Investing for absolute returns can liberate investors

is managing partner at Breakout Capital.

In my early days as an investment analyst, I was once pitching a stock to my fund manager boss. Two minutes into the pitch, he asked me “What’s the weight?” I had no idea what he was talking about and so I later asked one of my senior colleagues what he meant. Most institutional investing in India is of the relative return type, which means that every fund is benchmarked against an index and a fund manager’s competence or otherwise is measured by how well he or she performs against the benchmark. Hence the oft-asked question in investment discussions is the one my boss had asked me. It meant: How large is the stock in the benchmark index?

Before becoming a buy-sider, I was an amateur equity investor, and this weight question had never crossed my mind. One bought what one liked and didn’t buy what one didn’t like. But as I got steeped in the world of institutional investing, the term ‘index weight’ became the centre of many portfolio discussions. When you are incentivized to beat a benchmark, you quickly adapt to this new way of investing.

This shift has several implications. One ends up spending a lot of time analysing heavyweights: i.e., stocks that have a large representation in the index. Those stocks may not be the best money-making ideas, but getting them wrong will impact the fund’s relative performance, your annual bonus and even your career. HDFC Bank, Reliance Industries, ICICI Bank, Infosys and Larsen & Toubro are the five largest stocks in India, accounting for almost a third of the Nifty 100 index by weight, and it’s no surprise that they are some of the best covered stocks by equity research houses. Again, not because the sell side thinks they are the best investment ideas, but because they know that their large clients care a lot about them.

Apart from ‘index weight,’ other words that entered my investing lexicon were ‘overweight’ and ‘underweight.’ If the index weight of a certain stock is 3% and it is 5% of your fund, you are 2% overweight. Similarly, if it is just 2% of it, you are 1% underweight. To be honest, I struggled to grasp the concept of ‘underweight,’ as it suggested that the fund manager does not like the stock and yet holds it. The buy side marketing machinery will spin some version of ‘the fund manager is cautiously optimistic’ to justify the weightage, but the truth is that such positions are risk management placeholders. If, for whatever reason, the stock does well, the fund manager does not want to lag the index and so allocates some capital to it. It might be worthwhile to check what proportion of your fund portfolio comprises underweight names because that is a suboptimal way of allocating money.

The other outcome of the relative return framework is that portfolios tend to cling to the benchmark. The 12 biggest large-cap funds in India that together account for over 90% of large-cap assets under management own all the five index heavyweights.

Twelve of India’s top investing professionals having congruent views may seem surprising, but it’s not, given the incentive structure.

The motivation of retail investors who entrust fund managers with their money is to beat inflation. For institutional investors, it could be being sufficiently funded to meet wage and pension commitments, or to meet the stability and development needs of an educational institution, a town or even a country. These objectives require an absolute-return hurdle to be met. Retirees cannot be told that their pensions are going to be reduced by 10% because the benchmark against which the fund was being measured is down 10%.

Apart from aligning the end goals of the investor and money manager, absolute-return investing has other advantages as well. Efficient time allocation of investment professionals is the most important one. What stocks and sectors an investor decides to analyse is not dictated by index composition, but by the probability of making absolute returns.

If specific financial targets are to be met, then we must aim for absolute returns, and that grants asset managers the liberty to focus on what’s within their zone of investment competence.

Also, it allows investors to stay within their circle of competence and relegate other stocks, sectors and markets to the ‘too hard’ pile.

However, an absolute-return mindset requires some modification in approach. Warren Buffett’s advice to “never lose money” becomes paramount, which means an absolute-return investor thinks a lot about downside risks. These include what we call stroke-of-the-pen risks, like sudden regulatory changes, penal actions or the risk of a key employee abruptly leaving. An effective absolute-return strategy requires the ability to periodically hedge stocks or entire portfolios because short-term market downsides are inevitable, and an absolutereturn manager cannot hide behind the excuse of a negative index return.

This distinction between relative and absolute return approaches may not matter much in India, where there is a long history of robust index returns. But for an asset class like emerging-markets equity, where the annualized total dollar return for the past five and 10 years has been less than 2% and 3%, respectively, discarding the relativereturn mindset is probably the only way to generate respectably large returns.