The Tortoise Speaks...

A blog which periodically revisits evergreen investment principles!

Dilemma in selecting hybrid funds

By

On January 17, 2025

In Investing, Mutual Funds

Since March 2023, the category of hybrid funds has witnessed a significant surge in assets under management (AUM), almost doubling. This is largely due to the favorable tax treatment of certain hybrid fund types and their ability to offer diversified exposure across different asset classes. 

Source: Hybrid Fund AUM (Rs Lakh crore)(AMFI Data) 

The rise in popularity of Dynamic Asset Allocation funds, Balanced Advantage Funds , Multi-Asset Allocation Funds, and Equity Savings Funds can also be seen as part of a broader trend where investors are increasingly seeking tax-efficient, diversified  investment strategies, especially in the current volatile market environment. 

However, investors often make mistakes when selecting these hybrid funds, primarily due to a lack of alignment with their individual risk profiles, financial goals, and other critical factors. Here’s a closer look at some of the common mistakes investors make when choosing hybrid funds and how they can avoid them: 

Overestimating Stability and Underestimating Volatility :

Some investors mistakenly believe that hybrid funds, due to their diversified nature, are always low-risk. While hybrid funds are less volatile than pure equity funds, they can still experience significant fluctuations. 

A Balanced Advantage Fund /Dynamic Asset Allocation Funds might have a large allocation to equities, which could lead to substantial volatility in bear markets. If an investor expects consistent returns, they could be caught off guard during periods of market downturns.

It’s important for investors to understand that while hybrid funds are designed to reduce volatility compared to pure equity funds, they are not completely risk-free. They can still be impacted by market corrections, interest rate changes, and other macroeconomic factors

Ignoring Fund Strategy and Asset Allocation:

Focusing too much on past returns without understanding the underlying asset allocation strategy of the hybrid fund can lead to poor decision-making. The asset mix and how actively the fund manager adjusts the allocation based on market conditions are crucial factors in determining the future performance of a fund. 

Always check the fund’s investment philosophy and asset allocation strategy.  This gives a clearer picture of what to expect from the fund beyond just past performance. 

Time Horizon:

Hybrid funds, which invest in both equity and debt instruments, typically experience higher volatility than debt-only funds. As a result, these funds are better suited for medium to long-term investment horizons. While they aim to balance risk and return by adjusting the equity and debt allocation, hybrid funds are not immune to short-term market volatility. 

For investors with a shorter investment horizon, liquid funds or arbitrage funds are more appropriate. 

Comparing one fund with another:

One of the unique characteristics of hybrid funds is their flexibility to allocate between equity and debt based on the fund manager’s strategy and prevailing market conditions subject to SEBI MF Regulations. This flexibility means that hybrid funds are not directly comparable to each other in the traditional sense, especially when compared to more straightforward equity or debt funds. 

A Dynamic Asset Allocation Fund may hold a higher percentage in equities during a bull market, while another may hold a lower percentage. Some hybrid funds have a higher equity exposure, targeting more aggressive growth over the long term. Others may maintain a lower equity allocation and balance with arbitrage opportunities, focusing on capital preservation with some growth potential. 

The type of debt instruments used in a hybrid fund (e.g., government bonds, corporate bonds, or money market instruments) also affects its risk and return profile. A fund investing in higher-rated bonds will typically have lower risk and lower returns, while one investing in lower-rated bonds could have higher returns, but with a corresponding increase in risk. 

Because of the flexibility in asset allocation and different investment strategies, hybrid funds are not easily comparable. When evaluating these funds, it’s important to focus on the investment objective, risk tolerance, time horizon, and management style rather than just comparing them based on past returns or a single performance metric. Each hybrid fund is designed to meet specific investor needs, and understanding the underlying strategy is key to making an informed decision. 

Disclaimer: Views expressed herein are personal in nature and cannot be construed to be a decision to invest  

The obsession of Private Equity players in buying out Indian Hospital Chains 

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On January 9, 2025

In Equity


The overall Healthcare sector, specially Hospital industry has continuously seen rise in acquisitions with various deals by private equity firms. More and more hospital chains are acquired by foreign private equity firms.  

Why there is so much surge of deals in India’s healthcare sector. These private equities firms own majority stake in some of the hospital chains. What it means for patients ? 

Let us first try to understand what a private equity firm is ? 

Private equity (PE) is a form of equity capital that prefers investing in fast paced growth companies at an early stage predominantly in unlisted companies. Private equity has several characteristics that distinguish it from other forms of investment. Some of this includes Long term investments, illiquidity, high expected returns, active management, exit strategies etc. These characteristics make private equity a special and often lucrative form of investment, but one that is also associated with considerable risks and challenges.  

