»5 Minute Wrap Up by Equitymaster

On This Day - 13 AUGUST 2014
A low risk strategy to earn 12-15% per annum

In this issue:
» SEBI better equipped now to tackle ponzi schemes
» How direct cash transfers will reduce corruption?
» Japan suffers worst contraction in GDP amidst tax shock
» Will monsoons be deficient this time?
» ...and more!

Say, for example, you have surplus cash to invest in markets and two options at your disposal. Option one is to invest with a star fund manager who has managed to outperform broader markets most of the time. And option two is to passively index to any custom benchmark. Which one would you choose?

Most of us would be tempted to invest with the fund manager in anticipation of higher returns, right? However, the best investor of all times, Warren Buffett, who has managed to create US$65 bn of wealth through active investing, would choose option two. Surprised? Though being an active investor, Warren Buffett is a big fan of index funds. Hence, this does not bemuse us that much.

In fact, he has candidly admitted in his letter to shareholders that his legacy wealth should be passively mimicked. Now, you may wonder why a person who has created so much wealth through active investing is actually propagating indexing.

The reason is simple we reckon. Over a longer time period it becomes virtually impossible to beat markets. And the Oracle of Omaha recognizes this fact pretty well. Fathom this. A study conducted over the period 1996 to 2008 of the US mutual funds industry has showed startling results. Out of the 1,825 mutual fund managers that oversaw various schemes, only 25% lasted more than 5 years. And only 195 lasted a decade.

The fact that only a handful of managers managed to survive a decade signifies their underperformance. And the power of indexing. If over a 10 year period, only 11% of the managers survive, it speaks for itself how difficult outperforming benchmarks can be. Mind you, one also has to pay a management fee for this underperformance!

True, that even an index fund would have management fee associated with it. As a result, the true investor return would be slightly lower. Hence, the emphasis of investing in a low cost index fund. This would ensure that actual benchmark returns are partially mimicked.

Remember, it is not that money is made only by beating the index. In fact, when a fund manager tries to do the same he could perhaps take unnecessary risks and ultimately lose some. This is where index funds provide value. You are at least assured of the benchmark return which in the case of Sensex could be in the region of 12-15%.

So, does this mean that one should completely ignore investing with a fund manager and just index?

Well, not really. In fact, the decision to actively invest entails considerable due diligence. Historical track record of the fund manager, fee structure and research capabilities of the firm are some factors that investors should watch out for. Active investing would make sense if due diligence results turn out to be favourable. Else investors would be better off in indexing .

Do you believe low cost index funds can generate better returns than mutual funds over the long term? Let us know in the Equitymaster Club or share your comments below.

Editor's note: By the way, we are coming out with a new series starting 15th August 2014 wherein we will reveal the three most important factors that have helped Warren Buffett pick out some winning stocks. To ensure you receive this, all you need to do is reconfirm your free-for-life subscription to The 5 Minute WrapUp.

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In yesterday's edition of the 5 Minute Wrapup, we had discussed Dr Rajan's views on crony capitalism and how by focusing on direct cash transfer, the corrupt middleman can be eliminated. To expand on this further, Dr Rajan is of the view that by paying cash directly to the poor, they are free to use it in the manner that they want thereby reducing their dependence on intermediaries. Right now, there is an unholy alliance between the politician and the businessmen, which is exploiting the poor. The politician gets funds from the businessman to fund his patronage to the poor. After all, he needs the votes from them. And the businessman gets resources and contracts in return. All of this has resulted in the benefits of subsidies not reaching the poor for whom it is intended in the first place. Of course there has been opposition to this with the main argument being that money directly given to the poor will be squandered. But this line of thinking does not hold much weight. That is why Dr Rajan's proposal of doing away with the corrupt middleman makes a lot of sense.

The government has approved the SEBI Amendment Bill with the intention of empowering the regulator to crack down on ponzi schemes, a menace that has long haunted the country. Though SEBI has not been given the authority to tap telephone conversations, it will however have the powers to seek call data records while conducting an investigation. In fact, SEBI has also been given powers to conduct searches and seek information from suspected entities, even if they may be outside the country (though only after approval of a designated court).

Will this be enough to tackle the ponzi menace in India? While it may not completely eradicate ponzi schemes from taking root in India, with these much stronger investigation powers that the regulator will now posses, it will nonetheless go a long way in acting as a strong deterrent.

Cheap money. This has been America's answer to every problem related to economic downturn over the past 5 years. Ever since the US government decided to bailout the big banks, issuing cheap credit to boost employment has become the US Fed's primary focus! So much so that the Obama government has completely relied on the Fed's policy stance in the hope of economic revival. Fortunately, our own central bank has always chosen to tread the difficult path. And governor Dr Rajan is no different. Even his predecessors have chosen to do what is good for the economy. Sometimes even at the cost of soliciting the government's ire. Supporting growth with cheap money was never the RBI's idea of monetary policy making. And Dr Rajan has correctly pointed out that even government in the West should do more for economic revival. Relying on cheap money cannot bring in sustainable growth.

In India, the GDP growth drops by merely a couple of percentage points and we feel the ground beneath us shifting. That's the kind of a domino effect the GDP has on an economy. Now imagine the GDP growth not slowing down but actually suffering a decline. That would simply be catastrophic, isn't it? However, there's an economy that's witnessing a similar calamity currently and it answers to the name of Japan. As per reports, the Japanese economy shrunk by nearly 7% during the three months ended June.

And what are the policymakers doing to take it out of its current funk? Well, they are trying things like increasing consumption taxes and are creating their own version of quantitative easing. We are not surprised that the move is hardly working. Simply because it is the purchasing power that decides the fate of an economy and not things like money printing and consumption taxes. And for the purchasing power to increase, Japan will have to undertake some major structural reforms. It will have to unleash an improvement in both capital and human productivity like never before. And unless it does this, there's very little chance of the Japanese economy really taking huge strides forward.

 Chart of the day
Even as data suggests that economy might be crawling back to growth path, there is one factor that could derail it. Now that the industrial segment is showing some signs of recovery, the monsoons may play spoilsport. As per the Indian Meteorological Department (IMD), 2014 southwest monsoons are likely to be deficient. Estimated at 87% of the long period average, the rainfall this year has been revised down further by 6% points than the June estimates. These levels are well below the minimum cut off levels of 90%. In North West region also, the monsoon is likely to be 24% below normal. This could have significant implications for Indian economy and markets. Afterall, a lot of recovery this time is based on positive expectations. Not only poor rainfall is likely to moderate that, but could also result in higher inflation. Already, the high cost of food items has led to around 8% increase in retail inflation. Such developments will influence the monetary policy in the near term. They may further adversely impact economic sentiments and prolong the time Indian economy takes to recover. Not to mention the impact on markets. It is because of such erratic factors on the macro front that we often insist that investors should stick to a disciplined investing approach with a keen focus on fundamentals and valuations.

Will monsoons be deficient this time?
*LPA= Long period average
NW^= North West, NE$= North East, SP# = South Peninsula

The Indian stock markets slipped into red in the afternoon trading session, erasing the early gains. At the time of writing, the BSE-Sensex was trading down by 25 points (-0.1%). Barring IT sector, FMCG and healthcare sector, all the sectoral indices were trading in the red. Stocks from the sectors such as Realty sector and capital goods sector were witnessing maximum selling pressures. The Asian markets were trading mixed with Hong Kong leading the pack of buoyant markets. Malaysian markets led the pack of laggards. European markets on the other hand have opened the day on a positive note.

 Today's investing mantra
"If past history was all there was to the game, the richest people would be librarians" - Warren Buffett

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