How prepared are they?

Now that the stock market has begun correcting, we analysed the performance of some equity funds to pick out the hardy performers

 

The prolonged bull market over the last few years had taken stock prices and their valuation to unsustainable levels. Now that the much-awaited correction is finally here, investors must be wondering if the money they have parked in mutual funds is in safe hands.

We tried to answer this question in two ways. One, we looked back at the past corrective phases to assess which funds managed to weather the bouts of volatility relatively well. Two, we analysed the portfolio moves made by various funds to see which funds tried to brace themselves against the imminent volatility.

According to Bloomberg data, over the last one year, the Nifty 50 Index traded at record valuations — with the trailing 12-months PE multiple in the 21.5-24 times range with the average of 22.8 times. The valuation of its midcap counterpart was much higher, wherein the PE multiple of Nifty Free Float Midcap 100 index was in the band between 28 and 51 times. The BSE small-cap index traded at an even more stiff valuation; ranging between 50 and 236 times with the average of 113 times in the last one year period. Did fund managers take note of these crazy numbers? What did they do to protect investor returns?

To answer these questions, we analysed 190 equity diversified funds ,including large, mid, small and multi-cap funds. These are actively managed funds with total corpus of ₹5.15 lakh crore (as on December 2017), representing around 60 per cent of equity AUM of the mutual fund industry of ₹8.94 lakh crore. We have excluded other equity-oriented funds such as arbitrage, equity-oriented balanced funds, index and ETFs for the study.

 

Facing the bear

A comparative study on the performance of the funds during the previous bear phases throws some interesting insights. We chose three bear phases in the domestic equity market for this study; the periods between January 2008 and March 2009, November 2010 and December 2011 and, January 2015 and February 2016.

Some key takeaways

One, funds that contained the loss well during these phases mostly increased allocation to defensive sectors such as pharma, FMCG and IT. Two, funds that followed the dividend yield and value investment strategy managed to cushion their losses better compared to the other funds. Three, funds that invested in the MNC and consumption theme also withstood the market fall well. Four, cash calls played an important role in containing risk. Funds that held more cash, undoubtedly managed the bear markets better. Five, higher or increased allocation to large-caps also helped weather the downturn relatively better. Above all, these funds continued to maintain momentum stocks/sectors in their portfolio during the downturns, such as banks, refineries and telecom services, which helped them generate better returns when the market recovered.

 

The 2008 crash was the most severe leading to heavy erosion in fund NAVs. The declines in 2010-11 and 2015-16 were shallower. Factors that led to the declines in each of these phases were also different. But the ability of fund managers to read the warning signals when the market peaks and to take corrective steps, can reduce losses to some extent. Few funds have displayed this ability.

Among the large-cap funds, Franklin India Bluechip, UTI-Equity and ICICI Pru Focused Bluechip Equity Fund were the top performers and part of the top quartile in all three bear phases.

Among midcap funds, Mirae Asset Emerging Bluechip, IDFC Premier Equity and HDFC Mid-Cap Opportunities Fund contained the loss well and were part of the top quartile in at least two bear phases.

 

Small-cap funds typically find it difficult to contain losses in market corrections since the impact cost is highest in this category. However, SBI Small & Midcap Fund from small-cap category managed to put up a better show in the market downtrend in 2010-11 and 2015-16.

Two MNC funds from UTI and Aditya Birla MF stables, Aditya Birla SL India GenNext Fund and BNP Paribas Dividend Yield Fund were the top performing funds in all the three bear phases from the multi-cap category.

 

However, only few funds that had performed well in bear phases delivered higher returns when the market recovered. ICICI Pru Focused Bluechip Equity, UTI-Equity Fund, Mirae Asset Emerging Bluechip, Canara Robeco Emerging Equities, Aditya Birla SL MNC, Aditya Birla SL India GenNext Fund and Reliance Small Cap Fund managed to perform well in both the bear and bull phases.

Who made the right moves?

Given the signals flashing red on the current rally over the last few months, will fund managers take any corrective action to contain the downside, if this correction prolongs? Few funds appear to have taken steps to protect their returns from volatility. While the long-term returns of funds are more important in fund selection, you can keep these factors in mind while making your investment decisions.

Stock diversification

Some funds reduce the risk of higher market valuation through diversification strategy. They need to stick to specific mandates that will not allow them to retain higher cash positions. To address this, they have simply invested in a larger number of stocks and owned a more diversified portfolio, without upping their cash holdings.

For instance, Reliance Growth Fund (from 52 to 80 stocks), IDFC Sterling Equity Fund (from 51 to 81 stocks), IDFC Classic Equity Fund (from 61 to 83 stocks), Principal Emerging Bluechip Fund (from 70 to 87 stocks), DHFL Pramerica Large Cap Fund (from 38 to 54 stocks), DSPBR Micro-Cap Fund (from 72 to 87 stocks), ICICI Pru Top 100 Fund (from 38 to 53 stocks) and Reliance Top 200 Fund (from 37 to 52 stocks) have added more stocks to their portfolios over the last one year period. While diversification reduces the downside, a broad-based correction in the markets will still impact such funds.

There are many funds that have diversified their portfolio by expanding geographically. For instance, Aditya Birla SL Dividend Yield Plus increased exposure from 1 to 2 per cent in overseas equity while Franklin India Prima Fund included overseas equities (0.4 per cent) in 2017.

