Annual Letter to Investors

2018-19
“Do you want to trail the market when it’s going up or when it’s going down?”

Seth Klarman

The first quarter of this calendar year 2019 been great for equity markets globally, lest you think it is only India
that has done well. A confluence of factors has led to that. But the predominant reason seems to be Federal
Reserve changing its stand from projecting two rate hikes in 2019 to no hikes. This change in their stand was
bought about by the view that the US economy seems to be slowing down in-spite of healthy unemployment
figures. I believe they have changed their stand again and say that they will now be data driven. Isn’t that what
they were supposed to be anyways?

In Indian markets we have had a tale of two markets. I wrote about this in my previous letter. The average and
median stocks are down. Mid-caps have been battered and there has been some mean reversion in the past
quarter. While the Nifty is up 14% for the year, a whopping 91% of those gains have been driven by 6 stocks
namely Reliance, HDFC Bank, TCS, Infosys, ICICI Bank and Axis Bank. We own the first three in our portfolios. Mid
and small cap indices have not had it so good. As the table below shows. It was carnage

Return1 Having a multi-cap balanced approach focused on protecting

Max Drawdown
downside, we are lagging the Nifty by a bit on the upside but
AlphaBets 10.3% p.a. 9.4%
comfortably beating it on the lower side. And we are meeting
Nifty 50 12.7% p.a. 14.1% the Nifty Mid-Cap returns with less than one third the risk on
Nifty Midcap 10.5% p.a. 27.3% the downside. As the drawdown graph shows below, the
NIFTY Midcap Index continues to be in a deep drawdown.
And the March exuberance of the large NIFTY 50 Index was very narrow and confined to a few stocks.

NIFTY ALPHABETS NIFTY MIDCAP

0.0%

-5.0%

-10.0%

-15.0%

-20.0%

-25.0%

-30.0%
23-Dec-16

23-Apr-17

23-Jun-17

23-Aug-17

23-Dec-17

23-Apr-18

23-Jun-18

23-Aug-18

23-Dec-18
23-Nov-16

23-May-17

23-Nov-17

23-May-18

23-Nov-18
23-Sep-16

23-Jan-17
23-Feb-17
23-Mar-17

23-Sep-17

23-Jan-18
23-Feb-18
23-Mar-18

23-Sep-18

23-Jan-19
23-Feb-19
23-Mar-19
23-Oct-16

23-Oct-17

23-Oct-18
23-Jul-17

23-Jul-18

1 Annualised return for portfolio post fees and expenses since inception i.e. July 2016 to March 2019
QED Capital Advisors LLP
www.qedcap.com info@qedcap.com
 Annual Letter to Investors
2018-19
Fixed Maturity Plans – Nothing mature about it

Recently the mutual fund managers of the “mutual fund sahi hai” ilk have been caught napping. And their conduct
to say the least has been strangely defiant and “offence being the best form of defence” kind of approach.

This is the description of the FMP scheme on the website of one of the AMCs in question. “The investment
objective of the Scheme is to generate returns through investments in debt and money market instruments with
a view to reduce the interest rate risk. The Scheme will invest in debt and money market securities, maturing on
or before maturity of the scheme.”

Now the fund management house has informed its investors that they have given an extension to the corporate
which it had lent the investor’s funds to. So basically, on maturity the borrower is unable to pay. If a bank had
done this, it would have been called “extend and pretend.” Also, both these fund houses have banks as parents
and the parent banks themselves don’t seem to have any exposure to this company. So, if this company was not
worth lending to by the banks, the fund managers found it good enough to be lent to and that too in a fixed
maturity plan.

It is interesting that this lending was also collateralized by equity shares of the company. 2008 and similar crises
have taught us, liquidity vanishes when it is required the most. If the company is unable to repay back the loans,
who is going to buy the equity shares and that too at a fair value. Fund managers discovered this when they tried
offloading the shares which caused a collapse in the shares of the company by almost 30%. Along with that came
the news the company was being investigated by SFIO for its role in demonetization.

This begs the question: Did the fund managers take into account the fact that in the scenario the company is
unable to service its debt, what will be the value of equity (a riskier form of investment than debt). So basically
what these fund houses were doing was is known as “Loan Against Shares.”

Also, would these same banks, have done that for you or me, had we asked for extension on our home loans or
car loans. And the fund managers had the gall to say that this extension was being done in the interest of the fund
investors.

A leading daily reported that “most fund houses do not have credit teams to monitor investments on a daily basis.
They solely go by what rating agencies report periodically”. So, fund houses earning almost 50% profit margin in
hundreds of crores do not spend on credit teams. Last year, the mutual fund industry paid almost Rs. 15,000
crores to distributors. This was paid out of the investor’s funds2.

No lessons have perhaps been learnt from the crisis from 2008. I also wonder what action will be taken by the
regulator in this regard. The role and process of the rating agencies should also be investigated.

2
Source: The Ken
QED Capital Advisors LLP
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 Annual Letter to Investors
2018-19
Mutual Funds Sahi Hai Lekin Returns Nahin Hai

This leads me to the study that we had done on returns from equity mutual funds. We studied the period from
2001-2019 and were not very surprised by the results. What surprised us was how the math perfectly added up.
The market is a zero-sum game before expenses and a negative sum game post expense. Keep your expenses
low. That gives you the best chance to outperform.

