How important is a fund’s return?

There are some who may dismiss this as a pointless question with an obvious answer.  But if you are willing to read this with an open mind, it might just be worth your while.  Some of the thoughts presented here have been shared in the past, across different posts.  In this post, I’m attempting to connect these together to suggest an answer to the question in the title.

Do past returns really matter?

Most of us, when deciding on a scheme to invest into, look at its past returns.  Whether we admit it or not, most of us believe that a scheme’s past returns (relative to its peers) are a reliable indicator of its future relative returns. In other words, we believe that if Fund A has given a better return than Fund B in the past, it is likely to give a better return in the future as well.

Frankly, I have not seen any data that would compellingly support such a view.  On the contrary, based on the data that I have examined, I question such a belief.  As evidence, I’ve given below some observations from a study that I recently updated.  In this, I looked at the relative returns of domestic, diversified equity schemes over four market phases, listed below.

• 8 January, 2008 to 9 March, 2009 (Falling)
• 9 March, 2009 to 5 November, 2010 (Rising)
• 5 November, 2010 to 20 December, 2011 (Falling)

• 20 December, 2011 to 29 January, 2015 (Rising)

The study covered 141 schemes that had been around across all these four phases.  Based on their return in each phase, I grouped these schemes into quartiles.  These are a few of my findings:

• 33 of the 35 schemes in the top quartile in 2008-09 were not in the top quartile in 2009-10.  Of these, 26 dropped to the third or fourth quartile.
• 29 of the 35 schemes in the top quartile in 2009-10 were not in the top quartile in 2010-11.  Of these, 19 dropped to the third or fourth quartile.
• 30 of the 35 schemes in the top quartile in 2010-11 were not in the top quartile in 2011-15.  Of these, 19 dropped to the third or fourth quartile.
• Not a single scheme managed to be in the top quartile across all four phases.  Only 7 schemes consistently ended up in one of the top two quartiles in each of the four phases.

To me, what emerges from this is that the past ranking of a scheme is not a reliable indicator of what its future ranking will be.  In case you’d like to take a look at the data supporting these findings, please send me an email. 

Do future returns matter?

Once we invest in a scheme, it should be correct to believe that the scheme’s returns will impact our returns, right?  Well, yes and no.  If we make a single investment, then yes.  If we make multiple investments, then maybe not.  Let me illustrate.

Let’s say that 10 years ago, someone decided to start SIPs of an equal amount in the growth options of these schemes:

• Reliance Regular Savings Fund-Equity Option (RRSF)
• SBI Magnum Midcap Fund (SBIMMF)

Over these 10 years, RRSF ended up giving a higher return than SBIMMF.  However, the investor would made more money in SBIMMF than in RRSF.  The table below shows the difference.

Period: 1 May 2006 to 30 Apr 2016	Scheme Return (p.a.)	Investor Return (p.a.)
RRSF	13.8%	13.4%
SBIMMF	11.3%	18.0%

Scheme returns and investor returns have been calculated using the tools at Advisorkhoj and assume a monthly SIP on the first business day of each month.  Loads are not considered. 

Let me try and give these numbers a bit more context.  The growth in the NAV of RRSF over this period was 36% more than the growth in the NAV of SBIMMF.  Yet, the gain to the investor from investing in SBIMMF was 57% more than the gain from investing in RRSF.  I look at this as proof that investing in a scheme that gives better returns, in no way, guarantees that we will get better returns.  Indeed, the returns to us can be far less than what we may imagine.

The role of returns in building wealth

I remember a thought shared by a stock broker in my early days in the business.  I paraphrase: “You may earn a 100% in a year but if all you invested is Rs.100, all you will have at the end of the year is Rs.200.  By no stretch of imagination will you be wealthy just by seeking high returns.”

I have regarded that as a useful comment on how wealth is built.  To refine it a bit, the wealth that we build is most influenced by the amount that we save and invest, and the timeliness of our investments (i.e. our ability to invest regularly, without delay).  We can, and must supplement these with good investment choices.  However, we need to realize that there are practical limits to the rate of return that we can earn from our investments on a sustained basis.  And if the points made earlier are anything to go by, we have limited control over the return that we will end up getting.

Putting all of this together, I would like to suggest that a scheme’s returns are not as consequential as most of us might believe.  But I’ll let you be the final judge of that.  And along with what I have, so far, shared in this post, I’d like to offer you a parting thought that puts a whole different spin on the question in the title.

