.

Jargon buster: Alpha refers to market (i.e., index) beating returns.

Impact of Diversification

Pictures always say it much better than words.

Here is a graph of returns over time of 3 different asset classes:



Here is a graph of the returns including that of the average - represented by the black line - of the 3 asset classes



Source: The Coffeehouse Investor

As the author, Bill Schultheis, points out, the above chart

clearly shows that volatility is reduced (by diversification) without sacrificing long-term returns. In the short run, the top performing asset class will outperform the black line. That is to be expected. In the long run the black line (your diversified portfolio) keeps up with all the individual asset classes.

Want to argue that the above is just a theoretical graph with no numbers? Well, here is a graph based on actual data for a 38-year period in the US markets:

Source: Merriman

Interestingly, the next chart show what happens when you combine local stocks with international stocks - you get almost the same level of returns - but with less risk.


Source: Merriman

I rest my case!

"Faster economic growth = lower the stock returns!"

At a time when more international funds are being launched to lure Indian investors, an article in the Wall Street Journal - quoting a study by Elroy Dimson of London Business School - serves as a good reminder on the real purpose of international investing - diversification. Not returns chasing.

Based on decades of data from 53 countries, Prof. Dimson has found that the economies with the highest growth produce the lowest stock returns -- by an immense margin. Stocks in countries with the highest economic growth have earned an annual average return of 6%; those in the slowest-growing nations have gained an average of 12% annually.

...if you think about this puzzle for a few moments, it's no longer very puzzling. In stock markets, as elsewhere in life, value depends on both quality and price. When you buy into emerging markets, you get better economic growth - but, at least for now, you don't get in at a better price. "It's not that China is growing and everybody else thinks it's shrinking," Prof. Dimson says. "You're paying a price that reflects the growth that everybody can see."

...High growth draws out new companies that absorb capital, bid up the cost of labor and drive down the prices of goods and services. That is good news for local workers and global consumers, but it is ultimately bad news for investors. Last year, at least six of the world's 10 largest initial public offerings of stock were in emerging markets. Through June 30, Asia, Latin America, the Mideast and Africa have accounted for 69% of the dollar value of all IPOs world-wide. Growth in those economies will now be spread more thinly across dozens of more companies owned by multitudes of new investors.

Beware of the ULIP pitches - now, from MF distributors!

Now that SEBI has banned entry loads on mutual funds, beware of mutual fund distributors turning into ULIP marketing machines - lured by their ridiculously high commissions.

Quantum AMC's Ajit Dayal who has been promoting direct investments - ie, sans distributors - for a long time has an article on SEBI's move to ban entry loads.

The distributors are not yet out of business - or their Living in Plunderland mentality. They may stop selling mutual funds, and start selling you a lot more of Unit Linked Insurance Products (ULIPs). Do you want to guess why? Yes, that is correct; the distributors make a lot more money selling you that junk than they did selling you the elephant droppings which were disguised as musk oil - an aphrodisiac.

The distributors and wealth managers will play the regulatory arbitrage: go where the regulator is less vigilant.

AIG did that.
Lehman Brothers and Bear Stearns did that.
Most who worked for AIG, Bear Stearns or Lehman did pretty well in life.
Their customers and investors - well, who cares about them anyways?

So, don't be surprised if your distributor and private client wealth manager calls you and explains to you why mutual funds are terrible places to invest and why ULIPs is the best thing since aaloo tikki.

I've read several articles which clearly explain why ULIPs are a bad idea for consumers - compared to a combination of cheap term insurance and investments via mutual funds (or directly) in a mix of stocks and fixed return assets. Here is Deepak Shenoy's well researched post which shows how ULIPs are nothing but a rip off.

If you ask me, I would never invest in a ULIP, ever. I don't want to ban these products - I'm all for freedom here - but I ask you this, if a bank said they would give you 2% return on your Fixed Deposits, will you invest? Especially when you can get 3.5% in a savings account? The 2% offer isn't illegal, it just plays on how stupid you are at a given time. ULIPs prey on the same thing, under the guise of an otherwise less-than-toxic word: Insurance.

Fixing TV Coverage of Stock Markets

Here are extracts from Barry Ritholtz's advice to US financial television channels. I'm sure some of these recommendations apply very well to our business TV channels as well.

2. Bring us People We Don’t Have Access to. What various FinTV channels do really well is when they bring us long, thoughtful interviews with the likes of Warren Buffett, WIlliam Ackman, David Einhorn, and others. People we wouldn’t ordinarily have access to.