Apart from these, there are other equity diversified funds having slight exposure to international equities, including HDFC Large Cap Fund (3 per cent), Franklin India Prima Plus Fund (1.2 per cent), IDFC Focused Equity Fund (1.9 per cent) and SBI Contra Fund (4 per cent).

Increasing allocation to large caps

Given the steep valuation in the mid- and small-cap space, many fund managers have turned cautious and pruned their exposure to mid- and small-cap stocks, while increasing allocation to large-caps in the last one year. Some funds that have reduced mid- and small-cap exposure over the last one year are L&T Midcap Fund (11 per cent from 44 per cent), Canara Rob Emerg Equities (14 per cent from 46 per cent), Tata India Consumer Fund (5 per cent from 33 per cent), Sundaram S.M.I.L.E Fund (62 per cent from 88 per cent), DSPBR Small & Mid Cap Fund (16 per cent from 36 per cent).

Low PE and higher dividend yieldsare defensive now

FMCG and pharma sectors were the preferred choices of fund managers when equity markets were experiencing the downtrend. The stocks in the FMCG and pharma sectors withheld the market shocks well when other sectors were swayed by market turmoil.

However, in the recent period, FMCG and pharma sectors lost their sheen due to structural headwinds. The FMCG sector registered a dismal growth over the last two years due to demand slowdown, demonetisation and GST. The Indian pharmaceutical industry has been also going through a tough phase over the last couple of years. Major pain points such as regulatory issues in the US market and pressure on drug pricing in the key markets have continued to weigh on the revenue and earnings of pharma companies.

With prospects of defensive sectors not too favourable, fund managers adopted stock specific approach to contain the downside risk — picking stocks with low PE, high dividend yield and low leverage.

Increasing cash level

One of the strategies that funds adopt to mitigate risk in overheated markets is to hold a portion of their assets in cash. Increasing cash holding can help contain downside if the market turns volatile and help funds take advantage of attractive buying opportunities when there is a recovery.

Many funds, over the past year, have increased their cash holdings. For instance, among the schemes with the corpus of more than Rs 975 crore, Indiabulls Blue Chip Fund (11.5 to 24 per cent), Parag Parikh Long Term Value Fund (8.7 to 20 per cent), HDFC Small Cap Fund (5.6 to 14 per cent), L&T Emerging Businesses Fund (6 to 12.6 per cent) and ICICI Pru Top 100 Fund (4 to 10 per cent) have upped their cash levels substantially between December 2016 and December 2017.

Fund managers follow different approaches while managing the cash level. For instance, Parag Parikh Long Term Value Fund follows stock-specific approach — sitting on cash till they get better entry valuation in specific stocks. The fund uses the cash by deploying it in arbitrage opportunities in the market. ICICI Prudential Dynamic Plan has the flexibility to move from a 100 per cent equity portfolio to a 100 per cent debt/cash portfolio. As of December 2017, the fund had 32 per cent of its assets in cash.

Many funds also decreased their cash level in December 2017 compared with December 2016, showing optimism over the market up movement. For instance, IDFC Classic Equity Fund (from 14 to 2.6 per cent), Reliance Retirement Fund-Wealth Creation (15.4 to 5.2 per cent) and SBI BlueChip Fund (14 to 2.6 per cent) have reduced their cash levels substantially between December 2016 and December 2017.

Managing copious inflows into funds amid sky-rocketing valuations is not easy. Some equity funds stopped accepting fresh lump-sum subscriptions and SIPs too, as they found it difficult to deploy the large inflows into available opportunities in the market. For instance, SBI Small and Mid-cap fund, DSP BR Micro Cap fund and Mirae Asset Emerging Bluechip Fund either capped lump-sum or new SIP investments.

The average cash level at large-cap, mid-cap and small-cap funds were 7, 5.4 and 6.5 per cent respectively by December 2017, while multi-cap funds held 4.5 per cent in cash.

Few other trends that emerged from the portfolio churn of funds in the 2017 are:

Stocks with low PE and higher dividend yields were the preferred choices. For instance, National Aluminium Company, in which the equity diversified funds increased holding from ₹89 crore to ₹678 crore in the last one year period sports one-year average PE of 25 times, while its sector’s one year average PE is 43 times. The stock’s latest dividend yield is 4 per cent while its sector’s average dividend yield is 0.7 per cent. Similarly, other stocks such as Cyient Ltd, Chennai Petroleum Corporation, Oil & Natural Gas Corporation, Allcargo Logistics Ltd, Larsen & Toubro Infotech, Vijaya Bank, Tata Steel and Hindalco Industries were also value buys with higher dividend yield.

There is a notable shift to insurance and asset management companies under the finance space in the last one year period. These companies include ICICI Lombard General Insurance, SBI Life Insurance, HDFC Standard Life Insurance, Bajaj Finance, AU Small Finance Bank Ltd. Mutual funds were also active participants in many IPOs last year.

Many funds appear to have bet on a revival in construction and real estate. For instance, Godrej Properties, NCL Industries found favour with funds. There is a growing allocation to rural and agri stocks as well. Hatsun Agro Product, Dabur India, Jain Irrigation are some stocks belonging to this theme, that funds preferred.

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