FUND FLAVOUR

September 2012

If there is one element that makes a diversified equity fund evergreen in an investor’s portfolio, it is its adaptability, i.e., these schemes hold sway across the board.

The evergreen adaptor…

In 2011, the funds that hold a well-diversified portfolio and follow a defensive strategy outperformed the broader markets and even their peers in the sector and thematic category. In the diversified equity funds segment, the large cap funds category lost around 23%, mid and small cap funds lost over 25%, while those having multi-cap portfolio lost around 24% of their value on an average in 2011. The year was far worse for the thematic funds like infrastructure, power, and banking which on an average lost over 30% to 33% of their value, while those focusing on capital goods sector lost over 40% of their value in 2011. Some defensive sector funds like FMCG bucked the trend and ended in positive 8%, while Pharma funds were better-off and limited their losses to around 10%, whereas I.T. funds were supported by the spur in USD against INR and fell less than 20%. Balanced funds, belonging to the defensive category with a mix of equity and debt, on an average lost around 16% of the value. Even as equity markets were in a negative terrain throughout 2011, a good number of diversified equity mutual fund schemes can be said to have outperformed the markets, in terms of showing good resilience or curtailing their downfall. These include Magnum Emerging Businesses, UTI Opportunities, Canara Robeco Large Cap, and Axis Long Term Equity

…consolidates

In a clean-up exercise, partly prompted by regulatory pressure, mutual fund houses have eliminated one-tenth of the equity schemes in operation in 2011. As many as 33 equity funds were merged with other schemes in 2011, even as fund houses made fewer new fund launches. Fund houses have resorted to merger of narrowly defined sector funds with diversified equity funds, because the latter deliver steadier long-term returns. For instance, Franklin Templeton merged its FMCG and Pharma funds into its successful diversified equity scheme Franklin India Prima Plus in August 2011.

Quick comeback…

After a lacklustre year in 2011, diversified equity funds have made a quick comeback in the first six months of 2012. This is evident from their six-month returns as against the less inspiring one-year returns. While diversified equity funds, on an average, lost 5.5% in the past 12 months, they have gained 4.75% in the last six months.

… in 2012

Those who continued to stay invested recovered some of their losses as the markets grossed over 11% gains in January 2012 to record their best monthly performance since May 2009, according to data from fund tracker Lipper, a Thomson Reuters company. This out-performance can be attributed to fund managers positioning towards high quality mid cap stocks and low-beta (volatility) sectors. Among the top performing funds, one theme is common - their preference for mid cap consumer themes and low leverage stocks. UTI MNC Fund, SBI Magnum Gold Fund, and IDFC Premier Equity fund - all of them have exposure to consumer-oriented quality names.

Diversified funds, the largest category of stock funds in India by number and assets, returned an average of 4.8% in February 2012, according to Lipper. These funds outperformed the benchmark index, which rose 3.25% on robust inflows from foreign institutional investors (FIIs) and hopes of easing monetary policy.

Diversified funds fell 5.65% in May 2012, their worst monthly performance since November 2010 and the third consecutive month of decline, according to data from Lipper. In comparison, the main BSE index fell 6.4%.

Diversified equity funds recorded an average of 6.01% in June 2012, according to the data from fund tracker Lipper. New measures to ease the euro zone crisis and expectations that the Government may review economic reforms helped the benchmark BSE Sensex gain 7.5% in June 2012.

Stay with Diversified Equity Funds to tide over divergence

There is a yawning chasm between returns delivered by the best performing equity fund and the worst performing one. In the past five years, for instance, the top five funds each year outperformed the bottom five by anywhere between 22 and 90 percentage points. In the market rebound of 2009, the top diversified equity fund — Principal Emerging Bluechip — delivered a 147% gain to its investors. The worst performers managed less than 50%, a third of that! But return divergence is quite high in more sober market conditions, too. Take 2011, when the Sensex lost 24% in value. The same year, the top five funds contained their losses to 7% while the five biggest laggards saw their net asset values fall 45%. This is because most active equity funds invest aggressively outside of the Sensex and Nifty baskets in their hunt for that extra return.

A run-down of the return rankings over the past five years clearly shows that both the best and worst performing equity funds each year tend to be thematic funds. For instance, funds focused on MNC stocks have done exceedingly well in 2012, with returns of 14 to 18%. Those betting on infrastructure were predictably the worst performers with most suffering declines. In 2009, roles were reversed. MNC funds were laggards while infrastructure funds delivered the goods. This suggests that if you want to avoid large gaps between the performances of the funds you hold and that of the market as a whole, it is best to stay with diversified equity funds.

