The Hindu Business Line : Equity funds: Select themes offer a glimmer of hope

Investors need to remain patient during volatile times. The strategy of switching between funds every quarter not only exposes you to the risk of losses but also pegs up transaction costs.

The first quarter of 2007 may not provide fresh hope for those who wished that equity funds would once again display stellar returns. Volatility in the market over the last quarter has ensured that the returns were flat, or even negative, for those who hold equity funds.

Clearly, if the Sensex and Nifty returned a negative 6.2 per cent and a negative 4.6 per cent respectively over the quarter, and broad-based benchmarks such as BSE-500 and small- and mid-cap indices fell as much, or more, equity funds could not be expected to come up with any surprises.

An analysis of about 185 diversified funds (including tax-saving funds, but excluding sector funds) reveals that only two delivered positive returns of about 1 per cent. The two, Kotak Lifestyle and Birla India Genext, though not diversified, are theme funds with a broader universe than sector funds.

Among the others, while 46 per cent of the equity funds fell less than the Sensex, only 18 per cent managed to contain losses better than the Nifty. This time around, the Nifty turned out to be a tougher benchmark for the funds to beat, in terms of containing the downside.

Themes That Saved The Quarter

The quarter provided indications of the themes that aided some portfolios to perform better and they may well be the preferred market flavours in the coming months. For one, funds with themes such as services and consumer spending have done better than their peers.

Diversified funds that were overweight on the above-mentioned themes as well as IT and financial services bettered the bellwether index. Fidelity Equity and Standard Chartered Premier Equity are among the diversified funds with IT in their top slots.

JM Basic, a theme fund that holds over 50 per cent in engineering companies, was however an exception as it was among the funds that lost less than 1 per cent despite not holding stocks in the IT or services sectors. The fund's focus on the power equipment space paid off. Its performance is turning around following a change in fund management and requires a close watch.

Among the funds that contained the downside well, Templeton India Equity Income was conspicuous for its strong resistance to a declining market, thanks to its globally diversified portfolio. The fund stepped up exposure to foreign stocks (subject to a maximum limit of 35 per cent) with a high dividend yield. If the fund continues to invest in high dividend yielding international stocks, it may be a good option for investors who feel that value investing in the local market has not matched expectations.

In the dividend yield category, four of the six funds contained losses better than the BSE-100 (the benchmark for many of these funds) with average declines of 5.4 per cent. Oil and gas stocks played a role in UTI Dividend Yield's better performance. The BSE Oil and Gas Index saw a 2 per cent gain over the quarter. While the downside has been contained this time around, these funds may not be the best options for aggressive investors as their long-term returns have not been inspiring.

Interestingly, while diversified funds with IT exposure weathered the volatility better, most of the exclusively IT funds, barring DSPML Technology, declined in value (albeit less than the BSE IT Index). DSPML Technology was the lone star in this space, with a 5.8 per cent return. A look at its portfolio suggests that the three fancied telecom stocks — Bharti Airtel, Reliance Communications and Idea Cellular — may have propped up the fund's returns. This apart, many other IT funds were heavy on tech major Infosys, whose performance over the quarter remained lacklustre. DSPML Technology had relatively low exposure in this stock.

Reliance Media & Entertainment was another theme fund that fared well. This fund returned 6.2 per cent, next only to the DSPML Technology. JM Telecom Sector Fund also registered positive returns.

Funds banking on infrastructure and capital goods languished, losing more than the BSE Capital Goods Index. The rally in this sector was limited, because of which the index did better than fund portfolios.

Among others, auto, FMCG and banking sector funds were the worst hit. Sector funds can be risky investments in a volatile market. While a three-month period is no real basis for an investment decision in funds, it may send signals about slippage or improvement in long-term performance as well as the sectors in fancy. Investors holding sector funds need to track their performance more closely than they do diversified funds.

One must recall that over 2005 and most of 2006, infrastructure was the main theme of diversified funds that came up with stellar returns. While such funds had the flexibility to shift to other favoured themes, those dedicated to a single sector lost out. This only drives home the point that investors who cannot time their entry or exit and actively track sectors would be better off with a diversified or broad-based theme fund.

Balancing Well

While just nine of the 28 equity-oriented balanced funds contained their decline to a value lower than the CRISIL Balanced Index, the average return of a negative 4 per cent in this category is, nevertheless, better than the average negative returns of 6.9 per cent for diversified funds. Given that these funds are now constrained to hold at least 65 per cent in equity, their hedge from the debt portfolio is that much less. However, active management of the debt component in funds such as FT India Balanced and HDFC Prudence have helped them record superior average category returns over the past year.

Balanced funds may yet again emerge as an option for reasonable returns on a risk-adjusted basis in a volatile market. Calculations suggest that, at this point in time, balanced funds may emerge as a more cost- and tax-efficient alternative to owning a portfolio of Sensex and liquid funds.

A Small Story to Tell

If fund managers see value in small- and mid-cap companies, this value is yet to be unlocked; or so it appears from the category's dismal returns in the quarter. Among funds with mid-cap oriented portfolios, Tata Growth, Principal Junior Cap, Kotak Midcap and Reliance Growth lost less than 4 per cent and did not fall as much as the BSE-500. Investors who believe in the segment's potential may stay with such funds provided they do not form the core of their portfolio.

If you are wondering what happened to funds with a long-term track record such as HDFC Equity, Kotak-30 or HDFC Top-200, you can rest assured that they have at least bettered the Sensex returns and their sector and stock holdings show reasonable return potential. In addition to the above funds, investors could diversify with Birla Frontline Equity and DSPML Top-100, which recently entered the list of funds with a good long-term record. Templeton India Equity Income is also a good option for diversifying overseas.

Finally, the message for investors from the quarterly scorecard: It has probably not changed much from the previous quarters, but here goes:

Investors need to remain patient during volatile times. The strategy of switching between funds every quarter not only exposes you to the risk of losses but also pegs up transaction costs. Top performers change every quarter.

Just as there are no short-cuts to building wealth, investing in diversified equity funds for the short term doesn't work. Mutual funds are emerging as clear long-term investment vehicles

Sector fads can be captured adequately through diversified equity funds, even while assuming much lower risk, rather than through sector funds. IT and infrastructure funds are cases in point.

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