Deals in Private equity 

As per various sources, Year 2023 alone saw PE firms investing $ 5.5 Bn in Indian Healthcare industry. Some of the past acquisitions include : 

* Acquired by Radiant Life Care owned by KKR 

The PE firms provide a fresh air of capital infusion for hospital chains to expand rapidly, open new facilities as well as upgrade the existing facilities. The strategy adopted by PE firms is such that they like to take control of company’s operations and management. They seek out companies with high growth potential or those needing significant operational improvements. Once they find suitable investment, they inject fresh capital. The goal of the PE firm is to increase the value of the company usually between 5-7 year period.  

After enhancing company’s performance and growth, the PE firm will eventually sell its stake through various exit strategies by way of sale to another company or through public offering (IPO). Typically the PE firm do not stay for long term.  

Hospital bed per 1000 population is a metric often used to assess access to healthcare facilities in the country. India has 0.60 hospital bed per 1000 population as per the ministry of health in 2021. In contrast studies indicate 3 hospital bed per 1000 population is close to idle. This means there is a huge gap in access to healthcare services in India there aren’t enough hospitals or medical professionals in the system to take care of India’s rising population. This gap was one of the major reason why our healthcare system literally collapsed during covid pandemic. PE deals in Indian Healthcare space has actually shot up after pandemic 

Below chart highlights PE investment in Indian Healthcare space annually since Year 2020  

Source : Bain Capital 

Global investors are seeing the gap in Indian healthcare infrastructure as an opportunity for them. Also with rising bill of surgeries, insurance penetration and lifestyle chronic disease – all this factors are expected to boost hospital revenues. 

The top 10 healthcare chains in India on the private side would still account for less than 5% of total hospital beds, resulting into a fragmented industry. While large chains are growing faster, there is still a huge runway for inorganic growth.  

Impact on the industry :  

The immediate impact is the rapid expansion of this chains with fresh inflow of funds. The hospitals are able to open new facilities and upgrade their existing facilities to enhance the services provided. However PE Firms are here for quick spurt of growth where they can actually make profit and exit. However this may not board well for patients as PE firms focusses on profit with emphasis on maximising returns leading to higher healthcare costs. PE firms have bad track record in international healthcare industry including USA. Some of the same PE firms are buying out hospitals in India. 

Based on global hospital industry phenomenon, these hospital chains have set such high standards of protocols that small hospitals won’t be able to meet. Eventually, the micro health system will vanish and only the large corporate chains will be left. Ultimately the burden shall fall on the patients. Many often patients suggest that once a hospital chain is acquired by these PE firms their hospital bill has gone up by 15-20% including consultation fees.  

On the other hand increasing PE in Indian healthcare could also mean that India can become better integrated with global healthcare industry, and become a regional/global hub for quality medical care, medical tourism related opportunities etc. If anything goes south with Indian healthcare/hospitals, PEs alone will surely not be the reason for it. PEs only respond to ‘market opportunities’ and maximize their returns.  

Performance improvement and Exits :  

CVC Capital made investment in Healthcare global in 2020 since then the cash flow from operations has jumped to ~ Rs 300 Crs from being less than Rs 100 Crs, market cap since 2020 has more than doubled. Similarly Max Healthcare has seen its market cap rise by 5x since 2018 when KKR alongwith Radiant invested Rs 2100 Crs for 49% stake. EBITDA Margins for Max Healthcare improved from ~10% in FY19 to 27% in FY23. Care hospitals saw its EBITDA rise from Rs 98 Crs in FY18 to Rs 323 Crs in FY23.

One of the most successful exits in Hospital space was KKR cashing out 5x returns when it exited Max Hospitals in 2022 in just 4 years timeframe, the most lucrative since the PE firm started investing in healthcare space. Other notable exits in the space include Carlyle exiting Medanta, Everstone exiting Sahyadri Hospitals etc 

References: 

FOF talk on Overview of Hospital Industry in India – https://youtu.be/6_CWubvfQVU?si=-pHqufIytXHYZa6Z 

Why we Overestimate the Odds of Finding Multibaggers in Smallcaps?

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On November 17, 2023

In Uncategorized

In September’s FOF, I gave a presentation on the Opportunity and Challenges in Smallcap Investing. A recurrent question post the presentation was about how Smallcaps which have become Largecaps have generated a lot of wealth and consequently doesn’t it make Smallcaps attractive? Here’s a thought many share: When we look at the list of past multibaggers, we often find that many of those stocks started as Smallcaps. This leads some to infer that the probability of a smallcap becoming a multibagger is very high.