Equity funds as a category cannot boast of beating inflation in the last five years. Still, given the poor equity market conditions that prevailed in these years, the performance was not dismal. Diversified equity funds on an average delivered 6.2% annually in the past five years, beating the Nifty returns of 5.5% and BSE 500 returns of 4.1%. A hundred and forty diversified equity funds, excluding sector funds and index funds, were analysed for this purpose. These funds also beat the markets in the last three years. Almost 18% of the funds delivered double-digit returns in the five-year period suggesting that you would still have beaten inflation, had you held well-established funds. But at least 12% of this collection either lost value or delivered returns below 1%.

But how do you separate the wheat from the chaff?

To pick the best funds, go through their capture ratios. The best bets are those, which record a high value during the bull market and a low value in the bearish phase. To truly understand how your fund manager tackles market cycles, you will have to categorise the performance according to the bull and bear periods. This comprehensive research can be achieved by looking at the 'upside capture' and 'downside capture' of these funds.

When you invest in an actively managed mutual fund, you expect the manager to beat the broader market. So, the fund should not only capture the market's returns but also give something extra. This is indicated by the capture ratio, a simple measure that tells you how much of the market's move your fund has experienced. For instance, if during a period, the market moves up by 20% and the fund moves up by 25%, it means that the fund has captured 125% (25% of 20%) of the market's move, resulting in a capture ratio of 1.25. As the market has gone up during this period, it is referred to as the upside capture and it indicates the percentage of the market's gain that has been captured by the fund. Similarly, if the market goes down by 10% and your fund value drops by 8%, the fund would have a downside capture of 80%. This tells you the percentage of the market's fall that was captured by the fund. So, while an upside capture of over 100% indicates that a fund has outperformed the benchmark or category average during periods of positive returns, a downside capture below 100% indicates that a fund has lost less than its benchmark or category average during periods that the market has been in the red.

Morningstar India considered the up and down capture ratios for different categories of equity diversified funds from May 1, 2007 to April 30, 2012, to get a better idea of the abilities of various funds to handle different market climates. For large-cap funds, the index used for calculating the capture ratio is BSE-100 and for small land mid-cap funds, it is CNX Midcap. Based on the data, the funds have been divided into the following categories.

High upside, low downside

When you come across a fund that has the ability to not only deliver higher returns during a bull phase, but also to limit the losses during a downturn, it warrants a closer look. Consider Reliance Regular Savings Fund, a largecap equity fund, which had a high upside capture of 112% and a low downside capture of 96% during the given five-year period. In the mid-cap segment, IDFC Premier Equity has done particularly well, limiting the down capture to 74%, while giving a healthy up capture of 97% over the five-year stretch.

Low upside, low downside

Funds that can withstand downturns also make for good bets for conservative investors over the long term. The UTI MNC Fund, for instance, boasts a low down capture of 50% over the past five years and also a low up capture of 69%, yielding a healthy annualised return of 14.6%. Birla Sun Life Dividend Yield Plus and UTI Dividend Yield are some other funds that have done well on this front.

High upside, high downside

Typically, funds with a high upside are not able to limit their losses when the markets turn bearish. Consider L&T Opportunities, which has an upside capture of 113%. But the fund has an equally high downside capture of 110%. In other words, the fund has clocked big gains in bull markets, but has also suffered painful losses in downturns. Taurus Starshare, L&T Growth, and LIC Nomura MF Equity are some other funds that came a cropper while dealing with a declining market.

Low upside, high downside

This is the worst kind of fund to have in your portfolio. It not only captures very little of the market's gain during a bull run, but falls much more than the market when it is going south. For instance, JM Basic, a mid-cap fund, has had a relatively low up capture of 97% during this period, and has suffered from a very high downside capture of 137% over the same period. Among others, LIC Nomura MF India Vision Fund has shown a low up capture of 90%, while providing a down capture of 113%.

How capture ratio can help you

Investors can consider the upside and downside capture to make a smart choice while buying mutual funds. Theoretically, this can tell you if an investment is more aggressive or defensive in nature, which will help determine whether the investment is the right fit for your risk profile. You should ideally hold funds that consistently beat the benchmark in both bullish and bearish markets. These consistent performers are likely to deliver good long-term results. Investors can go through these ratios while choosing funds on Morningstar's website (morningstar.in), which displays the upside and downside capture ratios over one-, three-, five-, 10-, and 15-year periods.