Most good things in life come at a price.  Generally speaking, the more important something is to us, the higher is the price that we are willing to pay.  Conversely, the higher the price that we are willing to pay for something, the more important it can be considered to be to us.  Thus, the importance of a scheme’s returns to us can well be judged by the price we would be willing to pay or, more accurately, the compromises that we are willing (or not willing) to make.  Let me explain with a personal example.

I have taken a stance to not invest my money with HDFC mutual fund.  To be clear, I have great respect for their Chief Investment Officer as an equity fund manager.  I have no reason to doubt his ability to generate better returns than most of his peers.  On the flip side, I have regarded their disclosures around expense ratios as inconsistent and opaque.  Nonetheless, a few years ago, I went ahead and invested a small portion of my portfolio with them.  I was clear that I was making a compromise.  But then, a series of service issues started popping up which left an extremely bitter taste in my mouth.  To put it bluntly, I felt like I was being yanked around.  After a bit of deliberation, I came to the conclusion that this fund house did not deserve my business, and pulled out my investments.  In other words, this time around, I refused to compromise.

Yes, I am a small investor, and my stance may not affect them.  Some of my well-wishers have argued that I have had more to lose than them by depriving myself of good returns.  Fact is, that doesn’t bother me.  For my part, I am clear on where I draw the line on making a compromise, and my actions reflect that.  And that’s really the question we have to ask ourselves.  Would you be willing to chase the promise of ‘good returns’ at any cost?  Or would you want to draw the line somewhere?  And, if so, where would you draw it?

From High to Low

As readers of this blog may be aware, I am a sucker for statistics.  I frequently go digging into historical data.  But it isn’t something that I do for entertainment.  Every now and then, looking into data, I find something that sharpens or enhances my understanding of the nature of risk.  It is with the intention of sharing some of that, that I present below the results of my latest effort, which looks at the returns of some equity schemes over a 16 year period.  In such studies, it is often the case that some schemes end up with far more impressive returns than others- that is but to be expected.  While there may be a case to raise eyebrows and ask questions, I wouldn’t suggest passing judgment on any scheme without further investigation.  As I have maintained in the past, there is more to performance than what returns may convey. As I have also previously mentioned, one should be careful about drawing any inferences from such observations other than on the merits of diversification. 

Almost a month ago, on Feb 11, the BSE Sensex hit a new low, relative to its last high.  It may well fall further but at the time of writing, that has not (yet) happened.  Its closing value on Feb 11, was over 22% below the last closing high on 29 Jan 2015.  As far as I can make out, this was the 11th time since its inception that the Sensex has fallen 20% or more from a previous high.  The first time this happened, it fell just over 20% before rebounding.  On the subsequent nine occasions, the fall to the bottom has ranged from 27% to 61%.  On five of these occasions, the fall was in excess of 40%.

Feb 11 also happened to be the anniversary of an earlier high.  In 2000, the Sensex peaked on this date.  The identical date brought back the memory of something that I had heard many years ago, from a certain advisor.  He had said something to the effect that the acid test of the long-term performance of an equity scheme was the return that it generated from a market peak to a market bottom.  In that light, I thought it might be interesting (even if premature) to check out the returns of equity schemes over these 16 years.  I am aware of the vagueness of the term, “long-term” and the mixed feelings that people have about its use.  But I doubt if anyone would question the validity of a period of 16 years being “long-term.”  Using data from Value Research, ICRA Online and Moneycontrol, I give below some of my observations.  Do note that the scheme returns do not consider loads.

• Currently, there appear to be 49 actively managed, diversified, domestic equity schemes that were in existence in Feb 2000. 
• The return on these schemes over these 16 years ranged from 18.7% pa to 5.2% pa.
• The CAGR of the BSE Sensex Total Return Index (TRI) over this period was 10.6% pa.
• The return on 14 of these schemes was less than the CAGR of the BSE Sensex TRI. At least 4 of these were once positioned as flagship schemes, so to say, of their respective fund houses. 
• Amongst schemes that are currently rated with 5-stars by Value Research, the lowest return was 9.7% pa.
• Amongst schemes that are currently rated with 1-star by Value Research, the highest return was 18.5% pa.
• The preceding 13 months (i.e. preceding Feb 11 2000) was a period of extraordinary returns for equity schemes.  One scheme, it appears, had delivered a higher absolute return over the preceding 13 months than it did over this entire 16 year period. Its absolute return over the preceding 13 months was 326% while over the entire 16 year period, it was 297%.
• At least 4 other schemes delivered an absolute return over the preceding 13 months that was over 50% of what they did over this entire 16 year period.
• At the time, there was only one index scheme, which continues to be in existence.  This scheme tracks the NSE-50.  As against a CAGR of 10.6% pa for the NSE-50 TRI, the return on this scheme was 8.3% pa.

