The Hindu Business Line : A style statement for mutual funds

TEMPLETON Mutual Fund proposes to launch a fund that will invest in stocks without restriction on market capitalisation. The fund can, hence, construct a portfolio depending on the market condition. It may, for instance, overweight the portfolio with large-caps when the market is trending up and then move into mid-caps as the rally gathers momentum.

Alternatively, the fund may choose to follow value or growth style of investing. Clearly, then, such a dynamic investment style may not be preferred by investors wanting to create style-diversified portfolio of funds.

This brings to the fore the importance of disclosing a fund's investment style. At present, the average mutual fund investor in India is exposed to unintended risks because of lack of clear disclosure of a fund's investment style in its offer document. HDFC Capital Builder Fund, for instance, states that it will invest in "strong companies at prices which are below fair value in the opinion of the fund managers".

This is a typical value strategy. The average investor, however, may not be aware of it unless guided by a financial planner. Templeton Mutual fund's Franklin India Prima Plus seeks to "invest in wealth-creating companies across all sectors and market cap ranges". Should the investor interpret this to mean growth style? Style disclosure based on standard market usage is important for investors to construct meaningful style-diversified portfolio. Besides, such disclosure also helps in better performance evaluation among peer funds.

Style investing: Style investing can be defined as portfolio allocation across asset classes. Importantly, to be called a style, such an approach should be practised by a group of professional money managers. Growth and value strategies are some of traditional forms of style investing, while mid- and small-caps are the current popular themes. Investors can avoid unintended style biases if the fund clearly discloses its investment style. At the extreme, a portfolio could consist of an index fund and others that simply invest in large caps.

The investor would have then constructed a portfolio concentrated on just the large-cap style.

Style rotation: There is a compelling incentive for portfolio managers to engage in style rotation when no investment style is clearly spelt out in the offer document. Style rotation could enhance returns if the portfolio manager is able to time her entry into and out of a particular style. Otherwise, the downside risk will be high.

The problem is that investors may find it difficult to construct a style-diversified portfolio if a fund engages in style rotation. Suppose an investor buys into a large-cap fund and a value fund that is overweight on mid-caps. If the large-cap fund manager subsequently moves into mid-caps, the investor will be overweight on mid-cap style.

Such style concentration can hurt portfolio risk-adjusted returns. It would also hurt investors who want to construct style-neutral portfolio. Style rotation would also make it difficult for investors to know whether the portfolio manager is consistently adding value to the fund's style benchmark. This is important because the investors would want to know if it is beneficial to pay high management fees to generate active returns. This is not to suggest that the funds should not follow dynamic investment styles.

It is just that such funds could do well to state this fact in the offer document. Investors will then be aware the dynamic style risk.

Style indices: A laissez faire approach would be to encourage institutions such as CRISIL and ICRA to create style indices. Such indices will, perhaps, prompt fund-houses to custom-tailor funds to track such style benchmarks. An added advantage is that peer comparison becomes easier. An investor will choose a fund that has consistently added value to its style benchmark. It could help if funds clearly state in the offer document the investment style that they propose to follow. While there could be problems in positioning a fund into a particular style box, such disclosure has its benefits.

(Feedback can be sent to bvenky@thehindu.co.in)

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