Index funds outclassed

Index funds that passively track the S&P CNX Nifty and the BSE Sensex were once again outclassed by the actively managed funds in the July-September quarter. The average return notched up by equity funds for the quarter, at 24.7 per cent, was better than that managed by the S&P CNX Nifty and the BSE Sensex, which gained around 22 per cent.

What is more, investors in equity funds did not have to pick out their fund managers too carefully to beat these indices. Roughly seven out of every ten equity funds outpaced the Nifty and the Sensex during the quarter.

Measuring up to broader market

Equity funds have traditionally found it challenging to outperform the broader stock indices such as the S&P 500. But the July-September quarter provided succour on this count, too. Six out of every ten equity funds generated higher returns than the S&P CNX 500. In the April-June 2003 quarter, less than one in four funds managed to beat the S&P CNX 500 Index.

Large caps catch up

There appear to be two explanations for this trend. One, while small and mid-cap stocks led the initial leg of the equity rally, in July-September large-cap stocks, especially in sectors such as technology and pharmaceuticals, also joined the party.

As a result, the yawning gap between the performance of the Sensex/Nifty constituents and the rest of the market narrowed considerably. In the April-June 2003 quarter, returns on the S&P 500 index were a full 11 per percentage points higher than those registered by the S&P Nifty index. But this gap was down to just over one percentage point in the latest quarter.

Fund managers also deserve some credit for actively picking stocks outside of the Sensex and Nifty baskets. Many funds by now include a smattering of mid-cap stocks in their portfolio.

This apart, with fund managers looking outside of the tried-and-tested stocks to add value, the top holdings and sectoral allocations of leading funds no longer wear an identical look.

Stocks, not sectors, make the difference

In fact, the rankings of the top performing funds for July-September underscore the role of stock selection in determining returns. In the ranks of the top performers are two technology sector funds (Prudential ICICI Technology and K-Tech), one fund dedicated to pharma stocks (SBI Pharma), two funds focussed on mid-cap stocks (Reliance Vision and Sundaram Midcap) and a few diversified equity funds (Prudential ICICI Tax Plan, HSBC Equity and Reliance Growth).

There is actually very little overlap either in the portfolios, or in the investment styles adopted by these funds.

For instance, among the diversified funds, HSBC Equity Fund scored through its exposures in Indian pharma (Dr. Reddy's, Lupin) stocks and large-cap software stocks such as HCL Technologies, Hughes and Mphasis BFL. On the other hand, PruICICI Tax Plan made it to the top ten due its exposures in mid-cap stocks such as Eicher Motors, Trent and Bongaigaon Refineries.

Similarly, the two technology funds had distinctly different top holdings. While PruICICI Technology favoured stocks such as Hughes, I-Flex and Crane Software for its top holdings, K-Tech invested mainly in the frontline technology stocks such as Wipro and Infosys.

Divergence in sectoral funds

Even sectoral funds were not clustered together in the rankings, as would normally be expected. For instance, it is clear that merely investing in technology or pharma stocks would not have been enough to generate high returns during this quarter.

Prudential ICICI Technology, the top performer for the quarter, generated returns of around 42 per cent, while Franklin Infotech, was tucked away in the tail end of the first quartile with returns of 29 per cent.

Similar variations also existed between equity funds focussed on a particular universe of stocks.

While mid-cap funds Reliance Vision and Sundaram Mid-Cap were among the top performing funds, Franklin India Prima Fund and UTI's Master Value Fund, also mid-cap funds, figured much further down in the return rankings for this quarter. Both were among the top performers in the previous quarter.

Better at weathering the downside

The blip in the equity market towards the end of the quarter also provided an indication of fund managers' ability to handle a trend reversal. Though the decline of around 6 per cent in equity values between September 8 and September 23 was not particularly large in the context of the previous rise, it did take the market by surprise.

But 112 of the 134 equity funds managed to check the NAV erosion at less than the 6 per cent registered by the market.

This is no guarantee that equity funds will weather a sharper and more sustained decline in equity values with equal aplomb. But there are other indications too, which suggest that equity funds now have better risk containment strategies in place than they did in 2000.

Over the past six months, many equity funds have adopted practices such as regular dividend payouts, conservative profit booking strategies based on target prices and internal ceilings on exposures to mid-cap and small cap stocks.

Investment action

The performance evaluation of equity funds suggests the following courses of action for investors:

Actively managed funds offer a significantly better alternative to passive index funds tracking the Sensex or the Nifty. Most active funds have beaten the indices, not only this quarter, but even over a five-year period.

For investors who have missed the equity rally of the past six months and are tempted to enter equities at this juncture, investments made now could be vulnerable to any correction in market levels. But, for those willing to take this risk, routing investments through diversified equity funds may be a better option than direct equity investment.

The increasing importance of stock-picking in determining performance suggests that, from now on, your choice of fund manager can make a big difference to your eventual investment returns.

In the absence of other objective parameters to judge a fund's prospects, it may be best to stick with funds that have consistently proven themselves over two or three market cycles. Tracking manager changes closely also assumes importance.

Investing in the funds that top the return rankings over as short a period as a quarter, may be beset with risks. The top-performing equity fund for this quarter may well end up at the bottom of the pile the next.

If your fund has a poor long-term track record but has registered hefty gains over the past six months, consider this a good opportunity to clean up your portfolio.

Using profit-booking strategies, such as triggers and dividends, may be a good wealth accumulation strategy for the long term.

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