Fund Volatility and SIP Returns

A few readers of my previous post have said that I was wrong in suggesting that all funds are equally suitable for a SIP.  According to them, if an investor who is proposing to start a SIP, had to choose between two funds, he/she would be better off choosing the fund that is likely to be more volatile (i.e. the fund that is likely to see greater fluctuations in its NAV). 

This is not the first time that I have heard this argument.  Over the years, I have heard many advisors voice a similar view.  Unfortunately, this is a flawed perspective that is, paradoxically, the result of intelligent thinking.  In this post, I propose to clear the air on this.  But since this may not be easy to explain or even follow, let me first cut to the chase, and state my position:

a.       There is no conclusive or compelling evidence that supports this argument.

b.      Pursuing such a strategy can potentially have disastrous consequences if one is forced to redeem one’s investment in a bear phase.

If you’d like some elaboration on this, do read on.

Let me start by questioning the mathematical validity of the volatility argument, if I may call it that.  Imagine, if you can, two equity funds that, over a certain period, start with an identical NAV, and end with an identical NAV.  Let’s further assume that, over this period, these funds have an identical average NAV.  This may be a hypothetical scenario but it is one that immensely favors the volatility argument.  If the argument truly has merit, then in such a scenario, an investor opting for a SIP in both funds, should always gain more in the more volatile of the two funds.  Yet the fact is that even in such a favorable scenario, there is no certainty that that will happen.

For those who prefer empirical evidence, I’d like to present some data on three of the oldest equity schemes in the country.  The table below gives the data for the period from April 2012 through March 2015.  All the data has been taken from the fund factsheets.

Apr 2012 - Mar 2015	Fund A	Fund B	Fund C
Standard Deviation*	14.2	16.5	15.8
Fund Return (p.a.)	18.6%	17.1%	34.9%
SIP Return (p.a.)	24.9%	25.2%	35.2%

*Standard Deviation (SD) is a measure of volatility. The higher the SD, the more volatile a fund.

Over this period, Fund B was more volatile than Fund A, and despite its lower return, an investor opting for a SIP would have gained more in this fund than in Fund A.  One may say that this data supports the volatility argument.  However, when we compare Fund B with Fund C, the picture appears to be somewhat different.  Fund B was also more volatile than Fund C but an investor opting for a SIP would have gained less in this fund than in Fund C.  One may think that this was because of the much higher return of Fund C over the period.  But before drawing any conclusions, let’s look at the data for the preceding 3 year period.

Apr 2009 - Mar 2012	Fund A	Fund B	Fund C
Standard Deviation	22.5	27.9	28.3
Fund Return (p.a.)	27.9%	26.7%	34.6%
SIP Return (p.a.)	8.8%	4.5%	9.3%

 

This period was marked by a significantly higher level of volatility across all funds.  Yet when you look at Funds A & B, despite a much higher return over this period (compared to Apr 2012 – Mar 2015), an investor who opted for a SIP in these funds over this period would have gained much less than a similar investor in these funds over the subsequent 3 year period.  Fund C had almost the same return across both periods but here, too, an investor who opted for a SIP over this period would have gained much less than a similar investor in this fund over the subsequent 3 year period.  Clearly, the volatility argument does not hold good.

You may also note that during this period, Fund C was more volatile than Fund B.  However, in the subsequent period, Fund B was more volatile than Fund C.  Thus, even if volatility were to matter, to whatever extent, historical volatility of a fund (absolute or relative) can be no indicator of future volatility.  Just to be clear, the investment objectives of these funds did not change over these years.  In fact, these are among the most consistently well-managed funds in the industry.

Let me now flip back another three years to a period that highlights some of the risks of investing in highly volatile funds.

Apr 2006 - Mar 2009	Fund A	Fund B	Fund C
Standard Deviation	28.4	31.5	33.2
Fund Return (% p.a.)	-3.1%	-2.7%	-17.5%
SIP Return (% p.a.)	-13.9%	-13.7%	-30.2%

To put these numbers into context, the value of a SIP over this period in Fund A or Fund B would have been almost 20% below the amount invested, by the end of the period.  The value of a similar SIP in Fund C would have been almost 40% below the amount invested.  So much for the volatility argument.

