The Hindu Business Line : Timing the market right

With funds offering poorer downside protection now, conservative investors must be more active in their profit booking. Equally, the choice of funds and timing remain strongly relevant.

The Indian experience with mutual fund investing has, for long, been positive. Many `active' equity funds, by picking stocks outside the narrow indices such as the Nifty or Sensex, outperform the benchmarks during bull-phases, while containing declines better in a falling market. With almost all active funds, including those with a strong track record, trailing the market in the recent decline, investors are left wondering if the party is over for mutual funds. What good is a fund if it cannot protect you adequately from the downside, is what many investors are asking.

An analysis of the performance of 69 mutual funds over the past five years (August 2001 to now), against that of the BSE-200, reveals that funds outperform the indices more often than not. However, fund selection and timing of investment assume a greater role in determining the performance of your portfolio.

Performances were benchmarked against the BSE-200 on the following parameters:

Average monthly returns, risk-adjusted returns (the amount an investment returnsin relation to the level of risk it takes), consistency of out-performance over the BSE-200, lower monthly losses than BSE-200 in market downturns and lower level of underperformance than that of the index.

Business Line had undertaken a similar exercise in 2004. At that time, based on the results, we shortlisted a dozen funds that met all the criteria. Such funds had demonstrated the ability to cope with volatility reasonably well and were recommended as ideal for conservative investors who wished to build wealth steadily.

Interestingly, it has proved a lot more difficult to generate a similar list this time around. Funds now appear to carry a higher downside risks. Here are the results of our study:

Favourable odds

The analysis of fund performance, on an absolute return basis, paints a pretty picture. More than 80 per cent of the funds delivered an average monthly return higher than that of the BSE-200. On a risk-adjusted basis too, the majority of funds registered a higher return than the BSE-200.

They were also relatively consistent in outperforming the BSE-200. A majority of the funds outpaced the BSE-200 in at least 27 out of 60 months. The cut-off is based on the fact that the Nifty, as a narrow index, has beaten the BSE-200 in as many months. Typically, broad-based indices such as the BSE-200 and the BSE-500 outperform narrow indices significantly and are, therefore, tougher to beat. Of the 69, the list was pruned to 53 funds based on the above three filters. Notably, the period of analysis was dominated by a strong bull-phase, which could show the numbers in a more favourable light. Even in months when the BSE-200 declined, the majority of funds outperformed, though not by a large margin and not all the time.

Higher downside risk

Conservative investors should not, therefore, be swayed by these favourable odds. In fact, they must prepare themselves for a few performance shocks — months in which a fund loses heavily or more than the market.

It is not too hard to figure out how funds have managed such a spectacular performance against the BSE-200. Since the mid-cap rally that began in the latter half of 2004, fund profiles have become significantly more aggressive. By loading up on mid-cap and small-cap stocks, funds have been able to comfortably beat the BSE-200.

But here's the bad news. Funds have become more risky and this is beginning to show up dramatically in performance. Of the 53 funds that met the first three criteria, only two — Birla Equity Plan and Birla India Opportunities — registered lower monthly losses than the BSE-200 during market declines. When a similar exercise was conducted in 2004, a dozen such funds were identified.

Selection is important

So, if the downside risk is higher, should you switch to passively managed index funds? Not if you have a long-term horizon. This means you can relax the criteria a bit. For instance, you may permit your fund to under-perform by a small margin in some months, provided they outperform significantly in others. For instance, DSPML Opportunities has, at worst, underperformed the benchmark by 3.5 percentage points. But, some months, it has beaten the BSE-200 by as much as 6 percentage points. This is why fund selection is important.

From the 53 funds, as many as 24 compensated for the higher risk element over a longer period. Included in the list are DSPML Opportunities, Franklin Prima, Magnum Contra, Magnum Global, Reliance Vision and Reliance Growth. Had you held on to such funds through the ups and downs, you would be more than compensated for your patience.

timing matters for some

For the remaining funds, timing would have mattered, irrespective of their track record. For funds such asFranklin Bluechip, HDFC Equity, PruICICI Tax Plan, Kotak-30 and Birla Sun Life Equity, which enjoy a fairly good track record, the time of entry into the fund would have made a significant difference to your returns. Many of these funds show great returns on a point-to-point basis.

Yet an investor who bought Franklin Bluechip in 2004 would have more reason to be piqued with its performance than someone who invested in it, say, a year ago.

This is because Bluechip underperformed for a good part of 2004 and 2005, before it recorded a pick-up. But someone who invested in the fund around this time last year, may not have much reason to complain, as the performance has been well above average during this period.

Investment pointers

As things stand, investors are faced with two problems. One, funds offer poorer protection on the downside than before. This means conservative investors who cannot withstand sharp knocks to their portfolios must be more active in profit-booking.

A buy-and-hold approach works for only a few funds and you would have to be lucky to choose the right funds all the time. Most funds appear reluctant to shift their holdings to cash, though they sense a market peak, for fear of an opportunity loss.

They tend, however, to make hefty dividend payouts, which could be used as a trigger to sell a portion of your holdings. As a matter of caution, always invest in equity only money that you do not require for the next five years.

Second, the choice of funds and timing remain strongly relevant. As the analysis shows, point- to-point returns can be misleading, so choosing funds could prove difficult. This does not mean that investors should swear off active funds and switch to index funds, just to be free of the hassle of choosing the right fund.

Carefully selected active funds will continue to outperform passively managed funds over the next couple of years. Based on their performance of the past five years our preferred picks are: Magnum Contra, HDFC Top 200, Birla Equity Plan, DSP ML Opportunities and PruICICI Power, not in any particular order of preference.

Given the importance timing plays in determining the returns at the end of your investment horizon, you would be better off routing your investments through systematic investment plans (SIPs). These minimise the effects of poor timing and downside risk.

Considering that funds appear to outperform more in months when the market rises than when they fall, investing a lumpsum at the beginning of a bull market and selling at a high will certainly pay off more handsomely.

The problem with SIPs is that it makes investing go on autopilot. Convenient as this is, it is hard to keep track of your overall allocation to equity. You might end up over-investing in a bull phase (or under-investing in a market lull) relative to your preferred equity allocation.

Take SIPs for shorter periods of, say, six months to a year, so that you have a chance to evaluate market conditions and re-assess your asset allocation.

Make a mental note of your preferred equity allocation. Say, you decide that the value of your equity portfolio must not, at any time, be more than 30 per cent.

Even as you continue your SIPs, when the value of your portfolio exceeds 30 per cent, book the excess profit. When the value falls to 25 per cent of your assets, invest a lumpsum to the extent of the difference. This will prompt you to buy low and sell high.

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