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Diversified MFs: Best long-term bet
Ram Prasad Sahu | December 04, 2006
The bulls are on fire. This is reflected in the scorching growth that the Sensex has registered since 2003 with a 39 per cent return a year in the last three years and a 52 per cent return over the last one year.
Moreover, the Sensex has rebounded smartly from its June low and given a return of 51 per cent. This should be a reason for diversified equity fund investors to celebrate as a significant chunk of their monies are invested by fund houses in Sensex and large-cap stocks.
Why are they then staring at a 39 per cent average diversified equity fund return to the index's 52 per cent over the last one year?
The 13 per cent gap
Exposure to midcaps: The May mayhem put a halt on the mid-cap gravy train. The biggest gains of the chart toppers among diversified equity funds have come from the sharp price appreciation in mid-caps.
Investments in large-caps and select Sensex stocks have helped these funds recoup some of their losses, otherwise you would have had to reconcile with low double digit returns rather than the consistent 50 per cent returns that were achieved in 2004 and 2005.
Narrow rally: The gains in the benchmarks was spread across companies in the rally of the first half, but since June this year saw a few stocks are contributing to a lion's share of the increase. In the last six months the top ten contributors to the Sensex were responsible for 70 per cent (3,200 points) of the gains, while the top five accounted for half (2,300 points) of the Sensex gains.
Similarly, just six stocks in the Nifty contributed to 80 per cent of the gains. Among the show-stealers were Reliance Industries, Bharti, Reliance Communications, ICICI Bank and Infosys Technologies.
Cash compulsions: Ever since mid-caps started under-performing the markets, fund houses have been allocating a higher percentage of their corpus to take care of redemption pressures. During volatile periods, which has been the case in the last six months, fund houses either keep a higher share in cash to meet redemption requirements or to buy stocks at a lower price.
Both strategies are adopted to avoid disturbing the core portfolio, which the fund manager believes will generate the highest returns over a period of time.
Exposure limit: Diversified equity funds have a 10 per cent limit on the exposure they can take in a single stock. While there is a cap on this, the benchmark indices have just a few stocks with more than 10 per cent weightage, but these are also the same stocks that have done well.
To match Sensex returns, they need to have an exposure to stocks which have the highest weightage, which is either not legally possible or is against prudent fund management policy of diversification.
The FII bias: One of the major contributors to the rally has been the participation of foreign institutional investors. First time institutional investors typically invest in large cap stocks due to high liquidity, low volatility and risk.
Some institutions which had invested in mid-cap stocks were caught off-guard in the sell-off, and consequently preferred a defensive strategy and the safety of large caps.
This under-performance is however not limited to Indian mutual funds. Blue chip funds of reputed names in the international mutual fund industry such as T Rowe Price, Putnam Investments and Fidelity have been known to under-perform the S&P 500 over long periods.
The under-performance curse and the law of averages ensure that even the best slip. Bill Miller, rated as America's best stock-picker for having beaten S&P's 500 index for 15 years in a row, has turned out a disastrous performance this year with his $19 billion Legg Mason Value Trust Fund keeping company with the worst performers at the bottom of his category.
Indian fund managers have also found the going tough and seem to have run out of options. Says Anoop Bhaskar, fund manager, Sundaram BNP Paribas Mutual Fund whose Select Midcap Fund has turned out an eye popping 71 per cent returns this year and has been among the top performers ever since its launch four years ago, "Undervalued companies and those with low FII holdings have all but disappeared."
Lack of opportunities has meant that funds will fall back on large-caps to tide over volatile periods but in the bargain end up with average or low returns.
The investor's conundrum
All this makes the task of choosing the fund to invest difficult. In addition to under-performance over shorter periods, the top 10 diversified equity funds change with unerring regularity over various periods of time.
Apart from a few exceptions, equity funds which were the top performers over the last one, three, five and ten years do not find mention in more than one list. The only equity fund to find a place in the top 10 for the last one, three and five years has been SBI's Magnum Global '94 with returns of 67, 76 and 57 per cent a year, respectively (See table).
So, is a five-year record enough to help you make up your mind on the equity fund to invest? Not quite. Increase the investment horizon and things are not rosy as they seem. The fund's returns since inception (1994) is a measly 13 per cent compared to the 41 per cent delivered by the best performing mutual fund over a ten-year period.
Index funds as an alternative: Investors who are not too comfortable with dips and spikes in returns could look at less actively managed funds, which will give returns in line with the market and cost a lot less.
Says Mugunthan Siva, CIO, Optimix, a company that manages funds of funds, "In the long term, fund managers will beat the sensex. However, if you cannot see an alternative you could consider an index fund."
While index funds have given returns in excess of 40 per cent over the last three years, the returns for funds launched prior to August 2000 are in the range of 28 to 34 per cent. With so many options available what are the factors investors should take into consideration before opting for equity funds?