SIP Returns

A number of investment portals offer tools that enable one to calculate the so-called ‘SIP returns’ of mutual fund schemes.  Most fund houses also offer similar calculators for their schemes.  Some offer these calculations in their monthly fact sheets.  But does looking at the SIP return of a fund serve any purpose?  In this post, I will attempt to show that SIP returns are of little use, and that one is better off not using these returns to draw any conclusions.  To keep things simple, I will restrict my thoughts to SIP returns of equity funds.

The SIP return of a fund is not a representation of its performance. It only tells us the return that an investor would have got if he/she had opted for an SIP in that fund, over a particular period.  The SIP return from investing in a fund can be, and indeed often is, very different from the fund’s actual return over the same period.  As an illustration of this, I have given below some data of two of the oldest diversified equity funds in India. (PS: All the SIP calculations in this post assume equal monthly investments made on the first business day of each month from the starting month till the penultimate month.  Loads are not considered in any of the calculations.)

	Fund A	Fund B
NAV- 01 July 2004	70.67	47.73
NAV- 02 July 2007	228.91	142.70
Absolute Fund Return	223.9%	199.0%
Absolute SIP Return	65.4%	75.9%
Fund Return (p.a.)	47.9%	44.0%
SIP Return (p.a.)	35.5%	40.3%

Over the 3 year period mentioned above, investors in both funds who opted for a SIP saw a lesser return than those who put a similar amount at one go, at the start.  You may also notice that while Fund A gave a higher return than Fund B, investors who opted for a SIP in that fund saw a lesser return than those who opted for a SIP in Fund B.

If we now look at the 3 year period that immediately followed, a pretty different picture emerges.

	Fund A	Fund B
NAV- 02 July 2007	228.91	142.70
NAV- 01 July 2010	263.45	195.03
Absolute Fund Return	15.1%	36.7%
Absolute SIP Return	41.7%	35.1%
Fund Return (p.a.)	4.8%	11.0%
SIP Return (p.a.)	24.0%	20.6%

Investors in Fund A who opted for a SIP over this period, saw a better return than those who put a similar amount at one go, at the start.  Investors who opted for a SIP in Fund B saw a lesser return, in absolute terms, than those who made a lump sum investment, at the start.  However, if you consider the time value of money, as reflected in the annualized returns, the SIP investors benefitted more.  In contrast to the previous 3 years, over this period, Fund B gave a higher return than Fund A, but investors who opted for a SIP in that fund saw a lesser return than those who opted for a SIP in Fund A. 

In the examples above, both the fund returns and the SIP returns were positive.  Yet, it is possible for one or both of these to be negative.  The data below, of another diversified equity fund, illustrates the possibility of a fund’s return being negative, and SIP return being positive.

NAV- 01 Jan 2008	40.71
NAV- 01 Jan 2013	33.49
Absolute Fund Return	-17.7%
Absolute SIP Return	24.9%
Fund Return (p.a.)	-3.8%
SIP Return (p.a.)	8.8%

There is also the possibility of a fund’s return being positive, and SIP return being negative, as the data below, of yet another diversified equity fund, shows.

NAV- 01 Dec 2003	29.86
NAV- 02 Mar 2009	51.98
Absolute Fund Return	74.1%
Absolute SIP Return	-2.3%
Fund Return (p.a.)	11.1%
SIP Return (p.a.)	-0.9%

So, what explains these numbers?

While a fund’s return does influence the SIP return, the extent of that influence depends on the pattern of NAV movements over the period.  Odd as it may sound, some patterns cause the SIP return to exceed the fund’s return, while others bring down the SIP return to below the fund’s return.  But knowing the effect that a particular pattern has, doesn’t really help because neither can a fund manager control the pattern of NAV movements for a fund, nor is it possible to predict the future pattern for any fund.

In this backdrop, consider this: even if we believe that a more competent fund manager is likely to generate better fund returns than a less competent one, the pattern of NAV movements may make it possible for a SIP in a poorly performing fund to give a better return than a SIP in a well performing fund.  The only thing resembling any kind of certainty is that the longer we carry on a SIP, the more likely it is for the SIP return to mirror the fund’s return. 

Yet, every now and then I come across supposed advisors who wax eloquent about how some funds are “more suitable for a SIP.” At the start of each year, and occasionally in-between, I also see recommendations pop up for “the best funds for SIPs.”  To anyone who understands the maths of SIP returns, these are flawed notions which consciously or not, capitalize on the misconceptions of investors.  But all of these pale in comparison to a remark that was brought to my attention, that The Economic Times attributed to the CEO of a fund house: “our CIO-equity runs… …the number 1 fund in the country in 10-year SIP (systematic investment plan) returns.”  The statement may be factually correct, but to me, the mention of SIP returns in that sentence is nothing short of deception.