4. Risk: All traders must appreciate the potential downside of trades. So too, must FinTV. Explain stop losses. Understand Risk/Reward. Recognize there are periods when Buy & Hold is a jumbo loser.

6. Separate the Signal from the Noise. Understand that most of the day-to-day action is simply noise. Look at a long term chart, you can barely see 9187 or 9/11. If those major events get lost in the long term trend, what does the intraday jags, kinks and reversals mean? Very little. Recognize that not every data release, slice of news, or rumor is at all significant. Stop treating them as if they were.

7. Fact Check: An awful lot of things on air get stated with authority and confidence. Much of them are little more than junk or pop myths. Why is it that the more dubious a proposition is, the greater the confidence the speaker seems to muster? Consider fact checking as much of the statements that are made on air as possible, and making frequent corrections.

8. Accountability is important: I am astounded at some of the money losing hacks that are various shows again and again. These are the “articulate incompetants” to use Bennett Goodspeed’s phrase. Why not keep track of the records of guests — and let the viewers know how their past few calls have been. Are they Perma-bulls or bears? Are their stock picks awful? Are they reliable money makers? If not, let us know. (Of course, the better question is, if not, why even have them on?)

13. Most stock picks are losers. That’s normal, but the audience does not realize this. A big part of the challenge is informing the viewer that finding the biog winners is a low probability, high outcome event. As in a baseball, a 350 hitter is a star. Explain this to your audience.

14. Stop the Bull/Bear Debate: This is a vast over-simplification of the market, and often does not serve the audience well. There are nuances and variables that get lost when you reduce everything to black and white.

Hat tip: Paul Kedrosky

Know thy REAL enemy: INFLATION (not Volatility)

Amit Trivedi has an interesting article on the topic at moneycontrol:

If a financial plan is carefully drafted, one must adhere to that unless proven that it is a completely wrong plan or that the initial assumptions were wrong. However, often people tend to change their financial plan in light of adverse short term price movements, without giving a thought as to what inflation can do to their future finances. At the same time, people have also changed the allocation to the riskier assets looking at the recent short term superior performance.

Any investor would be better off understanding the two prime risks of investments – volatility and inflation. Volatility of prices is the short term risk – inflation is long term risk. An investment plan must be made keeping these two risks in mind.

Inflation does not affect one much in the short term as the prices of essential commodities do not rise too much in short period, normally. Because of this, we tend to take inflation very lightly and ignore it while planning for our long term goals. Volatility on the other hand is an immediate risk as the prices of various securities fluctuate in the short run. This is the difference between the two risks – the former being almost invisible in the short run whereas the latter being magnified by the discussions around it. We tend to, then, overweight volatility and underweight inflation.

The Market as a Weighing Machine

"In the short run the market is a voting machine. In the long run it's a weighing machine." - Benjamin Graham.

There couldn't be a better line to describe the current post-election euphoria in India (accompanied, of course, by a global rally). Hopefully, corporate earnings do catch up with the voting machine!!

"Investing shouldn’t keep you busy"

From an interesting article by Yogesh Chabria in MoneyControl:

I’m sure most of you might be wondering if it is really possible to get rich by doing nothing. Some of you might even be thinking that I have surely lost it. That is what one of my close friends, who was taking my advice, thought. She had received a sizeable amount of money after selling some ancestral property around a year ago, and wanted me to help her out with it. It was the first time she was investing in the stock markets, and like most other people, thought that she would spend hours a day, carrying a laptop, trading in stocks and watching business channels. She wanted to be busy with the stock markets.

Fortunately for her, I didn’t allow her to do any of that. I asked her to pursue a hobby, go on a holiday, meet her family, start a business, perform community service or do anything else to keep herself occupied. The stock markets aren’t a great place to be “busy.” I strongly believe that investments aren’t meant to keep you busy; they are meant to make you rich.

Based on my advice, she invested her money in a few companies that had strong fundamentals and a visible growth. I told her to stop looking at the prices everyday and tracking daily upward and downward movements. Just staring at stock prices would not magically make them rise.By doing nothing, she didn’t get scared of temporary falls in stock prices. She didn’t get nervous and sell her stock when it fell by 10%. When the stock rose by 30%, she didn’t feel greedy and sell it either. She didn’t even know about such minor falls or rises.

"Flee the bear but miss the bull?"

Well known indexing-focused US mutual fund Vanguard, points out using an interactive illustration, how of the nine US bear markets between 1950 and 2003, in all but one case, the market snapped back dramatically within one year of "hitting bottom."

At Vanguard, we're confident that the market will recover, and we're equally resolute in our belief that investing in stocks can be the best option for building wealth over the long run. And being out of the market when a recovery occurs can be costly, as history shows.