Investment horizon/objective: Not knowing the goal and the period you want to invest in could ruin your returns calculations. All it takes is one lacklustre year or a judgement error on part of your fund manager and your gains over the years could be significantly dented.
For investing in equity schemes, fund managers and financial planners suggest a minimum of five years and a goal to match the investment. Says Gaurav Mashruwala, financial planner and CEO of ACE, "The probability of losing money in equity funds is low for those with a seven-nine year horizon. For a lesser time period, debt funds are a better bet."
Irrespective of the returns given by the fund house or the outlook, investors should exit their funds once their goals based on risk appetite, return and investment horizon are achieved.
Fund philosophy: While the short term may not give you many clues, a ten-year period could give you an idea of the processes implemented at the fund house and the investing style of the fund managers.
Says Nilesh Shah, CIO, Prudential ICICI Mutual Fund, "The most important parameter to look at is the pedigree and track record of the house promoting the fund as it would speak of the discipline that is followed while making investment decisions for the fund."
What this ensures is that the manager does not take decisions on a whim but follows a prudent approach to investing based on guidelines, norms and fundamentals.
Performance: For many investors this is the clincher. Since performance can change over periods, it is imperative to define what a good fund is.
Dhirendra Kumar, CEO, Value Research says that a good fund falls less in a falling market and rises more than its peers in a rising market and for most part offers stable returns when compared with its peers and benchmark. Consistency in returns, according to him, is the only criteria that you should look at both in a declining and rising market.
His top picks based on a track record of good performance are Franklin Templeton Prima Plus, HDFC Equity, Reliance Vision, SBI Magnum Contra and DSPML Opportunities. The first three figure in the top ten mutual funds over a ten year period posting consistent returns of over 25 per cent.
Flexibility: How your fund manager reacts to the changes in the market during the year will decide the returns your scheme generates at the end of the year. The worst strategy would be to do nothing when the writing on the wall is clear.
If your fund manager continues to keep faith in the sector which has passed its boom cycle, you could be in for a sustained period of muted performance.
For example, in the absence of value picks a mid-cap fund will either have to look at companies with a slightly larger market cap or hunt for turnaround stories. In the absence of either, your patience could be tested.
While these are pointers that need to be given their due while making investments and when should the red flag be raised?
The pilot's missing
The fund manager is responsible for bringing you the dividend cheques and the capital appreciation that will help boost your income. At the time of making an investment you are betting your money on the fund manager's expertise, experience and judgement to deliver the goods. If the new manager's style is different from the one you are familiar and comfortable with, it is time to switch.
Change in flight path
If there is a change or modification in the objective of the fund then you must evaluate the decision to continue. If a large-cap fund changes course and starts investing in mid-caps, it will throw your risk-return equation out of gear and can expose you to the possibility of substantial losses.
The need to switch will also arise if a fund launches a new scheme just to garner more funds and has nothing new to offer vis-a-vis existing funds from the same fund house.
If a fund has been under-performing the benchmark and category returns on a regular basis, it is time to reconsider your investment. Says Hemant Rustagi, CEO, Wiseinvest Advisors, a financial advisory, "Review the performance of funds in your portfolio at least once a year. If there is significant under-performance vis a vis peers, switch."
Flying on a single engine
Warren Buffett is an increasingly lonely voice when it comes to the need to spread your risk vis-a-vis portfolio concentration. While some investment managers believe that a concentration strategy will help maximise returns, the risks tend to increase.
Says Ajay Argal, senior fund manager, Birla Sun Life Mutual Fund, "To avoid taking undue risk and ending up with under-performance, investors could look at a basket of options such as sector, thematic, large-caps and mid-caps."
Diversified equity funds help investors to participate in growth momentum of various sectors at a time and avoid overexposure in a few sectors. "A diversified strategy aids in bringing in stability and sustainability in returns," says Prudential ICICI's Shah.
If your fund has put all its eggs in one basket, then you should brace yourself for pockets of turbulence and may want to evaluate your options.
The way forward
Fund managers and wealth advisors say that in the long-term diversified equity funds are the best bet. Their strategy to stay afloat is one you could adopt as well if you are a new investor.
In times of high growth and bullish conditions, buy growth (thematic/mid-cap) funds to increase your returns and a diversified fund to manage risk. When there is volatility you could adopt a defensive strategy and look at large-cap funds to take care of risk, while picking up value funds to boost your returns.
In the US, a section of academia as well as fund houses like Vanguard recommend index funds strongly, citing evidence that such a passive strategy is better than active fund management, given the difficulty of stock-picking and fees.
However, in India, the case for active fund management is still strong except for the recent under-performance. Nevertheless, in order to reduce risks, investors could also look at putting a part of their investment in index funds.
Existing investors may consider opting out of their fund only if there has been a significant change in the people, processes, performance or philosophy of the fund. Short bouts of under-performance are not things to be worried about, the India story is shining and sooner than later it will show up in your favourite manager's performance.