As I see it, SIP returns serve little purpose and are best ignored.

Remembering the Tech Boom

This month, fifteen years ago, signalled the end of the bull run that has come to be referred to as the dot-com boom or the tech boom by some, and the dot-com bubble or the tech bubble by others.  As the monikers suggest, it was a period that was marked by the steep and questionable rise in the share prices of technology companies.  As I see it, what happened during that phase, and what followed afterwards, has a lot to offer current investors in equity schemes to think about.  In this post, I propose to take a walk down memory lane, and share some observations.

A number of people trace the start of this boom to December 1996.  But it was two years later that the boom truly gained momentum.  And though the biggest gains were seen by investors in the shares of ICE companies (information technology, communications, and entertainment), investors in equity schemes also saw significant gains, on account of the investments made by their schemes in these companies.  Consider this: over the fifteen month period from 1 Dec 1998 till 1 March 2000, 25 equity schemes and 2 balanced schemes saw their NAVs at least triple, while another 9 equity schemes and 4 balanced schemes saw their NAVs double.  There were 8 equity schemes whose NAVs went up 5 times or more, during this period.  Leading the pack was Kothari Pioneer Infotech Fund (now, Franklin Infotech Fund), whose NAV (adjusted for bonus units) astoundingly went up over 10 times during the same period.

An industry observer with whom I was speaking recently, had this to say about the gains during that period:  “Never before, or since then, has there been such an opportunity for the masses to legitimately make so much money, in so short a time.”

While the opportunity may have been there, the fact is that when the boom took off, very few people actually had investments in any of these schemes. Most investments in these schemes happened much after their NAVs had surged.  While this may be somewhat true of any bull market, in the case of the tech boom, this was partly because the sharpness and suddenness of the rise caught most investors by surprise, and partly because of a general lack of trust in mutual funds.

To go back a bit in time, the bear market from 1994 to 1998, on account of its prolonged tenure, had tested the patience of most investors,  particularly those in mutual fund schemes.  Funds such as UTI’s Mastergain 1992 (now, UTI Equity Fund) and Morgan Stanley Growth Fund (now, HDFC Large Cap Fund) had attracted large numbers of investors, but their investment performances had left a lot to be desired. Then there was the news of CRB Mutual Fund being wound up under charges of fraud.  Lastly, and probably, most significantly, UTI’s reputation took a major dent when it announced that the reserves on its flagship scheme, US 64, were wiped out and there loomed the possibility that it might not be able to meet commitments to unitholders in the scheme. 

It was not surprising, therefore, that most investors were naysayers or skeptics when it came to mutual fund schemes.  There were very few investors for whom the conceptual merit of investing in mutual funds remained intact in spite of all of these episodes.  When the tech boom took off (quite out of the blue, within months of UTI’s announcement), it was these few investors who gained the most.  In contrast, the naysayers and skeptics were left out for most of the rally.  By the time they shed their reservations to enter these schemes, the markets were into the last few months of the boom.  Given how late they entered the boom, the vigor with which these investors pumped in money, was truly astonishing .  To give some perspective, the gross investments into equity schemes in the quarter Jan-March 2000 were more than the total gross investments made into these schemes across the previous 11 quarters.  The net investments into equity schemes in that quarter were over 13 times the total net investments across the previous 4 quarters.  Obviously, these investors had no inkling of the brutal downslide that was to follow.

Over the nineteen months that followed the bursting of the tech bubble, most equity schemes saw their NAVs fall by over 60%, with some seeing a fall of over 80%.  As would be expected, investors who put most of their money around the peak were the worst affected.  Those who preferred tech funds (or funds with an overdose of tech stocks) were much more affected than those who preferred diversified equity schemes.  The differences were all the more starker for those investors who chose to hold to their investments for longer.  For instance, if an investment in a diversified equity scheme made at the peak of the tech boom were to have been held till today, the return on such an investment (without adjusting for loads) could range from 22% p.a. to 7% p.a. (most diversified equity schemes have given a return in excess of 15% p.a. over this period, which is the equivalent of growing one’s money by over 8 times). On the other hand, if an investment in a tech fund made at the peak of the tech boom were to have been held till today, the return on such an investment (without adjusting for loads) could range from 5% p.a. to 6% p.a. That would be equivalent to just over doubling one’s money.

