While there are several welcome trends underlying the recent boom in the mutual fund industry, boom times can bring challenges of their own. Here are three specific items on the to-do list that AMCs and mutual fund investors need to take note of
Too few opportunities
Assets managed by equity mutual funds have nearly trebled, from `2.2 lakh crore to `6.4 lakh crore, in the last five years. But as we all know, the number of stocks listed on the exchanges has barely moved. This has meant too much money chasing too few investment opportunities. Indian AMCs have traditionally held that in the listed universe of 6,000 odd stocks, it is only the top 200 or 250 which are liquid and investment-worthy. Therefore, the manifold growth in assets has meant more money deployed in the same old stocks. This is what has led to stretched market valuations, with the Nifty's price-earnings multiple already at over 23 times. Most equity-fund portfolios carry even higher P/Es than the market, setting a high bar for earnings growth from here.
Not content with the moderate returns on the top 250 names, more adventurous managers have also expanded their coverage universe by looking for 'value picks' among mid and small caps. But given the limited depth in such stocks and the possibility of price manipulation, the higher returns come with business and governance risks.
Imperfect benchmarks
One of the key reasons for the runaway popularity of Indian equity funds is the ability of active managers to beat their benchmarks by large margins. India remains one of the few global markets where three-fourths of the active funds still beat the indices. But then, this trend of outperformance owes as much due to inappropriate benchmarks as to domestic fund managers' stock-selection skills.
Most of the widely tracked stock indices in India against which funds pit their performance are liquidity-based - they feature stocks with the highest free-float and trading volumes in the market. This makes it easy for active managers, who screen stocks based on fundamentals, to stay ahead of these indices. Should index construction evolve and the exchanges come up with better indices based on stock fundamentals, active funds may find it harder to stay ahead in the game. Cases of schemes using benchmarks that don't correctly fit their mandates and the practice of benchmarking to pure price indices instead of total returns indices also make fund performance appear optically better.
Fund-manager churn
Most Indian investors are by now used to choosing their equity schemes based on their return record. Funds with a consistent three- and five-year record of beating their benchmarks and peers usually manage to attract new inflows. However, the wild card in extrapolating a scheme's past performance to its future is the continuity of its fund manager and his style of investing. Fund-manager churn is quite high in the Indian mutual fund industry, especially in boom times.
A recent Value Research analysis showed that across equity schemes, the average tenure of a scheme's current manager was just three years. Just a handful of schemes have seen their fund managers stick around for 10 years or more, resulting in continuity of the stock-selection strategy and style. This is a critical item on the to-do list for AMCs, which need to work harder at retaining talent. For investors, before extrapolating the past record, it is important to run a check on the fund's current manager and how long he has been with the scheme. Finally, healthy as recent trends in the mutual fund industry are, there are three aspects of financial behaviour that investors may need to work on.
Invest when the times are bad: It is no coincidence that the recent surge in the popularity of mutual funds has coincided with a four-year old bull market. Double-digit returns on equity funds over the last one and three years have obviously drawn in new money. Mutual fund flows were, after all, modest in the six years to 2013, when markets were meandering sideways. This shows that investors continue to make the cardinal mistake of chasing past returns while making their investing decisions (and even signing up for SIPs). To earn truly exceptional long-term returns, investors need to take the plunge when past returns on mutual funds are in negative territory.
Don't forget risks: While selecting top-quartile funds for their portfolio has become a habit, there's still too little attention focused on the risks assumed by a fund in delivering returns. Funds which pack their portfolios with small- or mid-cap stocks, those which stray from their mandate and those which ignore high valuations may show up at the top of the return charts in good times but will eventually pay the price for those excesses in a less friendly market. Therefore, pay greater attention to risk measures such as portfolio P/E, beta and record in previous bear markets while choosing funds.
Rebalance: During good times for the stock market, the temptation is always strong to throw caution to the winds and over-allocate to equity funds in the attempt to get rich quick. AMCs, which earn their fees from those assets, aren't very likely to tell you when the markets are overheated. But do keep in mind that there is no such thing as a perpetual bull market as a combination of factors - global cues, liquidity shocks, earnings disappointments - continue to pose risks to this bull run. So if your financial goals are less than three years away or your equity allocation has overshot your original level, do sell some equity funds and rebalance in favour of debt.
Yes, it can be painful to book profits in a steadily rising market and you will certainly be tempted to ride the rally just a little bit further. But resisting that temptation will ensure that you aren't swimming naked if the tide turns.
This article was originally published on September 04, 2017.
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