Don't Blame Mutual Funds

“I invested my retirement monies in mutual funds in 2006. All my investments are showing a loss. I will never invest in mutual funds again”

“I chose mutual funds to create a corpus for my daughter’s wedding. The investments I made in 2007 are languishing at half the value. I regret investing in mutual funds”

These are some of the testimonials that routinely appear in newspapers and television shows nowadays. While the facts of each case differ, the underlying message is the same - mutual funds are to blame for all investor woes. Although slamming mutual funds (equity funds in particular) is in vogue at the moment, we believe there is a case for adopting a more pragmatic approach while evaluating mutual funds and the investment proposition they offer.

Simply put, equity funds offer investors the opportunity to invest in equity markets in a convenient manner. The onus of making investment decisions (which requires a fair degree of expertise and experience) is shifted to the fund house and the fund management team. And for availing the fund house’s investment expertise, the mutual fund investor bears a cost in terms of loads and fund management fees.

Mutual funds also offer investors the benefit of diversification. For instance, a diversified equity fund typically invests in several stocks from across market capitalisations and sectors. Hence despite investing in a single fund, the investor benefits from the presence of a number of stocks in his portfolio.

So what went wrong?
Few would dispute that mutual funds offer investors an attractive investment proposition. So what went wrong? Nothing. While the investment proposition offered by mutual funds remains unchanged, market conditions have changed. After witnessing an almost secular bull run for nearly 5 years, the stock markets crashed sharply in 2008. From their peak in January 2008, markets have fallen by over 50% till date. Mutual funds being market-linked avenues have expectedly borne the brunt of the falling markets as well. For investors who became habituated to seeing their mutual fund investments clock attractive growth in a seamless manner, the crash in stock markets (and its severity) has come as a rude shock. As a result, mutual funds are being seen as villains and harbingers of misfortune.

At the core of this problem lies lack of complete and accurate understanding of the investment proposition offered by mutual funds. For instance, in several cases, distributors and investment advisors failed to impress upon investors the risks involved; instead, they were guilty of only emphasising on the returns aspect. Then there were instances of mis-selling as well. Investors with modest or no appetite for risk-taking were persuaded to get invested in equity funds and at times even in sector/thematic funds (which are typically suited for informed and risk-taking investors). Finally, investors need to accept a share of the blame as well, for having failed to make informed investment decisions.

Is it curtains for mutual funds?
Given the kind of doomsday scenario predictions that are doing the rounds, several investors are being led to believe that it’s the end of the road for mutual funds. Is that a correct assessment? We don’t think so. Let’s take a look at the performance of some well-managed diversified equity funds with a 5-Yr track record. From the diversified equity funds segment, we have chosen a motley mix i.e. large cap, mid cap and opportunities style funds.

Diversified equity funds: Long-term players
Equity Funds NAV (Rs) 1-Yr 3-Yr 5-Yr
DSP BlackRock Top 100 (G) 49.90 -46.1% 9.2% 20.4%
HDFC Top 200 (G) 90.17 -46.3% 4.8% 19.9%
Sundaram Select Midcap (G) 59.49 -58.4% 2.3% 19.8%
Sundaram Select Focus (G) 50.87 -52.5% 8.7% 19.7%
HSBC Equity (G) 58.64 -48.8% 5.0% 19.3%
ICICI Pru. Dynamic (G) 48.62 -46.2% 6.2% 18.5%
HDFC Equity (G) 107.92 -50.6% 1.1% 17.7%
DSP BlackRock Opp. (G) 39.44 -54.5% 0.9% 17.1%
Franklin Bluechip (G) 99.08 -49.1% 3.4% 16.4%
Sundaram Growth (G) 48.93 -57.2% 1.0% 15.2%
BSE Sensex -52.4% 2.0% 12.8%
(NAV data as on December 12, 2008. Growth over 1-Yr is compounded annualised)

