The hidden layers of safety

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Just a few days ago a cryptocurrency named Luna blew up. And there are a few things that make this particular blow up more notable than the others.

First is the fact that it was one of the largest crypto currencies by market cap. Sitting in top 5 with Bitcoin and Ethereum. Many people invest in blue chip companies, which are 10-20 largest companies, with the assumption that their size makes it an inherently less risky investment. Luna was a one of the blue chips of the crypto world.

And that brings me to the second reason why this blow up was a big disaster. The cryptocurrency was linked to a stablecoin named TerraUSD or UST. Stablecoins also live on blockchains like other crypto currencies but instead of being an independent currency they are supposed to be backed by an equivalent number of USD or other safe securities held by the issuers of said stablecoins. So if I want to issue 100 stable coins, I will keep with me 100 dollars at all times. Since USD is the reserve currency of the world, such stablecoins are considered very safe by crypto investors.

UST is an algorithmic stablecoin. What that means is instead of being backed by actual USD, the blockchain mints and removes coins from the circulation through another coin called Luna. The blockchain incentivises traders to convert Luna to UST and vice versa depending upon buying or selling pressure from the market. If UST starts to fall, blockchain makes more Luna to maintain the peg. Though this sounds a little fishy, this worked for small fluctuations in the market. And because UST had very high (up to 20%) staking yields which is like an interest on fixed deposits, investors flocked to the easy money. It is backed by US dollars isn’t it! What could possibly go wrong.

On one fine day, an investor purchased a huge quantity of TerraUSD and then sold it off in the market. This selling pressure caused the algorithm to create more Luna. This caused price of Luna to fall. In markets, fear and greed both compound. People started selling Luna because the price was falling. This sent the blockchain in a death spiral flushing the blockchain with more and more coins. When the dust settled, Luna and UST had lost more than 99.5% of its value.

What made this loss terrible was that because of its high yield, many people had put their savings in Luna hoping to get a sizeable return at supposedly no risk. There are testimonies of people on the social media who have lost their life’s savings.

This keeps happening where we lose the perspective on risk. A lot of money has been lost in explicitly risky investments like penny stocks and far OTM options. But that is the nature of those investments. Nobody in their right mind invests the money they are saving up for something important in such speculative investments. But the problem comes when we completely ignore risks of a type of security that is ‘generally’ considered safe. In the case of stablecoins there are many which have been around for a number of years and have given decent returns to the investors.

Bonds are considered safer than stocks. But a hedge fund ran by economic PhDs failed spectacularly in 1998 when they levered up and invested in Russian bonds. Now sovereign debt is considered safe. Theoretically, in any country, its sovereign debt is the safest investment. So Indian bonds in India, USA bonds in USA and so on. The managers of this hedge fund must have had similar notion about Russian bonds as well. Only the uncommon happened and Russia defaulted on its debt in 1998. Irony is, the hedge fund was called Long Term Capital Management. It lasted from 1994 to 1998, only 4 years. That’s not long enough by any stretch of imagination.

Similar incidents have happened repeatedly in India. DHFL bonds were peddled as very safe to retail investors by sales persons. Retail investors being retail investors bought them with the hope of making ‘safe returns’ that are higher than bank FDs. After DHFL defaulted, many are stuck, praying to get at least some of the capital back.

Punjab Maharashtra Co-operative Bank (PMC) is another such recent example. A bank is supposed to be ‘safe’. But painting all banks with the same brush is a fatal mistake. Well run, large banks are usually the safest ones. Smaller, local banks can be potentially riskier. With smaller banks, the rules can be bent, and books can be cooked more easily. In case of PMC, a large portion of its capital was loaned to a single entity which defaulted. As a result, bank suddenly had no money to pay its depositors. RBI stepped in and froze all assets of the bank resulting in people’s savings being stuck. Though the restrictions are being gradually lifted, if I had my life’s savings in that bank, I wouldn’t be able to sleep at all.

And this is where I see the paradoxical behaviour of investors seeking safe returns. Many will not invest in a diversified equity portfolio giving an average return of 10 percent but will line up to make FDs in local banks offering high interest rates. Or invest disproportionate amount of their portfolio in high yield bonds and be surprised when some of the bonds default. The ‘risk-free’ rate is called as such for a reason. Anything that is offered to investors above that as ‘risk free’ is in fact risky. Interest that the bank pays you on FDs and a company pays you on bonds is a reflection on the bank’s/company’s quality. Higher the interest rate, riskier is the investment. It will do well for investors to keep this in mind. And not blow away their risk free portfolio in supposedly risk free assets.  

The income obsession

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If you read finance theory, an asset returns two kinds of returns. One comes from dividends, interest or rent that the asset pays. The other comes from the appreciation of the price itself. What do I mean?

Since 1st march 2021, TCS has increased in price from about 2950 rs to about 3550 rs. That is the price appreciation part. TCS has also paid 36rs of dividend in the same period. So an investor has made a total return of 22%. That is not a bad return.

TCS is just an example. There are other stocks. REC LTD has gone from 135 to 125 in the same period. A loss of 10 rs. It has also paid out 17.21 in dividends. Total return here? Just 5%.

Comparing two stocks, you could have bought 22 shares of REC LTD for the price of one TCS share. That would have given you a nice dividend of 379rs. The dividend is 10 times more than what TCS paid but still, the overall return is just a quarter of what TCS gave over the same period.