What does the actual data tell us? Let’s define a stock that offers a 30% Compound Annual Growth Rate (CAGR) over five years as a ‘multibagger’. Analyzing past data (from 2013 to 2018) from the top 500 stocks, we find that there’s an 11% chance of any stock becoming a multibagger. Focusing only on Smallcaps, that probability rises slightly to 13%. In other words, out of 250 Smallcap stocks, only about 33 might deliver such returns. Furthermore, there’s a 16% chance of a Smallcap stock declining by 50% over five years, compared to 14% for the broader stock group. This data suggests we might be greatly overestimating the allure of Smallcaps.

But the interesting question is why do we overestimate these odds? The answer lies in a fallacy most of us fall prey to – Base Rate Fallacy. What appears to us a high probability phenomenon actually turns out to be a low probability phenomenon.

To understand Base Rates, we need to understand Bayes Theorem; a cornerstone of probability theory. And for that we need some notation. At first glance, the mathematical notation may seem daunting, but trust me, it’s quite simple and intuitive.

P(A) : Probability of event A occurring
P(A | B) : Probability of event A occuring, given that B has occurred. In other words, if we know that B is true, then what is the probability of A

Now, Bayes rule states that:

Translated to plain terms: If you want to know the probability of A happening given that B has happened – P(A|B), you can figure it out by looking at:

P(B|A) – How often B happens when A happens,
P(A) – The overall likelihood of A happening on its own, and
P(B) – Dividing those by how often B happens in general.”

A common error is to confuse P(A|B) with P(B|A). This error is also called the Inverse Probability error

Now, with this context let’s evaluate the probability of smallcaps turning to large caps.
So let’s put this in notation. We know a stock is a multibagger and we believe many of these are smallcaps. When we look at past multibaggers we find that 60% of the multibaggers were smallcaps.

P (Smallcap | Multibagger) = 0.6

It might be tempting to take this 60% as the probability that a Small Cap would become a Multbagger. But as we will see that would be a major error in estimating probabilities. When you think about it, what we really want to know is if a given stock is a smallcap, what is the probability that it will become a multibagger i.e. P (Multibagger | Smallcap)

By Bayes Theorem :

Of the top 500 stocks, half are Smallcap. So we know the probability of smallcap – P(Smallcap) = 0.5

Also, of all the listed stocks we found that approximately 11% of stocks become multibaggers; so P(Multibagger) = 0.11

Now, we have the required probabilities to calculate the probability we want

P (Multibagger | Smallcap) = (0.6 x 0.11)/0.5 = 0.13 i.e. 13%

The reason for this low probability is that the overall base rate for a stock becoming a multibagger – P(Multibagger) is extremely low (11%) and that number dominates the probability of a smallcap becoming a multibagger. Our intuition makes us focus on P(Smallcap | Multibagger) but the number that influences the end probability much more is P(Multibagger). You can try different assumptions for P(Smallcap|Multibagger) and P(Multibagger) in the formula and what you will find is that so long as P(Multibagger) is very low, the end probability will also be low.

Once you understand and appreciate inverse probabilities, you will see them everywhere. For example: many studies and books focus on very successful companies and try to identify the traits common to them. Again this is actually an Inverse Probability problem and prone to Base Rate fallacy. By starting with a list of very successful companies and then identifying a common trait, we are finding P(Trait | Success). What we are actually interested in is P(Success | Trait) i.e. if a company has a given Trait then what is the probability that it will be successful.

How can we mitigate this fallacy? When probabilistic judgements, especially for low probability events, we need to take a step back and ask ourselves whether the Probability we have calculated or assumed is what is relevant to the decision or have we estimated an Inverse probability where we need to account for base rates. By ensuring that we critically evaluate the information at hand and avoid jumping to conclusions based on intuition or selective data, we can make more informed and rational decisions.

References:

How to learn from others

By

On December 20, 2022

In Uncategorized

There is a saying – “When the student is ready, the master appears, but when the student is truly ready the master disappears.” 

Learn from Others

Those who do not have experience, learn by watching & studying others. It’s a valuable part of our development. This is exactly how kids learn how to speak or pick up a vocabulary and an accent by imitating and watching their parents. Mirroring others is an established form of learning. 

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Games We Play

By

On July 15, 2020

In Investing

A few months ago I read a very nice post by @Alex_Danco on why VC’s should play bridge. It’s worth reading & it inspired me to write from my own experience of learning this interesting card game along with my friends, during the lockdown.

For any investor it is impossible to ignore these steps, the data, the analysis, the partnership, the expectation, the execution & finally luck. 

In my view, the game of bridge is so well designed, that we get to see all these things play out in every single gameplay.

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