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Suresh Krishnamurthy

IN January 2002, the bond market looked set for a correction. Yields on government securities had declined substantially. The difference in yields (spread) between a short-term government security and a long-term government security had declined sharply. If interest rates had increased and in addition, if the spreads had widened, then the income schemes would have had to deal with sharp decline in their net asset value.

However, mutual fund managers still held on to long-term government securities and interestingly even invested the fresh inflows in such instruments. Their strategy was predicated on their ability to time the market.

Market timing: Timing the market in the case of the bond market involved an increase in duration of the portfolio when interest rates were declining and reducing the duration of the portfolio when interest rates were rising. Duration measures the sensitivity of the portfolio to changes in interest rates.

With interest rates having increased and spreads having widened, it is time to examine the performance of mutual funds. Evidence indicates that select mutual fund managers may have actually done reasonably well in terms of timing the market. Although, these fund managers may not represent the entire universe, these belong to almost all of the large size funds in the category. This makes their performance relevant for investors.

One of the interesting aspects relating to the performance of debt funds in the last three months is that Templeton Floating Rate Income Fund has recorded a positive return in the last one month when no other fund has done so. This suggests that more such products may be launched and that retail investors do have a product to hedge against rising interest rates.

Reducing duration: In April 2002, there were signs that asset management companies were reducing the duration on the income schemes. Average portfolio maturity of the income schemes that were much higher than seven years were down below five years. Now, the reduced duration has helped the funds mitigate the impact of the fall in bond prices.

For instance, the growth in the NAV for most funds over the past year continues to be above 13 per cent for a prominent set of income funds. This is despite the decline in yields seen in the period since the beginning of March 2002. Importantly, the average return over the last three months continues to be positive even after the decline.

Debt funds do well: The performance suggests that managers of the prominent income schemes have been able to anticipate interest rate trends reasonably accurately in India. Investors in the mutual fund debt schemes will breathe a sigh of relief since a significant portion of the appreciation in the period since June 2001 was at risk. In addition, the performance of fund managers in the period since March 2002 is relevant because debt funds have lost their tax efficiency. Now, they would have to do better than a naïve investor to justify the expense charged to the fund.

Expenses continue to be high and range between 1.25 and 1.75 per cent of the average weekly net assets. This can reduce the return from the income schemes significantly if they do not add value through active management. In such a backdrop, the performance of the fund managers in the last six months can be viewed positively. Still, investors need to keep a close watch on the performance of income funds.

From a long-term perspective, however, the performance during 2002 may not be entirely relevant. Managers may have to show consistent market timing ability to stake claim to superior market timing ability. One swallow does not make a summer.

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