December 11, 2017

The Scourge Of Volatility

Last week, one of my frequent collaborators brought to my attention the case of an investor who had been sold a closed-end equity scheme by his relationship manager at a private sector bank.  On the face of it, the episode had all the key elements that I associate with the rash of mis-selling pursued by young, ignorant, callous, smooth-talking bankers, fuelled by excessive incentives from sales-hungry fund houses.  Among other things, the investor was given the impression that this scheme was the real deal, and that the client could exit anytime he liked (“all you have to do is sell it on a stock exchange”).  For their efforts, the bank charged the client 1.50% of the amount invested (this was over and above what they gained on account of getting the client into the regular plan). 

I am not aware of the risk profiling that was done by the bank, but soon afterwards, the client started getting jittery.  He was tracking the NAV movements of the scheme, and what he saw, perturbed him.  At one level, he was flustered by the fact that despite the current surge in stock prices, one month on, the scheme had not shown any positive returns.  More than that, though, it was the seemingly unending daily spikes in the NAV that left him aghast.  If that sounds hard to believe, consider this: on 6 of the 7 business days in this month so far, this domestic, diversified equity scheme rose or fell more than any other equity scheme (including sector specific schemes and international funds). For the investor, things came to a head last week when the scheme’s NAV fell by an astounding 4.3% on a single day: a day when the scheme’s benchmark index, the BSE 200, fell by just 0.8%, while the BSE Sensex fell by a mere 0.6%.

So how on earth did this scheme manage to be so volatile?  What was it holding that caused such a fall?

The November-end portfolio was officially uploaded just this weekend, so till then we could only speculate about what the portfolio might be.  My guess was that this scheme was holding concentrated positions in dubious mid-cap/ small-cap stocks.  I was wrong.  It turned out to be a well diversified portfolio, with no concentrated positions.  Moreover, the top stock holdings were all respectable names.  Even more baffling was the fact that only about two-thirds of the portfolio was in stocks.  As much as 35% of the portfolio was in money market instruments.  With such a portfolio, that kind of a fall was impossible to fathom.

But then my collaborator pointed out a tiny element of the portfolio that I had overlooked.  The scheme had some exposure to Nifty December 2020 Put Options.  It was this part of the portfolio that was a key contributor to the fluctuation.  For those who understand how prices of derivative contracts fluctuate, this should not be a surprise.  But for those who don’t, consider this: on the day of that huge fall in the scheme’s NAV, the prices of the two sets of contracts held by this scheme tumbled by 67% and 71% respectively.  It seemed ironical, given that this exposure was ostensibly meant to hedge the portfolio against a fall in equity prices.

If you think that this is an isolated case, I’d like to suggest otherwise.  This may be an extreme case, but when I did a quick check on the data available at Value Research, I found closed-end equity schemes to be, on an average, 17% more volatile than open end schemes.  Additionally, within the limitations of what I could analyze, I could link this to the exposure that many of these schemes took to long term derivatives contracts.  If you consider the added impact of this on an investor’s ability to get a fair price in the event that he/ she decides to exit before maturity, you may get a sense of how much of a scourge volatility can be to investors in closed-end schemes.  Take the aforementioned investor, for instance.  The day after the NAV fell by 4.3%, he tried to exit the scheme, but couldn’t find a buyer.  Even if there had been a buyer, would he have got a fair price?  As it is, trading a closed-end fund on an exchange is loaded in favour of the buyer: it can be expected to happen at a discount to the NAV.  If the scheme happens to be as volatile as this scheme was, I’d say that it would significantly increase the level of discount that a buyer would expect. 

When I shared my thoughts with some industry insiders, the argument that I was offered was that most investors in closed-end schemes do not seek to exit before maturity, and hence volatility would not matter to them.  I find it hard to agree with that.  In the imperfect but real world that we live in, I believe that many, if not most investors feel humanly compelled to periodically track the performance of the schemes that they have invested into, regardless of whether these are closed-ended or open-ended.  And if they see excessive volatility, they are likely to feel uncertain about the future, and to consider exiting.

But more than my own view, let me give the final word to Peter Stanyer, an authority on the subject of wealth management and more.  In his marvellous book, Guide To Investment Strategy, in the context of investing with a target date, he makes the point that it is reasonable for an investor’s confidence “to be shaken by disappointing developments along the way, even if those developments are not surprising to a quantitative analyst.”  He further goes on to say that “the perceived risk of a bad outcome will be increased by disappointments before the target date is reached, undermining confidence in the investment strategy.”  Now that‘s food for thought.

Special thanks to Robin Jehangir for his valuable inputs to this post.

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