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Suresh Krishnamurthy

INNOVATION has been the hallmark of mutual fund operations in India in the last couple of years. The latest is the funds of funds concept, in which one mutual fund seeks to ride on the performance of others.

Money-making through investing in `balanced' funds is poised to become less risky with the `fund of funds'.

An analysis of mutual fund returns indicates that the `fund of funds' concept can reduce risks considerably.

As balanced funds are a more suitable option for retail investors, and as the performance of balanced funds has been poor, this is encouraging.

A fund of funds is a mutual fund scheme that does not invest in securities directly. Instead, it invests in other mutual fund schemes. The advantage — the fund of funds manager focuses only on allocation to specific schemes (fund manager selection) or asset classes such as equity or debt (tactical asset allocation) to add value.

To find out if the concept would have added value, Business Line picked a handful of equity and debt funds and analysed their returns between June 1998 and June 2003.

The equity funds were HDFC Top 200 (a broad-based fund), Franklin India Prima (mid-cap), Templeton India Growth (large-cap value) and HDFC Equity (large-cap growth).

The debt funds were Birla Income Plus, HDFC High Interest and Sundaram Bond Saver.

The analysis showed that:

A fund of equity funds does not perform better than a simple strategy of buying a handful of equity funds and staying with them.

A fund of debt funds delivers marginally superior returns compared to the simple strategy of buying a number of debt funds and holding on to them.

However, transaction costs could reduce returns considerably.

A fund of funds similar to an `asset allocation' fund that allocates between equity and debt performed better than HDFC Prudence on risk-adjusted terms.

This is no mean feat, as Prudence is way ahead of the other balanced funds. This suggests that an asset allocation fund has the potential to beat almost all balanced funds .

Asset allocation

A fund of funds that allocates between a clutch of pure `growth' schemes and pure `debt' schemes is somewhat akin to a balanced fund which, typically, has a mix of equity and debt instruments in its portfolio.

Balanced funds usually maintain constant asset allocation. Most balanced funds maintain allocation to equity at 60 per cent, the rest going into debt.

For our imaginary Fund of Fund too we may assume that 60 per cent of the amount is invested equally in select equity funds, with the rest spread equally across chosen debt funds.

An amount of Rs 100 invested in the imaginary asset allocation fund maintaining a constant asset allocation since June 1998 would have increased to Rs 265 in June 2003. Invested in HDFC Prudence, it would have appreciated to Rs 274.

However, the volatility of returns — changes in monthly returns — of HDFC Prudence was nearly 20 per cent higher.

In other words, the imaginary asset allocation fund performed better in risk-adjusted terms.

Asset allocation funds also have the advantage of changing the equity and debt mix tactically. In practical terms, this means allocation to equity would be determined based on expected returns from equity and the rest would be invested in debt.

For our anaylsis, tactical asset allocation was considered based on the price-to-book value ratio of the Sensex. A low price-to-book value would require higher allocation to equities, and vice-versa.

How would an imaginary tactical asset allocation fund have performed between June 1998 and June 2003? Again, the performance would have been substantially better than that of HDFC Prudence.

The returns of a tactical asset allocation strategy were 3.3 per cent higher in absolute terms. In terms of risk, the strategy's volatility of monthly returns was 27 per cent lower. In other words, the strategy delivered substantially superior risk-adjusted returns.

Bias of chosen funds

Can the results be misleading? Indeed, the possibility exists. The equity funds chosen may represent the best in their class between June 1998 and June 2003.

Their returns may not represent what an average equity fund could deliver. However, choosing HDFC Prudence as the benchmark controlled this risk largely.

HDFC Prudence is streets ahead of other balanced funds in the country. If the equity funds chosen represent the best in their class, so is HDFC Prudence.

This lends greater credence to expectations that asset allocation funds can deliver superior performance vis-à-vis balanced funds.

Importantly, balanced funds, other than HDFC Prudence and to an extent US-95, have generally delivered significantly lower returns in the past.

So, asset allocation funds offer a superior option to investors. An asset-allocation fund manager would focus only on allocation to a number of equity and debt funds. The equity and debt funds would focus on particular stock/security selection. Divorcing the function of asset allocation and security selection can generate better returns.

Anyway, the analysis of past returns is promising in this regard.

Equity and debt: Less promising

The analysis of past returns is, however, not promising in the case of a fund of equity funds. An amount of Rs 100 invested in a fund of equity funds that invests equally in the chosen equity funds would have grown to Rs 309 in five years. However, a simple strategy of an investor buying the four funds and holding on to them would have delivered similar returns.

Tactical allocation is possible even in the case of a fund of equity funds. Again, the price-to-book-value of Sensex was considered for our analysis. A low price-to-book-value ratio would require higher allocation to Franklin India Prima and HDFC Top 200. A high ratio would require higher allocation to Templeton India Growth and HDFC Equity.

An amount of Rs 100 invested in such a strategy would have grown to Rs 315. This does beat the buy-and-hold strategy. But this is before costs. Costs would bring down the returns substantially.

In addition, the risks — measured in terms of volatility of monthly returns — actually increase marginally. In other words, the returns are insignificantly higher. A fund of debt funds also provides insignificantly higher returns compared to the simple strategy of buying and holding a few debt funds.

In line with theory

Essentially, the analyses indicate that buy-and-hold strategies are still superior for investors in equity and debt funds. A fund of equity or debt funds is less likely to add value. In the case of a fund of equity or debt funds, even tactical asset allocation needs to be viewed with scepticism.

Such a view is also in line with theory. Index movements contribute a substantial proportion of returns in the case of equity funds. In addition, the character in terms of asset allocation or risk of the equity funds in operation also does not differ significantly.

When this is the case, a strategy diversification and rebalancing among equity funds cannot be superior to a buy-and-hold strategy.

However, a fund of funds in the form of an asset allocation fund can emerge as a lower risk alternative to balanced funds. This too is in line with theory. Theory says that asset allocation accounts for a major proportion of returns generated by a strategy.

So, a greater focus on asset allocation should add value. That is encouraging given the insipid performance of balanced funds so far.

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