Over the years, in conversations with people whom I met outside my work, I have often been asked to recommend a good equity fund to invest into. Once upon a time, I used to respond by whole-heartedly listing the funds that I believed to have the potential to deliver above-average returns over a period of 5 years or more. It would be an honest answer but the underlying assumption behind my response would be that it was an academic question, driven by the demands of polite conversation. Not for a moment did I think that any one of these people would ever act upon what I said. As it turned out, I was wrong.
I came to realize that a number of investors actually sought out funds to invest into, through random conversations with multiple investment professionals. More worryingly, I realized that a number of them did not have the temperament needed for successful equity investing. For instance, they exhibited the tendency to invest significantly during periods of mass euphoria and refrain from investing when prices were most attractive. Probably, worst of all, quite a few jeopardized their investment goals by not exiting these funds as their goals approached.
These observations triggered a few questions within me. What was the point of good returns if you didn’t get them when you needed them? What should an investor do to maximize the chances of meeting his/ her objectives? Could there really be a single fund that could help an investor do so?
I have, since, revised my response to anyone who asks me to recommend an equity fund. I present below the broad strokes of what I now say, and the beliefs supporting it.
Asking someone to recommend a good equity fund is somewhat like asking someone to recommend a good, strong medicine. Neither should be taken lightly. Medicines are best prescribed by a doctor who thoroughly understands the patient’s condition. Similarly, equity funds are best recommended by a trusted investment advisor who understands the investment objectives of the client and his/her psychological ability to handle market fluctuations, amongst other things. Done correctly, the chances are that the recommendation will have multiple funds, and will include equity and debt funds. Equity funds, on their own, have a clear limitation in their ability to protect downside risk. In 2008, for instance, the fall in the NAVs of a number of equity funds was so steep that it wiped out the gains accumulated over the preceding 2 years. Such a period of negative performance closer to the point when one needs to withdraw money could significantly, adversely impact the purpose for which the money is needed. In fact, more than the choice of individual funds, the quality of an advisor’s recommendation will hinge on the appropriateness of the mix of equity and debt funds at any given time, technically referred to, as ‘Asset Allocation.’ While it is not impossible for an investor to construct such a mix, it helps to have the expertise of a good financial advisor.
There are some hybrid funds that attempt to construct and adjust such a mix, based on market indicators. These are often referred to, as ‘Dynamic (or Tactical) Asset Allocation Funds’. In effect, these use this mix as a means to offer returns that are somewhat comparable to equity funds while attempting to minimize the risks associated with such funds.
These funds are not a substitute for the expert advice of a good financial advisor. Yes, some advisors do use these funds as part of their fund recommendations, but it is primarily through their understanding and execution of asset allocation that they add value for their clients, and not so much through the use of these funds. Nonetheless, in case you want to know more about these funds, the Value Research website offers a comparison that can be accessed here.
Do bear in mind, though, like any other fund, selecting the right Asset Allocation fund requires a thorough understanding of the investment objective and the strategy. Secondly, these funds come in two distinct variants: those that have an automated basis to the equity-debt mix and the adjustments to that, and those that rely on the fund manager to interpret the market indicators and determine the right mix and the subsequent adjustments. If in doubt, stick to the first type (better still, consult an advisor!) Lastly, there are very few of these funds, and fewer still that were actually around in 2008 and 2011 and can, thus, be analyzed for evidence of protecting the downside risk.