Over 1-Yr, the performance of funds across the board leaves a lot to be desired. For instance, the ‘best’ performer has posted a loss of 46.1%; the worst performer’s NAV has fallen by 58.4%. The showing over 3-Yr is nothing to write home about either. However, the 5-Yr performance for all the funds is quite impressive. The entire peer group has delivered in the range of 15%-20% (on a CAGR basis). Notwithstanding the recent downturn, the performance of funds over longer time frames continues to be noteworthy. Over the long-term, well-managed diversified equity funds have commensurately compensated investors for the risk borne by them. This only reinforces that equity investments must be made for and evaluated over the long-term. While over shorter time frames equity as an asset class can expose investors to high risk, its ability to deliver over the long-term is undisputed.

What investors must do
To begin with, investors would do well not to panic and make any ill-advised investment decisions. Instead, they must conduct an honest evaluation of their risk appetite and find out if their investment portfolio is in line with the same. Investors who do not have the requisite risk-taking ability or investment horizon, and yet are invested in equity funds should consider making necessary modifications to their portfolios.

Investors who are convinced that equity funds should find place in their portfolios need to evaluate the chosen funds. They must ensure that the funds they are invested in are suitable for them; this in turn will entail understanding the investment proposition of the funds.

Finally, investors must engage the services of a competent investment advisor. Not only can the advisor help investors select funds that are right for them, he can also aid them in reviewing the portfolio which is critical to the investment exercise.




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BIRLA SUNLIFE FRONTLINE EQUITY FUND

Leading From The Front
With risk controls well in place, this large-cap-oriented fund needs to be on your buy list to gain as and when market recovers.
The markets are in doldrums. Economies, global as well as the Indian, have slowed down and estimates for corporate earnings look bleak for near to medium term. Although there is talk of recovery in the markets, it’s uncertain when it will happen. Also, instead of waiting for the markets to fall further and thereby trying to time entry points, Outlook Money has always advocated a staggered approach to investing. When markets move upwards, large-cap stocks are expected to be the early gainers. A large-cap fund that merits a place in your portfolio is Birla Sun Life Frontline Equity Fund (BFE).

Launched on 30 August 2002, BFE is an open-ended diversified fund with major exposure to large-cap stocks. The fund is benchmarked to BSE 200 spanning across leading sectors and keeping the exposure well diversified.

Performance. One of the things that a better managed fund does is limit the fall in its NAV. BFE is one such fund that has not only delivered when the going was good but also limited the damage during bad times. Last six months have seen BSE 200’s value erode nearly 46.90 per cent. BFE scores high on containing risk. It has superior risk-adjusted return and has managed to limit its fall by about 38.97 per cent during the same period. The outperformance, says the fund manager, is largely due to better stock selection and avoiding weaker companies that are over-diversified.

BFE has been a long-time performer and has outperformed its benchmark index over all time periods and since inception. As on 31 October 2008, when the BSE 200 was able to manage a compounded annualised return of 4.65 per cent over 3-year period, BFE has managed 11.29 per cent compounded returns. Not bad considering the present extraordinary situation that is seeing sharp corrections and massive fallouts of NAVs in a small time frame. Also, the fund has managed to deliver what equity as an asset class is expected to deliver over this time frame.

Portfolio. As on 30 September 2008, the fund had a corpus of about Rs 400 crore with 63 per cent invested in large caps while 10 per cent in mid caps. In September 2007, the figures stood at 75 per cent and 20 per cent, respectively. By trimming exposure in large- and mid-caps, BFE has opted to increase its cash levels throughout 2008. From nil (including money market funds) in September 2007, the cash level went up to 15 per cent by May 2008 and to 21 per cent by September 2008.

Over the last one year, exposure to Reliance Industries, Bharti Airtel and ONGC have been upped. The top 10 scrips form almost 50 per cent of the equity portfolio and hence their performance will largely shape the fund’s performance. An upward move in the market is expected to be largely on the back of large-cap stocks.

One fallout of the recent meltdown has been that few sectors have been fully dropped from the fund manager’s portfolios or exposure in them has been heavily pared. With BFE, banking, petroleum and telecom are the preferred sectors as of now while construction and capital goods are two sectors where the fund looks to prune its exposure.

