2017 saw equity markets give a stiff competition to the heady 2014 market, clocking in returns excess of 30%. For debt funds though, the 2017 calendar was one of second-guessing interest rate movements and returns paling in comparison to earlier years. Against this backdrop, we would like to highlight two key trends characterising debt fund performance and equity fund performance this year.
Before we get into details, we would like to remind you that the performance of our researched list of funds – Select funds – was covered last week. You can read it here.
Fund returns falter: Despite worries over slack corporate earnings growth, the disruption caused by drastic tax reforms, and comparatively high valuations, the Nifty 50 and the BSE Sensex rose 28% in the year to date. The Nifty 100 index was up 30.4%, the Nifty Free Float Midcap 100 jumped 45% and the BSE Smallcap index gained a jaw-dropping 57.4%.
If there was one characteristic of the 2017 rally, it was that it lifted several stocks that were without strong business fundamentals or were very small. Rallies in some stocks or sectors or market segments also ignored valuations. Realty stocks, brokerages, and smaller capital goods companies for example, were among the top gainers. Stocks such as Rain Industries, Indiabulls Ventures, Phillips Carbon Black, HEG, V-Mart Retail, Bombay Dyeing, Avanti Feeds, Sunteck Realty and the like more than doubled in 2017.
For equity funds, the going was hard. Stock-picking on fundamental metrics, such as valuations, growth trajectory and its visibility for a company and its sector, business and management quality, and so on saw funds become more cautious this year than before. Stocks with massive rallies in 2017 did not, therefore, find their way into fund portfolios. For example, of the around 80 stocks in the BSE 500 that doubled in 2017, less than half of these stocks saw an increase in mutual fund holdings.
This apart, several funds also turned contrarian towards the end of 2017. On the whole, there was a drop in holdings of rallying sectors such as NBFCs, autos, fertilizers; funds have for long been underweight on performers such as FMCG. Funds also slightly increased weights to down-and-out software and pharmaceuticals.
Mid-cap funds had a rough going in 2017, despite the outsized gains you may have witnessed. Barely a quarter of them managed to beat the Nifty Free Float Midcap 100 index, a departure from even turbulent years such as 2016 when 60% of them outperformed. Part of the reason has been explained above. In addition, higher allocations to large-cap stocks by some funds also pulled comparative returns lower. Similarly, small-cap funds on an average underperformed the BSE Smallcap returns. Favourites DSP BlackRock Microcap and Franklin India Smaller Companies were severe underperformers. Funds also have been lowering small-cap exposure, another reason for the underperformance.
With an average return of 31.2%, large-cap funds on an average barely managed to beat the Nifty 100 index. This marginal outperformance continues from 2016.
|Nifty 100 index||30.4||3.6|
|Nifty Free Float Midcap 100||47.4||7.2|
|Returns as of December 22, 2017|
Performance divergence within a category increased: In any year or any market cycle, there always will be funds that perform well and funds that do not. But the divergence in fund performance within a category has increased significantly this year. In large-cap funds for example, the deviation of returns from the mean was 4.85 against the 3.5 in 2015 and 2016. In diversified funds, the deviation was 7.0 against the 4.3 in the two preceding calendars.
Fund strategy had a lot to do with these deviations. Here are a few trends that emerged:
- Those that followed a more value-based approach, or turned slightly contrarian or were cautious, such as ICICI Prudential Value Discovery, Franklin India Prima Plus, Franklin India Bluechip, SBI Magnum Midcap, Invesco India Mid and Small cap, all saw returns pale.
- Funds such as Invesco India Dynamic, ICICI Prudential Dynamic, SBI Bluechip had higher cash holdings, which again pulled down returns.
- Those that had a higher mid-cap share, such as IDFC Focused Equity or ICICI Prudential Multicap managed to deliver better than those that cut back on mid-caps.
- With the dichotomy between consumer-oriented and cyclical themes still persisting, those that picked up consumer plays, such as Tata Retirement Savings Progressive and BNP Paribas Equity benefited as consumer stocks still rule the roost.
- Funds that followed a more stock-specific or focused approach instead of a broader index-linked strategy gained well. Apart from a couple of sectors, stock markets have not uniformly pulled up sectors and have been selective. Funds such as DSP BlackRock Opportunities, Invesco India Growth, Axis Focused 25, HDFC Capital Builder, Kotak Select Focus, Principal Growth, and MOSt Focused Multicap 35, all managed to outperform comfortably.
Funds that had a rough time in earlier years made the most of this rally to course-correct and, aided by a lower base, staged a comeback. These include BNP Paribas Equity, Axis Equity, BNP Paribas Midcap, and Reliance Vision.
