FUND FLAVOUR - SEPTEMBER 2009

FUND FLAVOUR
(September 2009)

Diversified Equity Funds

Dodged the downturn!

Funds that were positioned to be different – hi-fi, emerging leaders and the like – took a severe beating when compared to their truly diversified counterparts in the stock market bloodbath in 2008 and early 2009. Inspite of the market mayhem, a majority of diversified equity funds (53.6%) have beaten the indices. Their absolute returns might have been negative but a lion’s share of such funds have fallen less than their indices. In contrast 61.3% of ELSS Funds lagged behind their indices. The performance of index funds too have been far from promising.

Fell from grace…

Net values of diversified equity funds fell more than half in 2008, giving up the entire gain made in the previous two calendar years, as the Sensex plunged 52.4% to record its worst annual performance ever. The fall was stunning and one of the major losses that we would have suffered in any calendar year. Indian shares recorded their first annual drop since 2001, surpassing the previous worst fall of 20.8% in 1995, slammed by foreign fund outflows and a sagging domestic economy. Seventeen stocks in the BSE index lost more than half their value during 2008 as foreign funds withdrew more than $13 billion after record inflows of $17.4 billion in 2007. Net asset values of equity funds fell drastically in 2008, recording their worst annual fall of 54.7% during the year, according to data from global fund tracker Lipper.

Reuters data on Indian mutual funds asset allocation in March 2009 shows that the equity component in the asset allocation of diversified equity funds has gradually reduced from nearly 90% in April 2008 to 80% in March 2009 while the bond component has gradually increased from nearly 1% to 3% in the same period. Cash component has also increased from nearly 9% to 15%, thanks to market volatility. The market capitalisation-based break-up of diversified equity fund portfolio shows large caps maintaining their reign with their composition in the portfolio increasing from nearly 55% to 65% from April 2008 to March 2009. Mid and small caps saw their share dwindle from approximately 35% to 30% and 7% to 4% respectively in the same time period. When the Sensex dropped to a three-year low in March 2009, small and mid-cap stocks had plummeted to a near-lifetime low. While the Sensex fell by 9.5%, the diversified equity funds fell by 11%. Nearly half of the actively managed diversified equity funds underperformed the benchmark index despite maintaining a double-digit cash levels almost through the year as their large mid and small-cap holdings plunged even more than the main index. Financial services, energy, and engineering continue to be the top three sectors during the same time period with energy and engineering having swapped their places. High interest rates and a slowing economy hit these sectors and pulled down the performance of these funds.

A study by Value Research, a firm that specialises in mutual fund industry research, showed that the average returns of almost all categories of equity funds had their worst three months since January 2001. Between January and March 2009, funds belonging to the most popular 'diversified equity category', lost an average of 28.3% in value. Compared to this loss, in the first three months of 2001, all the diversified funds put together had lost nearly 17%. The January-March of 2001 was the period when the dot-com bubble burst and the Ketan Parekh scam was just unfolding. Individually, funds in the diversified category lost between 16.2% and 40.6% during the first three months of 2009 while the Bombay Stock Exchange Sensex and the NSE Nifty both lost nearly 23%.

…rose like Phoenix from the ashes

For the first time since January 2008, when the steep and protracted slide in the stock market commenced, equity funds have outsmarted the Sensex. At least half of the 277 diversified equity funds rose by an average of 33% during May 2009. Diversified equity funds have performed well because of the momentum in small and mid-cap stocks. Fund houses recorded their best performance for the year in May 2009. More than 100 diversified equity schemes registered 30-40 % growth for the month in a strong post-election rally. However, they could not keep up the pace and came up with a tepid performance in June 2009. According to Valueresearch, only 50 funds registered gains and out of this just two funds managed a growth of above 5% during June 2009. SEBI data shows that mutual funds turned in a better show in July buying equity worth Rs 22,559.5 crore, the highest in a month in 2009. During August 2009, on tepid markets, out of 281 diversified equity funds, 273 funds outperformed the Sensex while 252 funds outperformed the Nifty. The top gaining diversified equity fund was Sundaram BNP Paribas Select Small Cap, a small-cap fund, which gained 12.31 %, but it was not able to surpass the gains of BSE Small-Cap index.

Call for caution!

With markets remaining indecisive due to concerns about poor monsoon, mutual funds are slowly moving to the sell-mode. Mutual funds have net sold equity worth Rs 756.7 crore in August 2009 (up to August 17), according to SEBI data. The volatility in markets has hurt performance, with returns from diversified equity funds slipping in August 2009. Only 23 out of the 281 diversified equity funds have managed to post gains in August (till August 18, 2009). The gainers too managed to deliver only single digit returns. Valuations are a little stretched. New issues (IPOs such as NHPC) have taken out some liquidity. The strong rally of the dollar, which made people shun risk, has also played a role. Markets have given strong returns and so some amount of profit booking is happening now. Investor confidence in India has softened in recent days. Investors are worried that poor agricultural performance could derail overall recovery. Though the concern on monsoon remained, the strong industrial production data has evoked a lot of optimism and it would be too early to conclude a downtrend.

History …

In January 2000, we were cautious of the euphoria surrounding the technology-media-telecom (TMT) sector. While we did believe that the sector had a great future, we doubted if they were attractive investment propositions at such high valuations. In hindsight, we know that the companies have done very well, but on a point-to-point basis, their stock prices have disappointed. Post the TMT meltdown, the interest shifted to the pharma sector. Then mid-cap stocks and then large cap stocks followed. Now, it is back to small and mid-caps. And, of course, the theme that is the hottest now is infrastructure.

… is on our side

The one thing we know is that, well-managed diversified equity funds have been consistent performers during all these cycles. And let there be no surprise, the well-managed ones tend to underperform in times of euphoria. As the sentiment evens out over a stock market cycle, the stronger discipline and process of such funds will help them deliver the desired risk-adjusted returns. That is the way a long-term investor would want it.

Systematic streamlining holds the key

Given the performance of diversified equity funds and how domestic markets are placed, investors would do well to add well-managed diversified equity funds, with proven track records over longer time frames and market phases, as part of their core holding systematically to their portfolio.