Navigating the Uncharted Waters of Unaudited Return Profiles: Challenges and Solutions for India

Introduction

In the world of finance, a brewing conflict has emerged between the Indian regulator, platforms like Smallcase, Registered Investment Advisors (RIAs), and the ever-present Finfluencers. The central issue revolves around the disclosure of unaudited return profiles and using that to attract gullible investors. To fully understand this conflict, we must explore the core challenges and intricacies involved in the valuation process and provide audited results for stock portfolios.

Part 1: The Challenge with Spectacular Returns

Validation of Claims

• The absence of a neutral third party for claims validation leaves room for unchecked assertions.
• Financiers have the ability to retrofit their portfolios to showcase past successes as current returns, potentially misleading investors.
• The lack of a model-based or rule-based approach in presenting backtested results raises questions about the reliability of the data.
• Platforms accepting these claims at face value and presenting them to unsuspecting users can perpetuate misinformation.

Part 2: Real Issues and Regulatory Challenges

Legitimacy vs. Fraud

• The regulator's struggle to differentiate between legitimate claims and fraudulent manipulations.
• Investors are left in the dark, with many Finfluencers and Portfolio Management Services (PMS) operating for only a few years, making it challenging to gauge their long-term performance.
• Investors, often new to the intricacies of financial markets, may mistake backtested results for actual portfolio performance, potentially leading to ill-informed decisions.

And for the "Unaddressed Aspects" section:

• The silence on market impact in the context of larger portfolios is a crucial issue, as large trades can influence market dynamics. The Finfluencer or PMS service will not be able to replicate the same results on a Rs. 100Cr. portfolio what they can achieve with a Rs. 10 lac portfolio.
• Neglect of transaction costs, which can significantly impact the realized returns.
• Tax implications in strategies involving frequent portfolio churn, such as short-term capital gains. The STCG taxes are higher than the LTCG taxes.

Risk vs. Return

• The emphasis on performance over risk by both Finfluencers and established services raises questions about the overall risk profile. What is the max drawdown of a portfolio? How does it behave in a bear market vs. in a bull market? None of these questions are addressed.
• A call for standardized risk terminology to define risk categories is crucial in ensuring investors understand the potential risks they are undertaking. Many PMS managers make vague claims that their portfolios are medium risk. What does that even mean? On what basis is one making the claim that their portfolio is medium risk? By default, equity investors are taking a lot of risk. In case of a company failing, equity HODLers will be the last in line to make any claim. So, how can they tout a momentum-based equity portfolio with not more than 20 names that claim to be medium risk? There has to be a standard language to define every risk category.

Part 3: The Role of Platforms Like Smallcase

Disclosure and Transparency

• An RA or RIA wants to showcase their performance. It is the responsibility of a platform like Smallcase to ensure these risks are disclosed in bold.
• If Smallcase wants to continue to be the intermediary, they need to be more stringent when it comes to disclosures.
• They cannot accept any time series data of returns as backtested results.

Risk Assessment and Portfolio Viability

• They need to impose market impact costs to every fund that wants to showcase their portfolio on their platform.
• The assumption should be that the strategy is viable for a reasonable-sized portfolio, and not just a small portfolio. At the minimum they need to disclose based on what sized portfolio is someone making a claim about their returns.
• The AUM, and portfolio size should be displayed in bold letters.

Portfolio Metrics and Risk Management

• They also need to independently calculate max drawdown, Sharpe ratio, realized volatility of the portfolios.
• They also need to disclose what percentage of the portfolio constitutes the top five positions in the portfolio. If the top five positions constitute over 50% of a portfolio, it is far more risky compared to someone who has only 20% in the top five positions.
• Remember concentration is a double-edged sword. When you are right, you make a lot of money, but when you are wrong, it works the other way.
• What kind of controls that an RA or RIA have in terms of sticking to their strategy. What do they do when their strategy fails? Do they start deviating from their goals?

Derivatives and Nonlinearity

• Next comes portfolios that use derivatives. What kind of leverage does a portfolio employ to generate the said returns.
• How much does it lose in theta decay?
• What is the worst-case scenario in case the underlier moves 10%, or 20% against you?
• Is the PM juicing up her performance by selling naked options?
• You need to capture the nonlinearity embedded in your portfolio by performing a full revaluation of all derivatives positions at various stresses to the underlying position. To elaborate, if you have sold a call on ICICIBank with a strike price of 950, see what kind of losses you would incur if the stock price of ICICI jumps to 1050. This kind of valuation needs one to have a sophisticated options valuation engine.

Conflict of Interest

• Last but not the least, why does Windmill Capital sell its portfolios on its platform? Isn’t that a conflict of interest? What we need is a company that can become a fund administrator whose job is only to monitor, value, and assess all the funds. You can’t have the fox guard the barn. Smallcase needs to decide what they want to be? An independent assessor or a manager of small cases. You can’t be both given the regulatory questions that are coming up.

The Role of Backtesting

Backtesting is a fundamental tool for investors, but certain misconceptions need clarification:

1. Unrealistic Expectations: When SEBI mentions someone touting a 300% return in one year, it's likely an exaggeration, often based on retrofitted positions to paint a rosy picture. Backtesting should not be abandoned; it's a basic tool for serious investors.
2. Being True to Oneself: The key is honesty. Hindsight investments, like betting on NVDA at a specific low price, don't constitute legitimate backtests. Instead, consider a scenario where investments are based on specific criteria, like the top 10 names traded on NSE with the lowest RSI, forming a valid case for robust backtesting.
3. Rule-Based Approach: In legitimate backtesting, one specifies the rules for the engine to follow and observes the results. This approach is crucial in making informed investment decisions, especially for investors without the means to make automated decisions.
4. Transparency and Validation: For credible backtests, the system should generate detailed holdings data for users to review and validate independently. Additionally, the system should calculate important risk metrics to provide users with a clear understanding of the associated risks.

The Media's Responsibility

The media's role in this context is impartiality. It should refrain from taking sides and instead focus on progressive solutions:

• Objective Reporting: In addressing challenges, it's essential to seek solutions rather than outright bans on activities.
• Biased Reporting: Biased reporting, where a single viewpoint is celebrated, hinders a well-functioning capital market. Such practices should be discouraged.

The Regulatory Landscape

The regulatory environment should aim to facilitate market accessibility for all, rather than deter small investors:

• Past and Present: Despite changes over the years, India's derivatives market still lacks diversity in traded names. The securities lending market remains underdeveloped.
• Barriers to Entry: The size of a single contract on NSE poses challenges for most investors, limiting participation to HNIs and institutions.
• Regulatory Goals: Regulators should strive to ease these barriers and enable small investors to engage in these markets. Restricting markets isn't the answer.
• Seeking Innovation: Regulators should focus on innovative solutions that foster market growth, recognizing the abundance of talent in a country with 1.4 billion people.

Conclusion

In conclusion, a well-functioning capital market requires a responsible media that promotes unbiased reporting and regulatory bodies that prioritize innovation and accessibility. It's crucial to address challenges through progressive solutions rather than stifling market opportunities. By doing so, we can create a more inclusive and dynamic financial landscape for all.