Mutual Fund: In Debt We Trust

Image: Nitin Veturkar for Forbes India

As the sun set on 2010, equity fund managers were a worried lot. Rising competition, the nascent rise of index funds and high correlation among asset classes have not been encouraging signs. Over the past year, most of them struggled to give returns superior to the market. Going forward, things will only get more difficult.

Look at it from any angle, there is not much reason why the equity market should rise significantly right now. The market is trading at a premium to the levels of other emerging markets. At 23, the price-to-earnings multiple of its key index NSE Nifty for the last 12 months is back to the level seen only during the dotcom boom. The dividend yield has fallen below 1 percent and the return on investment for firms is on a downtrend. As if all this is not enough, the economic environment is deteriorating. Commodities prices are rising and inflation is a big worry. Political tensions are making investors nervous.

Last year, fund managers were telling investors to pull money out of fixed deposits and other fixed income products and invest in equity. Today, they think the stock market will not return more than an FD or a gilt fund.

A Forbes India poll of eight top fund managers in India revealed that most believe the stock market will go up only by 10 percent or less next year. As interest rates rise, this is almost what one could earn from a safe bank deposit!

But fund managers believe they can spot niche opportunities that will help them ‘seek alpha’, jargon for chasing returns higher than the reference index. But there is a caveat. “Investors need to invest long term. We need to look way beyond 2011 if we want to build wealth,” says Kenneth Andrade, chief investment officer, IDFC mutual fund.

This is the year for stock selection. With luck and discipline, some fund managers will be able to exploit them profitably. With around 3,000 stocks and a growing economy, they are confident they can do better than the market. “In fact, we are spoilt for choice. Actively managed funds can give alpha in the Indian markets easily for the next five years,” says a senior fund manager.

With 153 diversified equity funds, retail investors too are spoilt for choice. The problem: How to choose that fund.

Christopher Traulsen, director, Fund Research, Morningstar Europe & Asia, says investors don’t look at costs. “We see a fund at the top of the league table and we buy it. We need to look at costs as they will eat into returns in the long term. We need to ask if the fund is taking more risks to be at the top and if it is consistent in giving those returns.”

The need is for funds with high returns and low costs. A Forbes India-Morningstar study shows that HDFC Top 200 and DSP Blackrock Top 100 Equity Growth are funds that combine safety and attractive returns. Investors should look for large cap funds with expense ratios at less than 2 percent and mid-cap funds at less than 2.4 percent. Among mid-cap funds, IDFC premier equity delivered 27 percent for the past five years against the industry average of 14 percent. But equity funds will find it difficult to keep people from taking refuge in fixed income funds.

Conservative investors should look at monthly income plans (MIPs) that ride on fixed income returns, but have a small portion invested in equity to benefit from buying in the stock markets.

Balanced funds may be suitable for those who think the stock markets could revive later and give decent returns. These funds have more equity exposure than MIPs and invest about 65 percent in stocks. They went out of fashion due to high entry loads. Now that the regulator has abolished entry loads, there is no reason to avoid them. HDFC Prudence performed well in 2010, giving 21 percent against the segment average of 13 percent.
Gilt funds are the retail investor’s only option to benefit from government securities. In 2010, their popularity began to rise as some funds started giving ‘equity-size’ returns. Investors should keep in mind that most of the underlying instruments, despite being of sovereign nature, are illiquid. Investments should be considered only after interest rates have risen. Returns will accrue when the rates come off their peak. Short-term plans are ideal.

Investors are likely to patronise short-term funds due to the changing rate situation. Last year saw the launch of 257 fixed maturity plans (FMP) collecting Rs. 60,000 crore. A year earlier, there were hardly any FMPs.

The year 2011 will be a challenging year so it is better to stick to what you understand best. Ask for funds with lower costs, consistent long-term performance and an investment philosophy that matches your preference.