It has been a tough few years for mutual fund investors with all schemes, barring just a handful, turning out to be laggards. One of the reasons for the underperformance is that gains have been limited to only a small bunch of stocks over the past year or so. Thanks to the credit crisis, even debt funds have not been spared. The year-end review of portfolios, therefore, would be an unnerving experience for most investors. Despite these hiccups, it is advisable that you keep calm, understand the reasons behind the divergence in performance, and take corrective actions only where necessary.
Gap between laggards and winners
Over the last three years, large-cap funds did well. But a deep dive into the performance highlights the divergence. The category delivered 11.48 percent average returns in 2019 with the best performer Axis Bluechip Fund delivering 18.57 percent and the worst performer Quant Focused Fund returning 2.98 percent, according to Morningstar data. Only a few large cap stocks marched up for two years while the rest of the markets languished. For two successive years - 2018 and 2019, the large cap category delivered 8 percentage point more returns than the mid cap category average, the widest difference in return over past ten years. Does it mean you should sell your mid-cap funds? No, and we’ll tell you why.
In 2017, mid-cap funds did well with average return of 41.56 percent. Based on this performance, a significant amount of retail money started flowing into schemes focusing on small and mid-cap funds.
The flows, however, changed course in 2019. After May 2019 and until January 2020, investors shifted focus considerably to large cap funds with investments of Rs 12,331 crore, as per data from industry body Association of Mutual Funds of India (AMFI). During this period, mid cap and small cap funds got investments of Rs 10,829 crore and Rs 8,766 crore, respectively. The inflows in mid and small cap fund categories went down significantly, except for the month of January 2020.
Though large-cap exposure has helped investors, investments in mid and small cap funds held for five years have underperformed even fixed income investments.
Why the performance difference?
Before you decide to exit any fund that hasn’t performed well, it’s imperative that you understand the reasons behind the underperformance. At any given point in time, only a few types of funds will do well, while others won’t. The cycle will turn in favour of the underdogs at some point while the star performers once might go through a slump.
Although this is not a unique phenomenon, the duration of such divergences this time around, has definitely been longer with a few stocks rising for nearly 18 to 24 months at a stretch.
Kaustubh Belapurkar, Director- Fund Research, Morningstar Investment Advisor India points out that for a prolonged period of time, value investment strategy has underperformed the growth investment strategy, especially in the US, where value- styled mutual funds underperformed over the past decade.
Some funds, though, did well because their fund managers genuinely focused on good quality and well-managed companies. “Quality, across market cap, has done well,” says Ravi Kumar TV, founder of Bengaluru-based Gaining Ground Investment Services, pointing to Axis’ equity schemes.
After the debacle of Infrastructure Leasing & Finance Company (IL&FS) and Dewan Housing Finance (DHFL), where mutual funds, banks and other creditors could not be repaid, fund managers wanted to avoid stocks with corporate governance issues, leveraged balance sheets and low growth at any cost. But, as the list of quality and well-managed companies’ narrowed, the prices of their stocks shot up and fund managers were left with no choice but to buy them even at a premium.
“In a narrow market, a few stocks did very well. Some of the better performing schemes have high allocation to such quick moving stocks,” pointed out Bhavana Acharya, Founding Partner & Head- Mutual Funds and Equities, Prime Investor.
Take the example of Motilal Oswal Focused 25 Fund. The fund has a compact portfolio of 22 stocks with top 10 stocks accounting for 71 percent of the portfolio investments as on January 31, 2020. The fund delivered 18.4 percent returns in 2019.
Gauging the nature of the impact
How a fund has managed its cash position also makes a difference. Equity mutual funds hold some cash in the portfolios to honour redemptions. This cash component can help you arrest downfall in a bear market, but in a bull market, it can hurt your performance.
As Deepak Chhabria, Founder and Managing Director, Axiom Financial Services pointed out, “Cash calls taken by Axis Small Cap fund has rewarded investors.”
Small cap stocks have been volatile. Axis Small Cap had 22 percent of its investment in debt and cash as on January 31, 2019. At the end of January 2020, the levels were down to 12.47 percent, as per the factsheet. This shows how equity funds from Axis AMC used cash as the right strategy in the recent past to limit the downside.
However, cash should not be seen as a reason of outperformance in isolation. Ashwin Patni, Head-Products, Axis AMC asserted that the AMC did not deliberately take any cash calls. “We were getting consistent inflows in our funds. While judiciously using the inflows to purchase the right stocks in a staggered manner, cash piled up. But the key to performance is stock selection,” he noted.
