The Hindu Business Line : Re-building your fund portfolio

Funds have had to take more risk to outperform, as a result of which they now offer less protection on the downside vis-À-vis the market. But there are still ways to reshuffle your portfolio to preserve wealth.

Shanthi Venkataraman

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Too afraid to even look at your equity fund portfolio? Scary as it sounds, it is time to open those excel sheets and assess the damage that the nearly 40 per cent market correction has wreaked on our equity fund portfolios. The verdict is not good.

Most funds have failed to contain declines, even to broad market levels; several have almost completely erased the gains made in the manic rally in the second half of 2007. How should investors view this underperformance? What lessons can we learn on portfolio construction from the recent market correction? Here’s a look at some fund investment strategies in the wake of the market downturn.

A case for ETFs?

For investors entrusting their money to professional money managers, the fact that most equity funds have declined much more than the Sensex or Nifty must come as a big disappointment. Should one just invest in index funds, which passively mimic the behaviour of the Sensex or Nifty and are devoid of the risks of stock selection associated with actively managed funds?

It is true that active funds are finding it increasingly difficult to beat the market. Historically, more than 80 per cent of Indian funds have beaten the indices. However, the proportion of funds that outperform the market has declined to about 40 per cent in the last couple of years. Years 2006 and 2007 were marked by heightened volatility and a narrow rally in large-cap stocks, creating a challenging environment for fund management.

Funds have had to take more risk to outperform. The fallout of this is that they now offer less protection on the downside vis-À-vis the market than earlier. Only about 20 from the over 150 funds checked declines to less than 30 per cent in the 2008 correction.

These challenges to performance are likely to remain. However, there are reasons why you should still invest the bulk of your portfolio in active funds. For one, top performing funds in the diversified category have, year after year, outpaced the market return by 10-20 percentage points. Such outsized returns make it hard to ignore active funds.

Second, the bigger opportunities for wealth creation in the long-term lie outside the 50 stocks of the Nifty. There is an absence of exchange traded funds or index funds that track a broader range of stocks in India.

Strategy: Considering that funds outperform significantly on the upside, but offer lower downside protection, investing in active funds when you are bullish and switching to equity ETFs (exchange traded funds) when you start to sense a peak, may be a strategy worth considering. This way, you can ride any upside, but limit your downside to the extent of the market fall.

Although you should continue investing in actively managed funds, you may have to evaluate your active fund portfolio more often. Book profits on riskier funds (theme funds, mid-cap funds) frequently and re-balance your portfolio actively to preserve wealth. If this sounds like too much work, think of the difference an additional 5 per cent return every year over the market can make to your wealth over the years.

Diversified funds rule

If you find that your portfolio has taken a nastier cut than the market, check out its composition. Do you have a high exposure to mid-cap and theme funds? That could explain why your portfolio is down almost 50 per cent year to date, when the market is down 35 per cent.

For instance, a large exposure to infrastructure funds may have exposed your portfolio to significant downside. Infrastructure funds have declined by an average 45 per cent year-to-date, while diversified funds have shed an average 35 per cent.

Barring some of the early entrants in the infrastructure space such as ICICI Pru Infrastructure and Reliance Diversified Power, most funds have turned in negative returns, even on a one-year basis. More importantly, their performance has not kept pace with several diversified funds over a two-year period.

The majority of new fund offerings in 2006 and 2007 were theme funds that focused on infrastructure, gold, commodities, international investing, contrarian investing, lifestyle funds and so on.

While it is good to add variety to your portfolio, subscribing to every new, “offbeat” theme may lead to heavy exposure to risky products. That is not good, as “hot” themes are the first to wilt under bear pressure, as is evident from recent fund performance.

Strategy: If theme funds account for more than 30-35 per cent of your portfolio, it is time to re-shuffle your holdings. Hold only one or two infrastructure funds with a good track record and exit the others.

In this market, we advocate loading up on diversified funds — funds that do not have a particular sector(s) bias. One, given the volatile nature of the market, it is better not to place your bets on any single sector.

Second, given that there are earnings concerns across sectors, this is likely to be a stock pickers’ market, meaning that stock selection, rather than sector selection, would be the key driver of out-performance.

Choose funds with a good long-term track record. HSBC Equity, DSPML Top 100 Equity and Sundaram Select Focus have outpaced the market by a significant margin over the past year, thanks to superior stock selection.

Use dividends to cash out

Wishing you had booked profits earlier? You might have been better off had you opted for the dividend payout option on your equity funds. This would have forced you to cash out on the market rather than hold on to your units indecisively when the Sensex was at 18k-21k.

Most leading fund houses declared dividends for their flagship funds between January and March this year. Funds such as Franklin Templeton and Kotak Mutual Fund declared dividends in early January, close to the peak, thus protecting unit-holders from further downside.

For investors with a long-term horizon, we would normally recommend opting for the growth option, as it helps compound your returns at a higher rate. But if you are not the kind to monitor performance and actively book profits on your portfolio, then the dividend option may be more advisable.

Funds normally declare dividends only out of profits on the portfolio after a rally; there is no guarantee of an annual dividend. Receiving dividends forces you to re-balance your portfolio, if your equity assets have appreciated considerably.

The dividend option also allows you to cash in on your investments in a tax-efficient manner, as dividends from equity funds are exempt from tax. The alternative of selling units is more expensive in the short term, as sale of mutual fund units within a year is subject to capital gains tax of 15 per cent.

Phase investments through SIPs

With its increasing choppiness, it is becoming quite impossible to time the market. Systematic Investment Plans (SIPs) are not the best options for a steadily rising market, as you are postponing investments. But they do minimise the impact of bad timing on overall wealth. If you had invested through SIPs since January, your portfolio would have declined by 15-20 per cent, on an average, as against 30-40 per cent in the case of a lump-sum.

Investing in SIPs may also be the appropriate course of action right now, given that more volatility may be in store.

With a “v-shaped recovery” appearing unlikely, you now have a longer period to build your portfolio without the fear of missing out on the rally. So, if you are looking to add equity funds at this juncture, you can opt for an SIP instead of investing in one big lump-sum.

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