Level 1-5 investing

Understand what you are truly investing in. 

The concept of Level 1-5 Investing helps explain what you are truly investing in, when you select an investment fund (MF, PMS & AIF). 

The typical issue is that often investors focus on evaluating funds in isolation, as compared to understanding that they are only vehicles that give you ownership in underlying companies (debt or equity), the performance of which is driven by growth & trends of the economy that these companies operate in. A fund’s performance is accordingly directly linked to the growth of the underlying businesses, economies & economic trends. This perspective can make all the difference, in terms of how we select funds and construct your portfolio.

The 5 Levels of Investing

Working Backwards & the Importance of Each Level

Smart investing works backwards. You need to focus the bulk of your energy on the Level 3-5 exposures you desire (the kinds of companies, economies & economic trends that you wish to invest in), and then with the help of your investment advisor (Level 1), identify the Level-2 funds that will give you those Level 3-5 exposures.

This approach leads to a much superior portfolio, as compared to a portfolio built focusing on fund selection.   

Every Level has it’s own Importance!

Many investors use a financial advisor or wealth manager who helps them with fund selection and how their wealth is to be managed. Advisers have a large impact on how funds are allocated, hence this becomes a critical decision for every investor.

The right wealth manager will have

  • Deep expertise about the funds in the market
  • A detailed insight into your financial needs
  • An ability to identify the funds that are the best suited for your needs

Investment Funds (MF, PMS, AIFs etc) are investment vehicles that allow you to hire a professional fund manager to make investments in underlying financial securities (Level 3) on your behalf.

The most important decision to be made here is ensuring that the funds that you choose with your Relationship Manager, are managed by AMCs/Fund Managers that truly have the depth of expertise & experience in that type of fund. For example, if you desire to invest in small-caps, it is better to go with a small-cap specialist PMS/AIF, as compared to more generic Mutual Funds.

The capabilities & experience of the investment fund are often more relevant than the past track record (which can often be misleading, especially if studied without understanding the environment in which this performance was delivered).

While you invest in a fund, the fund in turn invests in underlying securities (equity or debt). These underlying securities represent your true exposures.

There are pros & cons of different types of companies. Larger companies are more stable, but may not grow as rapidly as smaller companies. Higher quality & more established firms are typically more expensively valued. There are more stable and volatile types of businesses. Certain types of companies are more exposed to certain types of risks than others.

A great (and often neglected) way to protect yourself from economic volatility is geographic diversification.

What often happens is that people tend to have 100% concentration on one geography – but this is risky because all your wealth creation is wholly dependent on a single economy. This includes exposures to the risks that a country has (political, forex, policy, geo-political etc).

This kind of concentration can work if an economy truly demonstrates growth outperformance. However, diversifying your investment portfolio to international economics not just minimises risk, but it also taps the potential of those geographies to outperform.

In our experience, this international diversification is either overlooked or given very minimal allocations in investor portfolios.

Every economy has certain underlying trends that are its core drivers of growth. Companies that are exposed to these growth trends tend to deliver exponential value creation, a benefit that investors can avail of by having large allocations to specific trends.

Concentrated investments in trends (Level-5) is a more intensive form of investing and may not be ideal for a large segment of investors. The return volatility & dependence on particular trends playing out, make this much riskier than normal diversified investing via conventional funds. However, it is here that well timed investments can yield to substantial wealth creation.

Level-5 investing is best achieved via direct-equity investing, but this is a sophisticated skill set, making it unviable for non-investment professionals.

The Problem of Over-focusing on Level 2 Fund Selection

Unfortunately, most relationship managers & investors end up over focusing on analysing Level-2 funds, resulting in all forms of fundamental portfolio construction errors including: 

  • Spending time asking the wrong questions: Too much of investor-advisor conversations tend to be focused on Fund A vs Fund B, as compared to questions that are much more material to wealth generation (the right types of companies, the right economic exposures, exposures to specific economic trends)
  • Confusing real hard assets for volatile NAVs/fund performance): When you invest in a fund, you are ultimately investing in part ownership of businesses in an economy & sector. Business ownership is a highly tangible & real asset. If investors were to look at their investment portfolios in the right manner (ownership of real businesses) their investment behaviour & discipline would be substantially superior to when they look at this as volatile NAVs of paper financial securities. 
  • Meaningless Diversification: Investing in multiple funds (for example 4 large-cap funds, all giving you exposure to similar blue chip companies in India), as compared to true diversification (4 funds – one India large-cap, one India mid-cap, one US technology, one Indian sectoral fund)
  • Focusing on fund performance in isolation: The most common way of selecting a fund is to look at its performance. This often leads to a problem of investors getting into funds at the wrong time. For example, investors made large allocations to small-cap funds in 2017 & 2018 driven by very strong past performance, not recognising that the small-cap rally had possibly over-extended and the larger impact of the IL&FS funding crisis on smaller companies. Such investors accordingly saw large losses as small-caps corrected.