But cash in the portfolio has not helped all fund houses. Quantum Long Term Value Fund (QLTV), for example, had 9 percent in money market instruments as on January 31, 2020 compared with 17 percent exposure in January 2018. Over five years, QLTV delivered 1.07 percent returns – underperforming the TRI CNX Nifty 50’s 3.28 percent returns. TRI (Total Return Index) tracks the capital gains of a scheme and assumes cash distribution, including dividends by the indices, are reinvested.
“The rally took place in a few stocks with large weight in the narrow benchmark, which we did not own, due to overvaluation or corporate governance. Large cash in our portfolio and also allocation to PSU stocks also weighed on our performance. After the post-ILFS correction we bought into stocks of NBFCs and mid-sized private sector banks, which are yet to see upward movement in prices,” said Nilesh Shetty, Associate Fund Manager, Quantum AMC explaining the underperformance of the QLTV.
Quantum’s cash allocation is the residual after buying the stocks that fit our stock selection norms, he said. In the 2017 rally, some of the stocks hit our sell targets and we could not deploy all the cash due to paucity of opportunities, leading to high allocation to cash at the beginning of 2018. After the ILFS debacle, the broad markets crashed, despite a few stocks holding firm giving us many buying opportunities – reducing our allocation to cash, Shetty said.
Another crucial factor to keep an eye on is your fund’s size as that could also keep your fund slacking.
Acharya of Prime Investor attributed the large corpus size of HDFC Midcap Opportunities Fund (HMCO) to its subdued performance in recent past. It lost 13.82 percent over past one year and 0.12 percent over the past three years, underperforming the category. This, she pointed out, was because the large size of HMCO made the fund manager invest in more number of stocks. Had it been a smaller fund it could have taken focused exposure to less number of stocks, she added.
Should you be worried about underperformance?
“Investors must figure out the reasons behind the performance of the scheme,” according to Chhabria of Axiom Financial Services.
Two schemes may come from the same category but may have totally different investment style. In such a case, the investment outcomes tend to differ. Value funds are a classic example. These funds as a category have underperformed the broad market.
Take the example of L&T Value Fund (LTVF) – The fund delivered 1.46 percent over past three years, compared to 3.75 percent delivered by TRI CNX Nifty. “Since the fund portfolio is built using value investing approach, we stayed out of the expensive growth stocks, which kept on going up,” said Venugopal Manghat, Head of Equities, L&T Mutual Fund. The polarization in the stock market wherein a few expensive growth stocks kept on going up lasted for a long time, resulting in low returns for investors opting for value investing approach.
But experts say that all well-stocked up portfolios must contain some funds that pertain to the growth style of investment and some that follow a value investment approach. L&T MF’s track record in the past five years- barring recent underperformance- comes with a good vintage.
“Do not load up on any one particular investment style just because it is doing very well,” Belapurkar noted. There are times when growth has not worked in the past. For example, quality focused equity schemes managed by Axis AMC are now topping the chart. But in 2016, quality did not deliver the best returns, he pointed out.
Acharya recommends investment style diversification to the portfolio. It does not pay to keep jumping from one style to another style looking at past performance. It is better to have some exposure to ‘value focused’ funds as well, despite the underperformance; do not dump them altogether. When the growth investment approach starts faltering, we will see value-focus catching up, she said.
As the economy is at its lowest point and many stocks are quoting at attractive prices, it offers an opportunity for investors, said Manghat. He advises investors to stay put with three to five year time frame.
As the extent of outperformance recedes in the large cap space, investors may consider index funds to take large cap exposure. Low costs associated with index funds will add to their net returns. If you are seeking some outperformance then you have to take some extra efforts.
Aside from the fund’s investment style, Chhabria suggested that investors take a look at the portfolio composition. For example, Both Invesco India Contra Fund (IICF) and IDFC Sterling Equity Fund (ISEF) are value-oriented equity funds. But the IICF is a large cap oriented value focused fund with 64 percent exposure to large cap stocks whereas the ISEF has only 13 percent exposure to large cap stocks. Exposure to both these funds may deliver different outcomes.
Investors need to factor in diversification in terms of geography, market capitalization, investment style, and fund size in their equity portfolios. Not all your schemes will deliver at all times, but overall your portfolio will deliver healthy risk-adjusted returns, if you stay patient and consistent with your investments. In no circumstances, should you chase performance.
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