Typically, you have two ways to invest in the stock market. You can either invest directly through your trading account or indirectly through mutual funds.
If you invest directly, selecting stocks and building your portfolio is your responsibility, and you are accountable for the performance of your investments. Your brokerage may guide you with its research reports and stock recommendations.
If you invest in markets through mutual funds, the fund manager, along with a team of analysts, undertakes the task of selecting stocks and building the fund’s portfolio. The fund manager is responsible for the investment performance. Your task is to choose the right funds that match your risk tolerance and help you achieve your financial goals.
Your stock brokerage receives brokerage fees each time you buy or sell a stock. It typically ranges from 0.10% to 0.50% of the transaction value. Meanwhile, if you invest through mutual funds, the fund house charges an annual management charge on your investment, which could range from 0.5% to 2.5% of your investment value. The more transactions you do, the more your stockbroker will benefit. Meanwhile, the larger you invest in a mutual fund, the more management fees the fund house can collect. However, you gain only when your investment rises in value.
Whether you invest directly through individual trading accounts or indirectly through mutual funds, there appears to be a poor relation between your benefits (investment gains) and how your investment intermediaries are incentivised (fees). In a sound incentive system, the interests of all parties should be closely aligned. Your interest and your investment intermediaries’ interest are closely aligned if the intermediaries are compensated based on the investment gains they generate for you. This type of compensation is called performance fees – intermediaries are paid fees in proportion to the returns they generate on your investments.
However, compensating investment intermediaries with performance fees also involves challenges. Even if the intermediary generates good returns on your investments, it is challenging to determine whether it was a result of skill or luck. Most stocks tend to gain in a strong market. The stocks your investment intermediary bought on your behalf will also gain under good market conditions. However, you need to pay fees only for the returns that resulted from the intermediary’s stock-picking skill, not for returns generated by favourable market conditions.
Determining how much of the gains were due to the intermediary’s skill and how much was due to good market conditions is challenging and complicated. The best possible solution is compensating intermediaries only for alpha. Alpha is the excess return the intermediary generates over the general market return. For example, if an intermediary achieved a 15 per cent return when the general market achieved a 10 per cent return, the difference of 5 per cent is the alpha. The investor needs to pay performance fees only on the extra 5 per cent gain. These kinds of fees are called relative performance fees. The incentive system for our private investment funds is primarily based on relative performance.
Ninety-nine per cent of the stocks covered by analysts from stock brokerages and mutual funds have a market capitalisation greater than ₹5,000 crores. There are around 800 such stocks listed on the Indian stock market. But every day, around 4,000 stocks are actively traded on the markets. This means only 20 per cent of the listed stocks are covered by the brokerage and mutual fund analysts. In other words, 80 per cent of the stocks, those with a market capitalisation below ₹5,000 crores, remain unexplored. We mainly focus our analysis on stocks with market capitalisation between ₹100 crores and ₹2,000 crores. During good times, small stocks can achieve higher earnings growth than large stocks due to their lower base. Moreover, small and less-covered stocks are usually available at very low valuations.
AMN CAPITAL 