A shift to large-caps... Picking up value stocks... Loading up on `defensives'. Those were some of the strategies diversified equity mutual funds adopted to cope with the volatile market in 2006. Unfortunately, none of them worked. The year gone by proved one of the toughest in recent times for mutual funds as they struggled to keep pace with the capricious markets.
But despite the volatility, the equity market ended 2006 on a high note, with the Sensex and Nifty returning 47 per cent and 40 per cent respectively. But mutual fund investors have some reason to be disappointed. The average return of diversified equity funds over the period was 33 per cent.
Lagging The Market
Diversified equity funds hugely under-performed the market last year, a rare occurrence in the Indian context, especially in a rising market. Just 25 equity funds of the sample of 145 diversified funds — less than a fifth — outpaced the Sensex. The funds fared relatively better against the Nifty, with 46 of them delivering a return of more than 40 per cent. A disappointing performance, nonetheless.
This was an unusual year when diversified funds under-performed both during the rally as well as in the corrective phases. Only 12 funds managed to contain declines to less than 30 per cent during the free fall in May-June. Earlier corrections saw a greater proportion of diversified funds contain declines to a level less than the market. Interestingly, even in the unrelenting rally preceding the correction (January-May 10), less than half of the funds in the diversified category beat the benchmark indices.
Sensex, A Tough Benchmark
But the Sensex was a particularly tough benchmark to beat in 2006. The rally was so narrow that 19 stocks in the Sensex basket delivered returns below the average 47 per cent. That means a portfolio with concentrated exposures in Reliance, Infosys and ICICI Bank would have fared better than one that held the entire basket.
Barring the BSE Capital Goods Index, which recorded a 56 per cent return, the Sensex was the top performer across BSE indices, including the BSE Bankex and BSE IT. Not surprisingly, most funds that emerged at the top of the performance charts had concentrated holdings in engineering and infrastructure. Given the shallowness of the rally, funds should have abandoned all attempts at diversifying in order to beat the index and, should instead, have focussed on just a couple of sectors and a few stocks. Few did so, however, and in the end, it was the aggressively managed funds that trounced the indices.
Rolling With The Tide
Year 2006 rewarded funds that took risks. Those that held concentrated positions in stocks and sectors or frequently churned their portfolio in tune with ephemeral market fancies did better than funds that stuck to the tried and tested.
Sundaram Midcap, Franklin India Opportunities, Magnum Global and HSBC India Opportunities were among the year's winners. While Sundaram Midcap and Magnum Global are known for their aggressive approach in the mid-cap space, the other two tend to take concentrated exposures to sectors.
Many of these funds did take a hard knock during the corrective phases. Franklin India Opportunities, for instance. The fund, which figures in the top five of the ranking list, took its investors on a wild roller-coaster ride. Between January and the May peak, the fund returned about 44 per cent. In the month of correction that followed, it went on to shed close to 40 per cent of its net asset value, one of the bigger losers during that period. From there, it made an astounding recovery, gaining 75 per cent between its June 14 low and end-December.
The fund actively churned its portfolio to switch between prevailing themes. In April, media and automobiles accounted for about 30 per cent of the assets. The portfolio is barely the same now with 30 per cent in construction. But the active management appears to have paid off.
Investors who stayed with these funds through the ups and downs have been compensated for the risks assumed so far.
Infrastructure, IT Themes Dominate
Infrastructure, capital goods and software, in fact, dominated the portfolios of almost all diversified funds that figure in the top ten of the performance charts. Infrastructure theme funds, such as UTI Infrastructure, Sundaram Capex Opportunities and Reliance Diversified Power, with returns close to 60 per cent, delivered a superior performance relative to even the top performing diversified funds.
Magnum Comma was a theme fund that turned in a notable performance. This fund, focusing on commodities such as oil, materials, metals and agriculture, figures prominently in the top quartile, its 47 per cent return matching the Sensex. The fund's early entry into cement stocks and low exposures to sugar stocks ensured that it stayed at the top in a tumultuous year for commodity stocks.
Not all sector funds shone, however. Investors may have been better off taking direct exposures in ICICI Bank and HDFC Bank than holding on to banking sector funds, which turned in a sedate performance relative to the BSE Bankex. Healthcare and FMCG focused funds, of course, took a backseat as the sectors under-performed the market.
Mid-cap Funds, A Mixed Bag
With no smart money chasing mid-cap stocks, most mid-cap indices sharply lagged the bellwethers. But Sundaram Midcap, Magnum Global and Magnum Midcap delivered returns that beat the Sensex, largely due to their focus on the right sectors. Sundaram Midcap's decision to increase its cash holding during the mid-cap correction placed it in an enviable position. But cash has been a drag on performance during the market recovery.
Franklin Prima, HDFC Capital Builder and HDFC Long Term Advantage were the mid-cap funds with a good track record that figured at the bottom quartile of the performance rankings and under-performed the BSE Midcap. This was because of their sector choices, which went against the tide.
Good Guys Finish Last
Funds that turned conservative in May (because of rich valuations) and chose to load their portfolios with value stocks and defensive sectors such as FMCG were in for a rude shock as they took a beating in the correction.
Value funds such as Birla Dividend Yield Plus and UTI Master Value, which also sport a long track record, languished at the bottom of the rankings. These funds were under-performers even during the pre-May rally. Most of them were underweight on oil, which turned out to be a surprise winner in the months following the correction.
With investor appetite for growth stocks increasing, the focus on value stocks with the intention of protecting downside has just not paid off.
A Tough Year
Staying with the tried and tested approach to mutual fund investing may not have delivered the best results in 2006. Several funds with a good long-term track record lagged this year and theme/sector funds outpaced diversified equity funds. However, the scorecard for the year may not be reason enough to completely redraw your mutual fund portfolio.
Funds that topped the charts this year are predominantly suited to investors with a higher risk appetite. While aggressive investment strategies deliver outsized returns in a market that is in a rapid ascent, they could take an equally hard knock during a correction.
Therefore, while strategies focused on containing downside risk for investors have not paid off this year, they could do so over the long term. Value and mid-cap funds have been under-performers, but they still deserve a place in one's portfolio.