But what about those people who were already invested by the time the boom gained momentum?  Returns in equity schemes over the 34 months from 1 December 1998 to 1 October 2001 ranged from 51% p.a. to –24% p.a. (without adjusting for loads).  Most equity schemes had gained enough on the upside to weather the downside and generate positive returns, with 10 schemes clocking returns in excess of 20% p.a.(without adjusting for loads).  Returns in Franklin Infotech Fund (the lone tech fund over this period) were close to 18% p.a.(without adjusting for loads).  If investments in any of the diversified equity schemes were to have been held till today, the returns would vary from 32% p.a. to 11% p.a. (without adjusting for loads) with as many as 28 schemes showing returns in excess of 20% p.a. (this would be equivalent to growing one’s money by over 19 times).  If an investment made in Franklin Infotech Fund were to have been held till today, the returns would be close to 22% p.a.(without adjusting for loads).  That would be equivalent to growing one’s money by over 24 times.

Would investing through a SIP have helped?  Obviously, those investors who invested large sums at the peak of the boom would have been better off staggering those investments. It would have particularly helped in the case of schemes which fell the most.  Consider this: A one-time investment on March 1, 2000, in the worst-performing, diversified equity scheme (based on returns over the entire cycle), would have taken nearly 8 years to double in value.  A monthly SIP in that scheme for 1 year from that date would have taken less than 6 years to double in value. 

Should investors have timed their investments?  As I see it, good timing involves getting two things right: the time of exit and the time of re-entry.  Getting even one of these wrong can have a significant negative impact on one’s returns.  Given the odds against getting both right, I do not advocate such an approach.  I do, however, recommend that one rebalance one’s portfolio in line with one’s asset allocation.  Looking back, I remember that some of my clients, against my advice, did indeed try to time their exit, and re-entry.  As far as I recollect, all of them would have been better off not doing so.

I’d like to share one last observation before I close this post.  It’s about two diversified equity schemes and highlights the fickle nature of equity performance and fund manager success.  The first was a scheme that did exceedingly well during the tech boom.  It was an iconic fund, managed by a ‘star fund manager,’ as people like to say. In the last fifteen months of the boom, its NAV went up over 5 times, and by some accounts, its performance in calendar year 1999 was a world record of sorts.  In the downturn, it fell sharply, losing over 70% of its value from the peak.  In the years since the boom, its performance has been patchy.  The scheme still exists but is all but forgotten, its past glory relegated to a footnote in the annals of history.  The other scheme was one whose returns during the tech boom placed it in the bottom quartile of equity schemes.  In the downturn, its performance continued to be unexceptional.  Yet, in the years since, it has delivered spectacular returns that have caused investors to regard it as an iconic fund, and its fund manager as a legend.  For those of us who like to predict future winners among funds, the tale of these two schemes should serve as food for thought.

Seven Years On

Call it the Seven Year Itch, if you like.  I was curious to see how equity schemes and hybrid schemes had performed since the peak of the 2007-08 bull run, seven years ago.  In this post, I present some observations that I found interesting.  Just to be clear: I’m not intending to pass judgment on any fund.  My intention is to offer food for thought around investing in equity schemes and hybrid schemes.  As I have stressed in earlier posts, there are compelling reasons to invest into some of these schemes but at the same time, it’s important to be aware of the risks.

Here, then, are my observations.  The scheme data has been taken from Value Research and does not consider loads.

• A hypothetical investment in the NSE-50 Total Return Index on 8 Jan 2008 would have grown over these 7 years by 4.87% p.a.  In contrast, a cumulative, 7 year deposit with State Bank of India would have given a return of 8.77% p.a., before taxes.
• There are, in all, 224 actively managed equity schemes today, that were in existence at that point as well. 
• The returns across these 224 schemes have ranged from 23% p.a. to –10% p.a. 
• 162 of these (i.e. 72%) have shown a lesser return than that of the bank deposit (before considering taxes). 
• 80 of these (i.e. 36%) have shown a lesser return than that of the NSE-50. 
• 8 of the top 10 schemes, and 9 of the bottom 10 schemes are sectoral/ thematic schemes. 
• Amongst domestic, diversified equity funds, the returns have ranged from 16% p.a. to –4% p.a.
• Despite the upsurge in the markets in the last 1 year, 22 schemes have shown negative returns over the 7 year period.  In fact, 19 of these 22 schemes gave returns in excess of 40% in the last 1 year.
• 17 of these 224 schemes are currently rated as 5 star funds by Value Research.  The returns across these schemes have ranged from 15% p.a. to 3% p.a. 
• There are 25 ‘balanced’ schemes today (Value Research category: hybrid-equity), that were in existence seven years ago. 
  • The returns across these schemes have ranged from 14% to –7% p.a.
  • 14 of these schemes (i.e. 56%) have given a lesser return than that of the bank deposit (before considering taxes).  
• There are 54 ‘MIP’ schemes today (Value Research categories: hybrid debt-oriented aggressive, and hybrid debt-oriented conservative), that were in existence seven years ago. 
  • The returns in these categories ranged from 12% to 2% p.a. 
  • 38 of these schemes (i.e. 70%) have given a lesser return than that of the bank deposit (before considering taxes). 
  • The scheme with the lowest returns happens to be currently rated as a 5 star fund in its category.