..."Historical data can't be used to predict the future, but they do tell us that the stock market has been remarkably resilient over long stretches of time," (Vanguard's chief investment officer Gus Sauter) said. "Investors who were patient during periods of stress and dislocation were ultimately rewarded for their willingness to bear market risk."

..."In the past, bear markets have been buying opportunities," Mr. Sauter said. "Although we certainly don't know when market or economic conditions will improve, and we'd be foolish to try to pinpoint the 'trough' of the current bear market, the historical implications for investors are pretty clear."

The bottom line: If you react to a sharp decline in your portfolio by fleeing the stock market and abandoning your long-term investing strategy, you'll surrender any chance of benefiting from the market's recovery when it occurs.

"The Five Investment Essentials"

Harish Rao has a column in The Mint on investments that are "a must for anyone in today's investment climate".

1. Term insurance : Aggressive life insurance is possible only through Term products. For example a 30 year old can get a Rs. 1 crore cover over the next 25 years at just Rs. 3000 per month. Definitely a must-do.

2. Health insurance : An unquestionable necessity. Again, for less than Rs. 1000 a month, a whole family can be adequately insured with a floater plan. And there are tax benefits to this.

3. PPF : the # 1 Fixed Income investment vehicle. Truly EEE (Exempt from Income Tax at every stage, plus, eligible for tax benefit under Sec 80C). No bank can match the post-tax returns of PPF.

4. Retire Debt : Want the best returns? Then retire all debt, be it credit card or personal loan. This also sets your cash free in the future. Cut spending now if you have to, but just pay off your creditors.

5. Start a SIP : Systematic Investment Plans (SIPs) are the best way to create wealth for the long term. Start one in 2-3 good diversified equity schemes. Start with a 3 year time frame and review the performance once a year. If the funds are still in the top quartile, then persist for the next 3 years. With the markets at a depressing low, there has never been a better time to get into equities.

Equities anyone? Part 2

Harish Rao has a scenario analysis, backed with data, on returns from equity mutual funds based on different entry points.

What are the lessons?:
1. Investing when the market is at the peak is profitable only when time is given for the market to recover and deliver.
2. Investing in a good mutual fund multiplies the returns. Look for MF schemes with a LONG TERM track-record (atleast 5 years +)
3. Investing when the market is down is the best recipe for long term success. (And the market is down over 55% from its peak).

What you need to do?
a. Define long term horizon. Ideal : 10 years. Acceptable : 5 years +
b. Assess your asset allocation. If you're underweight on equities, start buying it now.
c. Identify 3 superior equity mutual fund schemes : Start a Systematic Investment Plan (SIP). It is the ONLY way to benefit from volatility.
d. Get a grip on your emotions. If you are there for the long term, better see it through everything, irrespective of whether the following happens : failed monsoons, hung parliament, oil @ $ 150 or inflation @ 15%, terrorist strikes.
e. Get yourself an investment advisor, who is concerned more with your returns than his/her commissions.

Signals to buy low and sell high

In an article for Business Standard, Devangshu Datta highlights key financial indicators for stock investors to watch: Index growth rate, Dividend Yield, Price-to-Earnings and Price-to-Book Value.

The average PE of the Sensex has been about 17 since 1996. The market has rarely been able to sustain PEs ranging beyond 20 and it has rarely seen dips below the 13 PE levels. Single-digit PEs have been rare. Every time the market has dropped below 13 PE, it has been a good buy. It's trading at around 12 PE now.

Similar number-crunching with respect to price book value leads to the conclusion that the market is a good buy whenever the PBV is below 2.5. It's hovering around 2.5 levels right now. Similarly, a dividend yield of over 1.5 per cent is usually a reliable buy signal. The current yield is at 1.9 per cent.

...Another interesting thing is that it is equally easy to build a set of sell signals from this basic data. You get a sell signal if the CAGR is over 19 per cent. You get a sell signal if the dividend yield is below 1 per cent. You get a sell signal if the PE ratio is over 20. You get a sell signal if the PBV is over 4.5. In combination, these sell signals have been correct an overwhelming majority of the time.

Equities Anyone?

At a time when serious questions are being raised about the performance of equities as an asset class globally (see here and here), Economic Times provides a primer on why investors should bother with this asset class in the Indian context.

Though its risky and volatile in the short-run, all kinds of long-term gains from equity, including capital returns and dividend income, are tax-free . In fact, as the investing period gets longer, dividend becomes a significant part of gains from the equity investment and it provides investors with a consistent flow of tax-free income.

