Mutual fund companies continually file draft prospectuses with SEBI to offer active funds with different names but not-so-different investment styles. It is disappointing that these companies are not designing products to specifically moderate the risks investors are exposed to.

One such risk is the asymmetric returns effect, especially on your investment in index funds. Here, we explain why you are exposed to this risk and how it can be moderated.

Asymmetric effect

Asymmetric returns effect refers to the fact that it takes more effort to recover losses than to give up gains of the same magnitude. Consider this example. A Nifty Index fund invests in the same stocks in the same proportion as the Nifty. The index fund manager simply buys and holds the portfolio. Suppose this index fund you bought has earned 25 per cent unrealised gains. You have to redeem the units and capture the gains.

But will you? What if the market moves up substantially after you take profits? You may want to avoid regret. But consider the risk if you do not take profits. Stocks in the fund’s portfolio have to decline by only 20 per cent to wipe out unrealised gains of 25 per cent. If, however, the fund has unrealised losses of 25 per cent, the stocks should increase by 33 per cent to recover lost capital.

Now, actively managed funds moderate this asymmetric returns effect. The fund manager sells securities to capture the gains. Further, the fund manager can also pay back the gains to you as dividends when appropriate.

But index funds do not capture the gains in their portfolio as they do not actively sell securities. This exposes you to significant asymmetric returns effect.

Index strategy

One solution could be that mutual fund companies offer a class of funds that takes rule-based profits on an index portfolio. This fund will invest in the same securities in the same weights as its benchmark index. It would, however, take profits when it accumulates a predetermined level of unrealised gains.

We call such class of funds as Index Payout Funds (IPF). IPFs should offer dividend option as the default choice to moderate asymmetric returns effect. Here is how the fund will operate: Suppose the fund targets 12 per cent annual return.

The fund would then take profits in any year when the unrealised gain is above 12 per cent. That is, if the unrealised gain is 14 per cent and the fund has ₹1,000 crore assets under management, the portfolio manager will sell ₹20 crore (2 percentage points excess gain on ₹1,000 crore). The sale proceeds will be returned to the unitholders as dividends, thus moderating the asymmetric returns effect. Funds can offer sub-funds within the IPF strategy with different profit rules — say, 11 per cent, 13 per cent and so on.

Your objective would be to choose a fund whose profit rule matches your required return. IPF is different from an enhanced index fund where the portfolio manager invests in index constituents but slightly varies the proportion of some securities to generate marginally higher returns than the index.

In the IPF, when the fund manager realises gains to moderate the asymmetric returns effect in the portfolio, the proportion of some securities may marginally differ from that of the index.

What you can do

But such IPFs are not yet a reality in Indian markets. Therefore, until these are introduced, you should self-moderate your portfolio’s exposure to the asymmetric returns effect. How?

You should set a target return, review your portfolio once every year, take excess profits over the return required to achieve your life goal and invest the proceeds in bonds.

(The writer is the founder of Navera Consulting. Feedback may be sent to portfolioideas@thehindu.co.in)

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