The Hindu Business Line : `Volatility can be managed by derivatives'

I believe that derivatives, used judiciously, can really help increase the alpha. Not many have done it because fund managers usually tend to be not so comfortable with derivatives. — MR R. RAJAGOPAL, HEAD-EQUITIES, DBS CHOLA MUTUAL FUND

Taking over in December as Head of the Equities at DBS Chola Mutual Fund, Mr R. Rajagopal has set in motion a restructuring of the equity portfolios managed by the fund house. He believes that a focus on a fund's stated benchmark, active churning of the portfolio and the use of derivatives to contain volatility, could add considerable value to fund management. In this conversation with Business Line, Mr Rajagopal discusses the investment style and rationale that now underlies DBS Chola's equity strategy.

Excerpts from the interview:

What key changes have you made to DBS Chola's equity funds since taking over?

As each fund manager tends to have an individual style of investing, there are bound to be changes when a new fund manager takes over. I too have made a few changes to the investment style of the funds we manage. I have preferred to keep the objectives for each of the funds unchanged because I believe that we have a comprehensive set of funds spanning the entire spectrum — a large-cap fund, a contra fund which complements it, a multi-cap fund, a mid-cap fund and an opportunities fund.

What I have tried to do is to align the portfolio of each of these funds more closely with their respective objectives and benchmarks. For instance, in the Contra Fund, we stepped up exposure to the petroleum and gas sector to reflect the contrarian stance and this has paid off.

We similarly added bank stocks after they were slaughtered following the CRR increase, automatically qualifying them as contrarian picks. A sector such as chemicals and fertilisers may qualify as a contra bet and even sugar may eventually qualify as a contrarian pick. I believe that even fancied sectors such as IT can offer contrarian picks as select stocks may be beaten down because of near term earnings expectations.

I also believe in being more or less fully invested because our investors have given us a mandate to invest and not to take a cash-call. Taking an asset call between equity and cash is not warranted. Our effort would be to remain fully invested, with a 6-7 per cent allocation to cash to manage liquidity.

Another exercise that we have commenced is to re-evaluate our portfolios in light of their stated benchmarks. In the Indian context, there is a tendency to club all the equity funds together and compare them, irrespective of their investment objectives and their benchmarks. We believe that this is incorrect. All funds benchmarking themselves to a specific index should be compared to each other. Increasingly, our effort would be to focus on the stated benchmark, while also giving comparative performance.

We believe that this will help us differentiate our funds from the 160 or 170 equity funds that are there today in the marketplace. I believe that the period between the quarterly results, where there is limited news flow, offers a good window to re-evaluate your exposures. A certain amount of churn is good for the portfolio, as long as it reflects the investment philosophy and adds to the fund's returns.

Portfolios of Indian funds are often very different from what their benchmarks indicate. A fund with the Sensex as its benchmark may have a sizeable mid-cap exposure. How should you evaluate the performance of such funds?

A fund manager is not prohibited from taking that bet. But to do so, you should have your risk-return matrices in place. When the fund manager deviates significantly from the benchmark in terms of sector or stock composition, he adds incremental risk to the portfolio. The returns have to be higher to compensate for that risk. In our case, whenever we do deviate from the benchmark, we will keep tabs on the stock to track the returns. Hereafter, we will be objectively disclosing both the risk and return profile of our funds. This is also in line with international practices where funds routinely disclose their overweight and underweight positions with respect to their benchmark.

We find significant changes in some of your equity portfolios for some of your funds. In the Chola Growth portfolio, only seven stocks from the preceding month have been retained. What is the rationale for these changes?

I look at the current portfolio of any fund at today's prices, without taking into account the cost at which these shares were acquired. Only this process will help me truly assess the potential of the companies that we hold in our portfolio, objectively. It is this underlying rationale that would have influenced the changes to the portfolio. I would hold on to a stock only if we believe it to be a "buy" at that price. We use a combination of a top down and a bottom up approach to stock picking. The former will expand our universe of stocks and the latter will help us identify buys and sells within a sector. We may have booked profits in certain stocks because we believe that the price has captured the intrinsic value or have identified sectors with better potential.

For instance, I have added telecom stocks to the Chola Growth portfolio. One, the sector offers a pure growth play that cannot be ignored. Second, the sector constitutes a significant weight in the underlying benchmark and, therefore, not having telecom stocks would expose the fund to higher risk, relative to the market. Finally, I think that managing portfolio volatility is as important as selecting the right stocks. I would like to have a higher standard deviation of returns on my portfolio in a bull market and a lower one in a bear market.

How would you manage that?

This can be managed by making extensive use of derivatives. I believe that derivatives, used judiciously, can really help increase the alpha (excess returns generated by the fund). Not many in the industry have done it before because fund managers here usually tend to be not so comfortable with derivatives. I have noticed that funds that have done well in a bull phase often do not perform well in a volatile or a bear phase. Theoretically, I think the beta (the extent to which a stock moves relative to the index) can be managed quite well.

If you see the market falling, you exit high beta stocks and if you have a positive outlook, you add them. In the growth fund, if I have to reduce the beta, I could book profits in high beta stocks and buy the Nifty instead; this would automatically reduce the portfolio beta. Using a tracking error for actively managed funds would help you identify risks and potential for greater volatility.

If you can call the direction of the markets, wouldn't holding cash be more effective?

That is why I stated in advance that I wouldn't take a cash-call. I think that holding cash distorts the asset allocation pattern for the investor. He has given me the mandate of investing in equities and it is up to the fund manager to manage returns as well as volatility. I look at it this way.

I have already stated in the offer document that I will invest 80 per cent of the portfolio in equities, this gives me only a 20 per cent leeway to hold cash... . anything more than that will be a deviation from stated objectives. And I believe that a 20 per cent allocation to cash cannot protect the remaining 80 per cent from downside. I think it is much better to look for stocks that are reasonably priced in relation to their intrinsic value.

Over the past year "value" based strategies have sharply under-performed "growth" based strategies. Do you see a reversal of this trend?

I think the question is not about choosing between value and growth, but about having an allocation to both styles in your portfolio. I believe that investors should have adequate diversification between fund management styles and market caps in their portfolio.

For instance, an investor cannot choose our Growth Fund and ignore our Contra Fund right now because the former has performed well recently. You cannot predict in advance when the Contra Fund may start outperforming. Hence, investors will need to invest in both to optimise returns from his portfolio. If there is a multiplicity of schemes in the fund industry, it is there because investors require opportunities to diversify.

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