Even when many stocks are available at attractive valuations now, BFE’s fund manager still prefers to stick to companies with growth potential available at reasonable valuations.

Long-term investors of the fund have benefited and with low valuations as of now, the time to enter the market with long-term view could be around the present levels. BFE has been able to deliver returns higher than or in tandem with the market and keep its risk levels in check. Over longer periods, it has beaten the benchmark by a wide margin. Choose the systematic route to widen the gains over the long term.




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RELIANCE REGULAR SAVINGS EQUITY FUND

Quick To Grab Chances
Having performed well in the troubled markets, the aggressively managed Reliance RSF-Equity is ready for an encore.
Despite being India’s largest fund house, Reliance mutual fund (MF) was conspicuously absent from the equity-diversified category, up till now. Its two most successful broad-based equity schemes were in the large-cap (Reliance Vision; RV) and mid-cap (Reliance Growth; RG) space, apart from a couple of well-performing sectoral schemes. But that’s changed now and Reliance RSF-Equity, which recently completed three years and is the latest addition in Outlook Money’s fund selection OLM 50, is an option that warrants your attention.

The scheme. Reliance RSF-Equity (RRSFE) is a diversified equity scheme that invests across all market capitalisations. Like RV and RG, this scheme is opportunistic and is quick to get in and out of companies. The scheme is benchmarked against BSE 100 index. Like all Reliance MF equity schemes, this one too uses cash aggressively. As per the October-end portfolio, 30 per cent of its corpus is in cash.

Returns. RRSFE has performed well over a longer period of time. In our latest fund rankings (The New OLM 50, 19 November) RRSFE is one of the toppers in the diversified equity category. Despite being aggressively managed, it kept its volatility in check and was among the least volatile in its category.

To check the scheme’s consistency, we looked at its rolling returns; an average of one-year returns over a three-year time period. With returns of 38.3 per cent, it topped the charts here too. Thanks to its aggressive management and its ability to pick the right mid- and small-cap scrips, RRSFE outperformed the category in 2007 with returns of 92.29 per cent against a category average of 57.24 per cent.

One of the reasons behind its performance is its corpus size. Although a small size is not as big a hindrance to a diversified equity scheme as it is to a typical mid-cap scheme, it does help as the fund manager can take small exposures in smaller-sized companies and still make a difference. At Rs 576.1 crore (the scheme’s current size), we feel it can continue its good performance over a longer period of time.

Portfolio. RRSFE prefers to maintain a crisp and tight portfolio in times when the fund manager feels that the markets would move in one direction, either up or down; it has consistently held 25 to 30 scrips on an average. In uncertain times, the fund manager reduces scrip concentration and broadens the portfolio.

The portfolio is aggressively managed. During the height of the market run-up, it had 58.2 per cent in small-cap scrips (with scrips less than Rs 3,000 crore market capitalisation). Its top scrip for many months at the beginning of the year was Pratibha Industries, an infrastructure sector company with a small market cap of Rs 101 crore. In December 2007, RRSFE had 13 per cent of its corpus in the company’s scrip.

The fund manager does not hesitate to churn the scheme’s portfolio. For instance, between June and December 2007, when the market jumped by 39 per cent, RRSFE had just five common scrips between its December 2007 and June 2007 portfolios out of a total of 25 scrips as per its December-end portfolio.

But the scheme’s aggression has paid off. For instance, it sold off its entire holding in L&T as early as September 2007 when infrastructure companies were trading at sizzling valuations. The fund manager believes that the worst in the capital goods sector may not be over yet as the order books of several companies in this sector may have to be scaled down. The fund’s top sectoral allocation is in banking, software and pharmaceuticals sectors.

The scheme is ideal for an aggressive investor looking for all-round action.

