Insights

Over the past five months, mutual fund houses have been overhauling their funds and strategies to comply with SEBI categorisation rules. This re-categorisation has made peer comparison of funds challenging.

For one, there are entirely new categories. Funds slotted into these come from a variety of other categories and share little similarity. Second, even in existing categories, some funds may have moved from other categories and thus may not yet show the characteristics of that category. For example, funds moving to the corporate bond category may still have a high allocation to low-rated credit.

As a result of the challenges, fund ratings may not fully explain a fund’s performance. For example, a fund slipping to 3-star or 2-star may be simply because of new funds entering its category or it moving to a more aggressive category and not because of a performance deterioration. As funds adjust to changes, these issues will eventually resolve. We will put out a separate article on how we went about tweaking our rating methodology to ensure, to the best of our ability, that we compared the right set of funds using the right parameters.

We have always had a process to define categories based on fund strategies and portfolios. This ensured that we categorised them appropriately (even before SEBI’s rules) and compared them with the right set of peers. We also ensured that the Select Funds comprised funds with a unique and clearly defined strategy and avoid, wherever possible, multiple funds that follow like-styles. Therefore, the bulk of the Select Funds list hasn’t seen a change in strategy or category.

We bucket the Select Funds based on a fund’s portfolio, strategy and risk levels and not only on its category. Therefore, each bucket comprises funds from different categories. We do this to keep the list simple and self-explanatory, and to focus on risk and time frame to choose funds. We have always maintained this approach and will continue to do so.

Equity funds

Equity fund returns, in general, don’t look like they are in good shape. One-year double-digit returns have given way to the single digits. Since January this year, domestic stock markets have corrected based on global and local factors.

This correction has been steep in mid-cap and small-cap stocks more than large-caps. Given the almost unidirectional rise in the mid & small-cap segments in the past three years.

without an underlying improvement in earnings, a correction serves to bring some rationality in markets. Large-cap indices have held strong. The Sensex is up 7% on a year-to- date basis while the Nifty Midcap 100 is down 13% and the Nifty Smallcap 100 is down 22%.

Market movements, especially in 2017, defied what conventional fundamental metrics had to say. Equity funds, sticking to stock fundamentals, turned more cautious. This is also the reason why most equity funds seem to be undershooting their benchmarks. Mid-cap funds have, in fact, been able to weather the mid-cap correction because of this caution.

In large-cap funds, apart from fund caution, a factor causing underperformance is that, of late, only a handful of stocks have contributed to index gains while others languished. Consider the BSE 100. In the past 1 year, only a third of the stocks managed to deliver returns above that of the BSE 100 or even the BSE Sensex. The other stocks are laggards. Of the stocks that gained more than the index, equity funds raised stakes in just about three-quarters. Therefore, other stocks where equity funds raised stakes are underperformers. In some of the gainers, such as HDFC Bank, Kotak Mahindra Bank, or Bajaj Finance, several funds may already have high weights and would not be able to increase it further.

The bottom line is that, yes, several equity funds are lagging the market indices. But that is due to a mix of caution in the face of exuberant markets, gainers being concentrated in only a few stocks, and the market-cap weighted construction of indices themselves. Funds need time for markets to move back into more rational zones and for broader earnings and economic recovery to push stocks back up. This is a time for being patient and averaging, as far as equity funds are concerned.

Our choice of funds in the equity category is one, based on the extent of risk a fund takes and its return, consistency and so on in comparison with similar funds regardless of the category to which it belongs. Two, we prefer funds where the strategy is clear and there will not see change. We’ve steered clear of funds that can see a potential change in strategy, which are recent outperformers, or which are extremely aggressive.

Debt funds

The April-June quarter was a turbulent period for debt mutual funds. With the 10-year gilt making a steep climb from 7.3% to 7.9% on the back of a rate hike, debt funds with longer maturities faced a setback. But almost all categories of funds barring some long duration/gilt funds, managed to generate positive returns over the quarter.

Besides, the good news is that all funds right from liquid to medium duration categories, sport very attractive yields (yield to maturity or YTM) now. Sample this: the average YTM of liquid funds is now 7.2% against 6.5% a year ago. For short duration funds it is 8.5% now versus 7.4% year ago. For medium duration and corporate bonds funds it is 8.85% as opposed to 7.9% a year ago! With these yields set to transpire into returns over the time frame of the respective fund categories, debt fund investors would be in for handsome returns if they waited.

Our choice of select funds, in the debt category, has taken into account possible impact of category changes, where it is evident. In all other cases, we have stuck to assessing consistency in performance, the yield of the portfolio and the risks that a category can afford to take to generate optimal returns.

As a FundsIndia investor, you would have received a mail from us detailing the fund changes this quarter and the reasoning for the same. You can also see the updated Select list by logging in at www.fundsindia.com/select-funds.

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