This past year, as the year before it, was one that was marked by hopes of earnings and growth revival taking place. The fact that this recovery is still nascent has left valuations expensive in many stocks and sectors. The exuberance of this market calls for caution and is a difficult one for fund managers to navigate, especially in the small and mid-cap segment.
It is good to keep in mind the following:
- It is best not to get carried away by this calendar-year returns. Chart-toppers, especially in a rallying market often are at the top simply because they got lucky in getting into stocks driven by market momentum and not fundamental business strength.
- A fund that has proven its worth in previous markets but is underperforming now should not be a cause for worry, especially if its strategy is such that it is getting into under-valued stocks or sectors.
- Mixing up funds following different strategies is one way to get around such bouts of underperformance.
Look out for our call in January on equity market outlook, what funds may do, and the strategies you can follow.
2017 saw debt funds returns yo-yo from double-digit to low single-digit returns. From excessive exuberance arising from an interest rate rally, the debt market was left confused by the end of the year with rate increases beginning to hurt duration calls. This led to two-fold actions – one, funds changing their maturities of instruments and second, some upping their credit risk profile to avoid rate volatility.
Dynamic bond funds get truly dynamic: Low inflation, high government bond demand post the demonetisation, and low growth led to rate cut hopes going into 2017. But an unexpected neutral, no-rate-cut stance in February 2017 by RBI, led to a rise in gilt yields and a fall in dynamic bond returns. Yields headed back south in the middle of the year as rate cut hopes resurfaced. The situation reversed sharply towards the close of 2017 with gilt yields shooting higher to 7.28% now on higher inflation and a sell-off by banks and foreign investors. Yields are close to mid-2016 levels, before the rally that drove returns higher in that year.
With this interest-rate roller coaster, dynamic bond funds were left scrambling. But fund managers held divergent views on whether there would be rate cuts or not. Some funds got extremely dynamic in their calls and rapidly moved their portfolios around. Those such as L&T Flexi Bond, Kotak Flexi Debt, DHFL Pramerica Dynamic Bond, DSP BlackRock Bond, ICICI Prudential LTP, and SBI Dynamic Bond, swiftly raised and lowered average maturities and duration calls through the year. Many of these are among the better performers in the category thanks to these quick moves. Others such as Aditya Birla Dynamic Bond or HDFC Income took an aggressive stance on duration – i.e. they maintained longer term gilt holdings at higher levels. However, even these aggressive funds have begun to cut back on duration.
The yield movement over the year sent returns of dynamic bond funds crashing; average 1-year returns today stand at 3.5% against the 13.1% average they were in December 2016. Yield movements not only impact gilts but also AAA-rated traded bonds. Income and short-term funds too, as a result, saw returns dropping as bond prices fell.
|Dynamic bond funds||3.5||13.1|
|Returns as of December 22, 2017|
Funds upped credit risk: With bank lending rates dropping, mutual funds cannot expect high yields on the money they lend to institutions. Average portfolio yields and returns for debt funds, therefore, shrank in 2017. Short-term debt funds, for example, saw average yields drop below 7.4% for 2017 against the 8%-plus they were for much of 2016. Liquid funds, similarly, saw yields dropping to less than 6.4% by November 2017 against the 7.5% they were in the first half of 2016. For many funds, the quest to shore up yields saw them move down the credit quality curve. This move to lower credit for higher yields already began in 2016 and became more pronounced this year.
In ultra short-term funds, for example, the share of bonds rated AA and below averaged 18.7% for 2017, against the 15.4% in 2016. In income funds, low credit stood at 14.5% on an average in 2017 against the 12.5% the year before. At research, we have shifted funds from the short-term and income categories into the credit opportunity category for taking excessive credit risks.
In 2017, it was funds with higher credit calls that delivered higher returns. These include the likes of Franklin India Ultra Short Term Bond, BOI AXA Treasury Advantage, Kotak Low Duration from the ultra short-term stable and Axis Regular Savings, BNP Paribas Corporate Bond, or Edelweiss Corporate Bond Opportunities from the income stable.
The takeaway: 2017 was a trying year for dynamic bond funds with no firm cues on interest rates. Funds taking aggressive calls will take time to reverse positions or adapt their portfolios if the rate cut scenario does not pan out. Either way, going by this year’s performance should not prompt exits as it will be akin to getting out at lows. The same holds for categories such as income funds. Holding period is as important in debt funds as it is equity; 1-2 years is too limited a timeframe for dynamic and income funds. They need longer holding periods. Debt fund returns are also not immune to changes, as 2017 has showcased. This holds true for new investors into debt funds following the sharp drop in fixed deposit returns. Despite these movements, debt fund returns will still be superior to fixed deposit returns of similar holding periods.
Look out for our call in January on debt funds and what you can do.
FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis for investment decisions. To know how to read our weekly fund reviews, please click here.
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