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Dividend Yield Funds

During a bull run, it’s very easy to ignore stocks with high dividend yields. After all, what could be more enticing than a growth stock? But in times of crisis, these boring ones tend to be the most sought after. The reason being that not only do dividends provide a cushion when the market is in the doldrums but such stocks also tend to fall less.

The lure of dividend yield stocks is not easy to ignore. These stocks offer capital appreciation as well as cash payments. But logically, any company that pays a substantial portion of its earnings in dividends is reinvesting less and, therefore, would grow at a slower pace. So the trade-off is between higher dividend yields for lower earnings growth.

On the other hand, companies with high growth potential and volatile earnings tend to pay less by way of dividends, if at all. Such companies would rather reinvest their earnings to sustain their growth. The capital appreciation of growth stocks is obviously higher than in dividend yield ones.

But it does not mean that every single stock that pays dividends is a worthwhile pick. Yes, high dividend yield stocks tend to be cash rich companies. After all, only those companies which are financially healthy can pay consistent dividends. But there could be some high dividend yield stocks that may be paying much more than they can afford.

So it would only be a matter of time before the dividends are cut. Or, it could also be that the dividend yield is up because the stock price has got hammered and not because dividends have risen.

Dividend yield is a function of the amount a company pays out over the trailing 12-months period divided by its share price. So if a company pays Rs 10 as annual divided and its share price is currently Rs 100, the dividend yield is 10 per cent. Yield, obviously, can fluctuate if a share price moves up or down or if the dividend amount increases or decreases. The trick is to find companies, which tend to generate lot of cash with modest, but steady growth.

Brokerage firm India Infoline conducted a study on dividend yield stocks in August 2008. Using a screening methodology to ensure that the results were not skewed towards small-cap stocks and to even out the risk-reward in the selection, they narrowed down on 25 companies from the BSE 500. These companies had dividend yields ranging from 3.5 per cent (Tata Motors) to 8.9 per cent (Bongaigaon Refinery).

According to the study, 14 companies were stable dividend payers, but to a great extent aided by the strong economic growth in the last few years. While 15 of them reported a significant YoY decline in profits in the latest quarter (April-June, 2008).

Investors need to study prospects and fundamentals of a company before taking any investment call, including dividend yield stocks. As dividend yield is based on the past performance, it is hardly an indication of the future profitability and sustainability of dividend. Investors must look at growth potential, quality of management, industry prospects and macro issues. For instance, given the current economic scenario, it would be wise to avoid companies with high debt or large capex plans even if the dividend yields are attractive.

One option for investors looking at such stocks would be to consider dividend yield funds. Here too the criteria would be the same. A good dividend yield fund would be one that does not focus solely on stocks with the highest dividend yield but aims at finding the best overall investments.

Typically, a dividend yield scheme would predominantly invest majority of its assets in a well-diversified portfolio of companies with relatively high dividend yield, which provides a steady stream of cash flows by way of dividend. Thus, dividends received from these companies are earnings for the scheme.

If you take a look at the six dividend yield funds available, what comes across is their own interpretation of what makes a stock a ‘high dividend yield’ one. Some are very specific, others are not (see: Each To Its Own).

EACH ON ITS OWN
Fund Allocation to High Dividend Yield Stocks (min-max)
Birla Sun Life Dividend Yield Plus 65% - 100%
Fortis Dividend Yield 65% - 100%
ING Dividend Yield 65% - 100%
Principal Dividend Yield 65% - 100%
Tata Dividend Yield 70% - 100%
UTI Dividend Yield 65% - 100%


While we have looked at all of them, three funds stand out. These are the ones that have been consistently appearing in the top performing list as equity funds continue to plummet. It’s not that the Net Asset Values (NAVs) of Birla Sun Life Dividend Yield Plus, ING Dividend Yield and UTI Dividend Yield have not fallen. It’s just that they are amongst the least unfortunate (in terms of 1-year returns).

However, all of them do not appear in the following analysis. We have looked at UTI Dividend Yield, Tata Dividend Yield and Birla Sun Life Dividend Yield Plus. Over time, these have proven to be the better bets.



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