Want to invest? Don’t select fund based on short-term outperformance alone

Want to invest? Don't select fund based on short-term outperformance aloneOn August 28, the BSE Sensex closed at a lifetime high of 38,896. Year-to-date (YTD) it is up 8.39 per cent. The midcap and smallcap segments, which were market favourites until last year, have underperformed year-to-date. The S&P BSE Midcap Index is down 9.72 per cent while the S&P BSE Smallcap is down 14.49 per cent. Meanwhile, there are ominous signs emanating from abroad. Currencies of various emerging markets like Turkey and Argentina have depreciated sharply against the US dollar. India’s GDP growth rate for the first quarter of 2018-19 was high at 8.2 per cent. But the rupee has depreciated around 11 per cent YTD against the dollar and with crude oil prices trading at high levels, the current account deficit widened to 2.4 per cent of GDP. On the positive side, there were indications in the first quarter results that earnings are poised for a recovery.In recent days, large-cap indices like the Sensex too have witnessed a lot of volatility. With a crisis brewing in emerging markets and the country set to enter election mode – we have the state elections first followed by the general elections next year – many market experts expect the current bout of volatility to continue for the next year. Here are a few danger signals that mutual fund investors need to watch out for in the late stages of the current market rally.Narrowing rally: Towards the end of a long bull run in equities, the market rally tends to get narrow. The market is driven by only a few stocks. This is what we have witnessed in the stock markets in recent times. The recent large-cap rally was driven by less than 10 stocks. Funds that were invested in these stocks have done well, while those that did not pick these stocks have lagged behind.GraphIf your large-cap fund is currently lagging behind its benchmark, do not exit it and switch to a fund that is outperforming. The holdings that the outperforming funds benefited from have already rallied. For future gains, these funds too will have to invest in stocks that are underperforming currently. So, the outperformance of these funds could end just when you enter them. Instead, give the fund that you are in more time. If it is has a sound long-term track record, it will catch up with its peers in due course.Entering the funds that are outperforming currently entails another risk. In case of a correction, it may be the sharpest in those stocks and sectors that have run up the most to compensate for the higher growth they have witnessed in the past. Your portfolio could end up being hurt even more by being invested in these outperforming funds.Closed-end new fund offers: Investor participation in equity funds tends to go up when there is a boom in equities. We have seen the asset under management (AUM) of the mutual fund industry swell in the past few years. While overall industry AUM has risen from Rs 7.59 trillion in August 2013 to Rs 25.22 trillion in August 2018, equity AUM is up from Rs 1.59 trillion to Rs 10.12 trillion over the same period.In buoyant times, the mutual fund industry launches a slew of new fund offers (NFOs) to take advantage of positive sentiment and gather more funds from investors. In the past, these NFOs tended to be mostly sectoral and thematic. During the tech boom of 1999-2000 it was technology funds, while during the boom of 2006-07 it was infrastructure funds. The risk of investing in such sectoral and thematic funds is that they do well for only a limited period of time. When the sector starts going downhill, the fund manager doesn’t have the option to move into another sector that is doing better, as the manager of a diversified fund can. There can also be long periods during which that theme or sector is out of favour, causing underperformance in these funds.During the recent rally, we have not seen as large a number of NFOs as in the past. This is because of market regulator Sebi’s insistence that fund houses only launch NFOs in the open-end category if they are substantially different from the existing funds that the fund house runs. After the recently introduced norms on re-categorisation of mutual funds, fund houses can only run one fund in each category. All these regulations have limited the scope for NFOs in the open-end category.Most NFOs in recent times have been in the closed-end category. The regulator is reportedly working on tightening the norms for launching new funds within the closed-end category as well. Until then, however, investors need to be cautious about investing indiscriminately in new closed-end NFOs.One of their shortcomings is that you can only enter these funds during the NFO period. This introduces the risk of market timing. If the market is expensive at the time of entry, as it is now, you could end up earning poor returns from closed-end equity funds. Since you can’t run an SIP, you can’t average out your cost of purchase of units. Your timing of exit is also fixed. If the market is underperforming at that point, you could end up with sub-optimal returns despite a long investment period. If you wish to exit these funds mid-tenure, you will have to sell the units on the exchanges where trading volumes tend to be thin. Even if you find buyers, you may have to sell at a discount.Strong consensus: A strong consensus about a certain theme, sector or market cap among fund managers and investors is also a signal of trouble ahead. It can lead to fund managers loading up excessively on that theme, sector or market cap. When the inevitable downturn comes, funds and investors having concentrated exposure tend to get hurt more badly. In 2017, for instance, a strong consensus had emerged among investors in favour of mid- and small-cap funds. Many investors chose to invest only in these fund categories. Such investors have been hurt more badly during the downturn in these categories in 2018. Those who chose to stay diversified, or booked profits in mid- and small-cap funds and re-allocated to large-cap fund, have fared better.Gains already made: Another indication that things are getting worrisome is that the area or sector where the potential lies can have stocks that have already run up. There are times when the actual good conditions on the ground might be some time away, but stock prices have run up in anticipation. This happens because the markets discount the future and stocks run up based on early signals.If your fund has invested in such stocks, you could be in for trouble. First, such stocks may not rally further because they have already run up. And in case of a downturn, such stocks could fall more steeply. Many of these conditions taken together suggest higher risks for investors. The only way to counter the risks that arise in the late stages of a market rally is to be diversified across asset classes and categories, and stay true to your asset allocation.The writer is a certified financial planner
Source: Business Standard