In part, these observations highlight the risks associated with investing in equity funds at the peak of the markets, something I talked about at length in an earlier post.  In part, these make the case for diversification, something I spotlighted in another post.  Some observations even highlight the limitations of Star Ratings, something I touched upon elsewhere.  But there is no denying that the performance of a number of funds is questionable and if the answers are not convincing, there is no reason for investors in these schemes to continue holding those investments. 

By my calculations, there seems to be in excess of Rs.32,000 crore invested in equity schemes that have given lesser returns than the NSE-50 over these 7 years.  While it would unfair for me to draw any sweeping inferences, I hope those investments are there for the right reasons.

The new usefulness of equity funds

This isn’t for everyone, so unless you are confident that you understand the risks involved and are willing to live with a potentially unfavourable outcome, don’t attempt this on your portfolio without consulting a good investment advisor.

Till recently, for investors in the higher tax brackets, with an investment horizon of between 1 and 3 years, debt funds were arguably the most attractive investment option, in terms of potential return that could be earned, relative to the risk.  In the wake of the taxation changes announced in the recent budget, these funds are now, more or less, as attractive (or unattractive) as any other debt instrument.  The taxes that such investors would now have to pay in these funds could well be up to three times (or even more) what one would have paid based on the earlier tax laws.  This would also be the case for investors who have already made investments in debt funds and need to withdraw some or all of those investments, some time after the completion of 1 year (from the date of investment) but before the completion of 3 years from that date.

For all such investors, who are uncomfortable with the additional tax now needed to be paid, I would like to propose the case for a greater allocation to equity oriented funds.  A note of caution: Equity funds are not a natural substitute for debt funds or any debt instrument.  These require far greater risk management as compared to debt funds, and it would help to bear that in mind while evaluating this.

The background: According to the new budget proposals, gains from exiting a debt fund before completion of 3 years will now be taxed at one’s normal tax rate.  Gains from exiting an equity oriented fund after completion of 1 year continue to be tax-free.  At the time of writing, a deposit with State Bank of India for a period of between 1 and 3 years, is assuring an annualized return of 9.31% p.a.  If taxes were to be taken at 30%,  then this roughly translates into a post-tax return of 6.52% p.a.  One could say that an equity oriented fund needs to produce returns in excess of this number for it to be a more worthwhile investment.

The case: To understand the odds, I looked at data of the NSE-50 Total Return Index, and tried to examine the outcome from making a hypothetical investment in this index on each day between 11 Feb, 2000 and 5 Nov, 2010 (both dates represent market peaks).  More specifically, I tried to see how long would it have taken such an investment made on each day to deliver an annualized return of 7.00% p.a., after taxes (subject to a minimum absolute return of 7.00%, after taxes).  Tax (on investments held for less than a year) was assumed at 15%.  Here are some of the key observations:

• Of the 2682 trading days in this period, there were 2207 days (82%) on which, if an investment were to have been made, would have resulted in this target return in a period of 1 year or less.   
• There were 1864 days (70%) on which,  if an investment were to have been made, would have resulted in this target return in a period of 180 days or less. 
• There were 621 days (23%) on which,  if an investment were to have been made, would have resulted in this target return in a period of 30 days or less.  
• There were 179 days (7%) on which, if an investment were to have been made, it would have taken over 3 years to achieve this target return.  These include 43 days on which, if an investment were to have been made, this target return would have not yet been achieved (as on 30 June, 2014).  
• The longest wait to achieve this target return would be for an investor who invested on 29 Oct, 2007.  As on 30 June, 2014, he/ she would have waited 6 years and 8 months.  As on that date, the return on his/ her investment would have been 5.06% p.a.
• There were 1754 trading days on which the trailing Price-Earnings (P/E) Ratio of the NSE-50 was below 20.  An investor who invested on any of these days would have had to wait no longer than 2 years and 11 months to achieve the target return.  Of these, there were 1553 days (89%) on which, if an investment were to have been made, would have resulted in this target return in a period of 1 year or less.   