Many people prefer dividend investing. Dividend investing is where one picks stocks that pay out high dividends. There are several problems with it. Many companies pay dividends at the cost of growth. Those that pay dividends upwards of 5% usually do not appreciate too much in price. But still, because dividends are credited in the bank account, it feels like you have made more tangible returns than just some green numbers on the screen.

There are some disadvantages to this cash in the bank though, First, dividends are taxed higher than capital gains. Second, companies paying dividends are not the most efficient capital allocators, at least in India. As a result, dividends are the only reason many shareholders buy and hold those stocks. Even a year of low dividend distribution can send the stock spiralling downwards as the investors will look for returns elsewhere. Third, most of these companies fall under the same peer group, viz. government-owned, commodity or power businesses. That adds concentration risk to the portfolio.

A much better option would be to systematically sell part of your portfolio to meet your income needs. There are ways to do it. Simplest would be to move part of your portfolio in fixed income every year and eventually withdraw it when you need money. Maybe we can discuss it in another article. But as is the name, it is called personal finance. So find what works best for you.

Ask the right questions…

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Every time an IPO or NFO comes on the block, the first question everyone asks is “Should I subscribe to XYZ?”. The overwhelming marketing material biases ones opinion towards a “Yes”. I think it is the wrong question to ask.

Whenever we want to buy something, lets say a watch, we ask ourselves, “Where is a shop which sells watches?”. We don’t just walk into any store, and then figure out what to buy.

So just a couple of days ago one of the mutual fund AMCs came up with an NFO. It wouldn’t have been much of a news if it had been any of its peers. But this one in particular has been very adamant about not needing to do ‘AUM seeking activities of releasing a fund for every category’. Plus their flagship fund has posted one of the best performances not just in multi cap across categories. Investors trust the fund managers and their philosophy of value investing. So much so that they were amongst few AMCs who had seen net inflows through the uncertain times that was the year 2020.

Recently they launched a liquid fund which would hold only T-bills and G-secs and would be mostly used as an STP vehicle for people not wanting to put lump sum in equity fund.

The third fund now is a conservative hybrid fund. It’s marketing material says it is for generating income from debt and money market instruments. Capital appreciation from equity and REIT, InvIT components as well as some income from the latter.

There’s nothing to worry about in debt part. The AMC is known to be conservative and hence wont take any credit risk. Equity component is limited to 25% so my guess is that it will be a scaled down version of their flagship fund itself. But with such small allocation, I don’t think exposure to international equities will be there.

The last component is up to 10% exposure in REITs and InvITs. There are several points to discuss here. Most Indian investors are highly exposed to real estate market anyways so logically anyone investing in REITs should take that into account. The 10% exposure in itself isn’t high enough to contribute to the returns of the fund in any meaningful way. And unless this fund forms the core of someone’s portfolio, the exposure to REIT, InvITs will be miniscule. Think of it as 10% of 10%. The AMC is also known to include provisions in their scheme documents which it may not use. The flagship fund has had the provision for REITs for a while but to the best of my knowledge REITs haven’t been part of its portfolio till date. Same is the case with the provision for covered calls.

A doctor doesn’t see the available medicines in the market and then decide what to prescribe to the patient. They first examine the patient and then come up with the best treatment based on available medications. We should look at our portfolios the same. Before looking at funds, stocks etc., we should know what we are looking for…

The perspective

Every time a stock hits its lifetime high, the social media starts buzzing with lines such as ‘Just 3 Lac invested in XYZ-MULTIBAGGER company in the year LISTEDDATE would have been equal to YOUCOULDHAVEBEENRICHB*TCH today!’.

When I was a newbie in the markets and came across such tweets, I felt my parents (and by extension me) missed their opportunity of being filthy rich. But once I became a little used to the stocks and their erratic behavior, I realized how smart, albeit unknowingly, my parents were. Let us talk about one of the poster children of such multibagger returns; MRF. Since its listing in the year 1999, it has increased by approximately 4500%. I will throw one line as well. Just one lac invested in this stock back then would have been 45 lac today. But here’s the detail I missed. back then access to markets was not as straight forward as it is today. The maze of brokers, sub brokers and market operators would have been very difficult to navigate for someone like my parents. Not being savvy about financial world, they would have relied on the recommendations of their broker. And we all know how shady that business was for small investors back then.

And looking at MRF today and talking about how great that investment would have been is the epitome of hindsight bias. What if you had invested the same one lac in reliance power? It would have been equal to one thousand. Yes that’s right. 99% of your capital would have been lost in ether. There are countless other stocks which were trading at 1600 once and now quote at 1.6 rs. Many have completely vanished altogether.

There were some logistical issues as well. Shares were issued in physical format, the settlement period was long, minimum margin requirement with the broker was high, etc.

Many can’t afford MRF today. At the CMP of almost 64000 rs, it remains the most expensive stock listed in the Indian markets. When it was listed, it traded at around 2000 rs. But remember in the year ’99, 2000 rs was more than what many people earned in a month.

We all revere Warren Buffet as one of the greatest investors of all time. One of his commandment clearly states that you should only invest within your circle of competence. Tech companies were out of his. Stock market was out of my parents’ and of many contemporary of theirs. So they did what they understood; LIC, PPF, real estate and gold. Is it the optimum portfolio allocation by modern portfolio constructions standards? Not by a mile. But at least they didn’t lose their sleep over what market did…

Disclaimer – The names of the companies are for illustration purposes only.