...Equity outdoes other asset classes not only because of the lower tax incidence, but also due to much higher pre-tax returns. To ascertain the extent of the out-performance, let us say, an individual had invested Rs 100 each in the Sensex, bank deposit, commodity index and gold on January 1, 1991. The sum of Rs 100 invested in equities must have swelled to Rs 965.4 on December 31, 2008. During the same time period, the investment in bank deposit, commodity index and gold would have swelled to Rs 499, Rs 158.7 and Rs 225.7, respectively. This shows that equity has outperformed other asset classes by leaps and bounds. Not only that, at the peak of equity market, the value of Rs. 100 would have swelled to Rs 2,031.6.

...The combination of high pre-tax returns and lower-tax incidence make equity perhaps the best asset class to invest in. However, there is a caveat here as the equity investments are subject to much higher fluctuations, hence, only on a longterm basis that an investor should expect high returns.

(Emphasis mine)

“This time it’s different”. Really?

Amit Trivedi has a philosophical take on the stock market crash of 2008 in this Moneycontrol.com article:

The market crash was inevitable. It was destined. The reasons that we hear are only the instruments of a much bigger force, called the market. Some of the justifications that we hear today from many experts seem so logical and obvious that sometimes we wonder why we did not see it coming. If this thought has ever crossed your mind, please do not worry. You are not alone. The same experts that give the reasons today were silent then. Unlike the medical profession, in securities markets, there are a lot of experts who can do post-mortem, but very few who can do a correct diagnosis. We get perfect knowledge of the disease after the patient is dead.

The bull market, which may come in the future, is also destined. We will once again come out with the stories justifying why the market started to go up. And those stories will seem very logical and obvious.

But do we learn from the episodes of the past? My understanding is that years from now, once again all the lessons of the current crash will remain of academic interest only. The practitioners will start to take risks once again as there will be pressure to increase return on capital. There will once again be some new instruments, new markets, and new phenomenon that will catch the investor's fancy. The euphoria will be justified with the age old words, “This time it’s different” – the four words described as the most dangerous in financial markets by legendary investor Sir John Templeton.

(All emphasis mine)

How the "experts" fared in 2008

Prateek has an interesting post on this at ApnaPaisa:

Miss 1: India is decoupled and will continue to grow in excess of 8% (GDP growth) - Well not only did the economist pack get this one wrong, our very own economic agencies and the infamous ministers got their expectations horribly wrong. The only saving grace has been that the various economists have been fairly quick to revise their numbers while the others are still arguing that the next few months are tough but then we will bounce back just like a baby on a trampoline.

Miss 2: The classic market trap - 22nd January ‘08 - Sensex @ 17,000 - a life time buying opportunity - Well from the looks of it, the last 11 months have presented more buying opportunities. Everyone including the shoe shine boy at the station had formed a view on the market and 25,000 is the first target of 2008. Fun(d) managers who were on TV boldly stating that any fall in the market should be seen as a buying opportunity, were themselves holding on to cash levels of 25-30% in their funds…strange ?

Miss 3: Oil to boil - Oil, a commodity whose movements are most difficult to predict, saw everyone comment that from levels of USD 100/bl it will cross USD 200 then will peak at USD 250. No one understood the basic economics (Well, I have understood this in hindsight) that a weakening global economy - rising unemployment will see people being conservative thereby leading to demand destruction.

Miss 4: Chinese and Indians eat too much? - World wide there is a shortage of farm land and we Indians with our fellow neighbours are living it in style by eating more than required. This was suppose to keep agriculture commodity (rice, pulses etc) firm. Well, speculation got the better of this pack.

Will Individual Investors Ever Learn - To Buy Low And Sell High?

I created this blog to share my journey - as an individual investor - to create long-term wealth by using the seemingly easy rule of "buying low and selling high". As this article by Harish Rao in The Mint shows, implementing this "rule" does not seem to come easily to most individual investors:

Data released by the Association of Mutual Funds in India (AMFI) shows that Net inflows (Purchases - Redemptions) in 2008 was 3,088 crores, as compared to 18,967 crores in 2007. This is a huge fall in net inflows and reflects the prevailing mindset amongst Indian investors. (What is interesting is that nearly 60% of inflows for 2008 came from ELSS, a tax savings category). The figure for January 2009 is no better. Net inflows into Equity is a negative 35 cr. So 2009 is off to a bad start as well.

...Till Sept 2008, the net inflow into equities was 4,004 crores. However, in the last quarter - when the equity markets tanked and sank to new lows, the net outflow was 916 crores. Thus, despite buying equities during the first nine months of the year, when things became really bad, investors redeemed their holdings.