In Investing, You Get What You Don't Pay For

John Bogle

We studied all the equity mutual fund returns between January 2001-March 2019 and compared them to the
available index fund at the time i.e. Nifty BeES. And if you see the difference, it is approximately 2.3% which is
broadly what the MF industry has been charging on average over these years. We also looked at 15 year rolling
returns and in all cases, the mutual fund industry returns were lower than the Nifty Index Fund.

Details Returns MF vs Index

MF Industry 9.92%
Nifty Index Fund 12.22% -2.31%
Nifty 50 TRI3 13.05% -3.13%

Markets are a negative sum game

Let us do a thought experiment. Let us say that the stock market comprises of two active fund managers and two
index fund managers. We assume the amount invested by all of them is Rs. 100 each before fees. Market goes up
by 10% next year.

Before fees: The index fund managers will collectively and individually do as well as the market. The active fund
managers will collectively do as well as the market but individually for one active fund manager to do well, the
other has to underperform. That’s how the math works because before fees markets are a zero-sum game.

After fees: Now we are in negative sum game territory. Again, the individual index fund managers will do well as
the market less the 0.20% that an index fund charges on average. The active fund manager charges around 1.5%
on average. So, they will collectively underperform by 1.3% and individually one again same as above. One will
have to under perform for the other to outperform. There is no other way.
Index Fund Index Fund Active MF Active MF
1 2 1 2
Year 0 ₹ 100 ₹ 100 ₹ 100 ₹ 100
Year 1 ₹ 110 ₹ 110 ₹ 111 ₹ 109
Pre-Fee Returns 10% 10% 11% 9%
Fee 0.2% 0.2% 1.5% 1.5%
Post Fee Returns 9.80% 9.80% 9.50% 7.50%
Average of Fund Category Return 9.8% 8.5%

3
TRI – Total Returns Index i.e. includes dividend

QED Capital Advisors LLP

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 Annual Letter to Investors
2018-19
The index fund managers have done 9.8% post fee individually and collectively. The active fund managers have a
variation, because they both can only win at the cost of the other. Now in a two active fund manager market, the
odds of picking the out performing manager are 50% or a coin toss. In real life the odds are worse. The odds of
picking a large cap out performing fund over ten years is about 35% as you will see below. That is worse than a
coin toss.

S&P reports data every six months on performance of active mutual funds versus their benchmarks. As you can
see the underperformance for the large cap segment over a 10-year period. The underperformance has only gone
up from approximately 58% in June 2017 to 64% in December 2018. Also, if you see style consistency has sharply
dropped in June 2018 to about 12% which is when the new SEBI recategorization rules came into play. Earlier
large cap fund managers would also own a substantial number of midcaps and would try and beat the large cap
indices by taking more risk. Thus, the label did not match the product. In 2018, SEBI mandated that large cap funds
could only invest in the top 100 funds by market cap.

10 year performance for largecaps

80.00%
60.00%
40.00%
20.00%
0.00%
Jun-17 Dec-17 Jun-18 Dec-18
Underperformance 58.47% 53.54% 62.77% 64.23%
Survivorship 66.10% 70.08% 67.88% 66.67%
Style Consistency 28.81% 28.35% 12.14% 14.63%

Underperformance Survivorship Style Consistency

To give context, in developed markets like United States, the underperformance of actively managed mutual funds
is about 90% and this is across large, mid and small caps. In India this has happened in large caps so far and will
increase rapidly over the next decade.

The other interesting aspect is that even if you pick an outperforming fund today, the likely hood that it will
continue to outperform over your investment horizon of 10-15 years is again less than 30%, worse than a coin
toss. And that is when your friendly neighbourhood financial advisor (who is actually a distributor) will ask you to
switch to another fund which is currently out performing. And it tickles me pink, because no one I know will go to
a doctor for advise if he is paid by the pharmaceutical company, but they will happily go to a online or offline
distributor (many of the robo-advisors are actually distributors) and take financial advice from them.

Our take

Our take is that fees must be linked to performance for actively managed strategies. And that is what we follow
for our active strategy – AlphaBets. This ensures that our interests are aligned with yours and that we earn fees
only in those years in which we make returns for you.

We also believe that investments in large cap mutual funds should be moved to large cap index funds where the
expense ratio is much lower, there is no fund manager risk and you eliminate the risk of picking an

QED Capital Advisors LLP

www.qedcap.com info@qedcap.com
 Annual Letter to Investors
2018-19
underperforming fund. And that is what led us to launch Index Alpha which will build a managed portfolio of Index
funds for you to enable you to meet your long term goals.

And for un biased advise go to a fee only financial advisor, ensure that they have no part of their revenue coming
from the mutual fund company, directly or indirectly. At the least you can be sure that the suggested plan and
advise is agenda free. I am not sure how many of us would be comfortable going to a doctor knowing that our
consultation charges will be directly reimbursed by the pharmaceutical company, whose medicine is being
prescribed. However, it is amazing we don’t apply that same standard to our financial health. We readily accept
recommendations of a financial distributor masquerading as a financial advisor but gets a commission from the
mutual fund company. Like they say, if the product being offered is free, then you are the product.

As you are aware that we charge only performance fees on our actively managed strategy – AlphaBets i.e. only
when we make returns over a hurdle rate. This year we have been selling mid-caps stocks or have been in cash.
Hence there are no fees being charged. Because of this fee structure, we also do not tie up with distributors for
marketing as we do not pay commissions. We rely mainly on your referrals to grow. And that is how we have also
grown in the last three years. We hope you continue to do that and help us in our growth journey.

Anish Teli and QED Capital team

April 2019

QED Capital Advisors LLP

www.qedcap.com info@qedcap.com