In case you think there is a case for using this information to formulate a strategy, here are some suggestions:

• I believe that the primary motivation for using this information as part of a strategy should be to bring down taxes.  This will help determine how much should be additionally allocated to equity funds.  Any motivations beyond that should be carefully assessed before moving ahead. 
• Judiciously pick the moments when you would want to allocate money to equity funds.  The P/E Ratio can be a good indicator.  In addition, I would also consider how much below the last peak is the index.
• Don’t defer your exit from an equity fund till the time when you need the money.  If, at that time, prices are down, it may have far more adverse consequences than you may realize. 
• Do bear in mind that any gain from exiting an equity fund before the completion of 1 year is not tax-free.

At the time of writing, the P/E Ratio of the NSE-50 stands close to 21, and markets are around their all time high.  Personally, I would use this as an opportunity to exit equity funds to the extent that I can anticipate a need that would otherwise increase my tax liability.

Balanced funds may be riskier than you think

Balanced funds are widely understood to be funds that invest across equity shares and debt instruments, but with a slight tilt towards equity shares.  In India, to attract investors with tax benefits, over the years, that tilt has increased.  As things stand today, it would be unlikely for a balanced fund to hold, on an average, less than 65% of its portfolio in equity shares.

For a number of people, balanced funds represent a sweet spot between debt funds and equity funds- “the best of both worlds,” so I am often told.  Most advertisements, articles, and literature seem to encourage that view.  In the eyes of most people that I speak to, in a bull run, these funds are expected to do nearly as well as equity funds, while in a bear phase these are expected to protect the downside risk better than those funds.  While these are generalizations which theoretically appear sound, in this post I’d like to delve into some specific issues related to the risk in these funds.  In case you’re an investor in one of these funds, wondering whether to continue holding these, or you are someone who is considering investing in one of these, this post may help you make a more informed decision.

Don’t go by the name: There is at least one fund with ‘Balanced’ in the name, that is described by its fund house as being an equity fund (and not a balanced fund).  There are also funds that are described by their respective fund houses as being balanced funds, something that you wouldn’t know from their name.  The only sure way to know is by going through the investment objective.  Another way could be to go by the fund categorization of Value Research (Hybrid – Equity-oriented).

All balanced funds are in the ‘brown’ category:  Effective July 2013, fund houses are required to group their funds into three categories, distinguished by color, based upon the level of risk to one’s principal.  While the effectiveness of this coding itself is a matter of debate, as far as I have been able to make out, all balanced funds, along with all equity funds have been lumped together as high risk investments (brown color).  One could infer that within the framework of this coding, there is no significant difference between balanced funds and equity funds.

It is possible for a balanced fund to fall more than an equity fund: The rise or fall in a fund’s NAV depends upon the rise or fall in the prices of the underlying investments.  A balanced fund’s equity investments, as a percentage of the portfolio, will usually be less than that of an equity fund’s.  However, it is possible that the fall in value of those investments be more than those of an equity fund.  In the bear phase of 2008-09, going by data from Value Research, the worst performing balanced fund fell by over 74% from its peak.  To put that number into context, this fund underperformed 98% of the equity funds (including sector funds).

The equity allocation may be more than you think: Based on my conversations with investors, I gather a perception that a balanced fund would usually have 60%-70% of its portfolio in equity shares.  Based upon data from Value Research, as on 30 June, 2014, 12 of the 15 largest funds in the category, ‘Hybrid Equity-oriented,’ had equity investments in excess of 70% of their portfolio (most were closer to, or above the 75% mark).  One of the funds had over 81% of the portfolio in equity investments (its objective allows it to go up to 100%).

There is risk in debt, as well: Going again by data from Value Research (as on 30 June, 2014), if interest rates were to rise by 0.5%, the value of the debt instruments in the portfolios of some of the largest balanced funds could go down by close to 3%.

There is nothing wrong with taking risk so long as we are clear about the nature of risk and consciously make our choices.  Personally, I avoid most hybrid funds.  Most of these have investment objectives that are too vague for my comfort.  Further, investing in these means agreeing with whatever allocation the fund manager chooses to have between equity and debt, and also the choice of strategy and instruments in each of these investment categories.  As I see it, investing in separate funds for each investment category gives me a lot more clarity and flexibility.