Sensex Soars Past 30,000-Are you Investing In The Right Mutual Funds?

Apr 28, 2017

On April 26, 2017, the S&P BSE Sensex and the Nifty 50 set a new record. The Sensex surpassed the psychological 30,000-mark and the Nifty for the first time floated above 9,300.

As the Indian economy stabilises and the Bhartiya Janata Party (BJP) proves to be a dominant force under Prime Minister, Mr Narendra Modi's leadership, improved reforms seem more definite, leading many to buy in to India's growth story. Global liquidity facilitated by accommodative monetary policy has been an abetting factor too.

There's evidently a celebratory atmosphere of cake cutting on Dalal Street and champagne flowing. Undoubtedly, mutual fund investors are a happy lot. Large-cap equity funds have gained over 20% in the past year (as on April 25, 2017), while mid-cap funds are sitting on gains in excess of 30%. Now as the rally is gaining steam, others are flocking to equity mutual funds in a hope to be part of future celebrations.

But for those who are acquainted with market history will know that market euphoria is often followed by a correction, if not 'depression'. The volatility stems from the burgeoning valuations that are often unsupported by tangible growth.

Remember the dot-com bubble? Software stocks commanded obscure valuations. In January 2000, the Sensex was at 5,000 with a P/E of 22 times. A month later, the Sensex went on to touch nearly 6,000 points. The Sensex P/E crossed a whopping 26 times. What happened next-went down as the historic dot-com crash. By September 2001, the Sensex had crashed to half its value at 2,600. The P/E fell to under 15 times.

In the current market rally, many seem oblivious to the soaring market valuations. Though the market may not be in a bubble zone yet, do not ignore the margin of safety that has narrowed considerably. Currently, the trailing price-to-earnings (P/E) of the Sensex is nearly 23 times, while that of the BSE MidCap is over 33 times.

This does not mean that you should stop investing in equity mutual funds or even withdraw your investments because of the high valuations. All you need to do is prudently invest in carefully selected mutual funds, with a good plan or strategy in place.

There is a variety of equity-oriented schemes. Based on the investment objective of the schemes, we can classify them into different categories. So broadly, we have:

• Large-cap Funds
• Multi-cap or Flexi-cap Funds
• Mid-and Small-cap Funds
• Opportunities Funds
• Value Funds
• Balanced Funds
• Thematic and/or Sector Funds

From the categories listed above, which are suitable for you given the current market high? Let's take a look at the different categories in terms of risk...

Very High Risk

Mid-and Small-cap funds offer investors the potential to generate significant wealth. However, the risk is substantially magnified if you look at the valuations in this space. If the market corrects from here, mid-and Small-caps will buckle first and plunge the most. Therefore, it is extremely risky to invest in the mid-cap funds at the current juncture. Unless you have a very long-term investment horizon, this category of equity funds is best avoided.

Thematic and/or Sector Funds are a complete no-go. These mutual funds tend to capitalise on investment themes and/or sectors. When a theme or sector is doing well, fund houses launch schemes connected to that specific sector. As the portfolio is concentrated to specific sector or theme, the risk too, is concentrated. Hence, if there are certain micro or macro factors that affect the specific sector that you are invested in, it could lead to deep losses. Therefore, you should invest only if you understand the fundamentals and economics of the theme or sector you are investing in. Sector and thematic funds are best avoided, unless you want to take greater risk while your core mutual fund portfolio is well in place.

High Risk

Opportunity Funds are more aggressive, hence, riskier than the usual equity diversified schemes. These funds hold a mandate to seek investment opportunities across sector/themes and across market capitalisation segments. They place short to-medium-term bets, depending on the outlook of the fund management team. Some fund managers and/or their investment processes may be more successful than others in discovering market opportunities. At a market peak, it becomes difficult to find good opportunities, as most good sectors are priced out. Hence, you need to pick a scheme that has delivered superior risk-adjusted returns. Else, this category too, is best avoided.

Multi-cap or Flexi-cap Funds that have a higher proportion of mid-caps in their portfolio may suffer bouts of high volatility. Due the high market valuations, many funds are adopting a cautious approach. They are moving out of mid-caps to large-caps. Hence, those with a higher large-cap allocation will be more stable than others. Therefore, certain funds within this category can be a worthy investment. Make sure you do your research well.

Moderately High Risk

Value Funds usually do arrest the downside in a bear market, and reasonably outperform in a bull market. In an overvalued market, it is tough for the fund manager to find undervalued stocks. The best time to go digging for undervalued stocks is in a beaten down market. The fund manager needs to be extremely prudent when it comes to picking stocks. Therefore, it is imperative that you consider the long-term track record and analyse the potential of the fund to generate higher risk-adjusted returns. A few established value funds are able to deliver superior risk-adjusted returns across market cycles.

Large-cap Funds are less volatile and are well poised to handle uncertain market conditions. Large cap stocks turn attractive in volatile markets because of their stable businesses, greater market share, quality of management and the sustainability prospects. Large blue chip companies with strong balance sheets and proven track records could help ride the wave of short-term volatility to a certain extent. Therefore, equity funds with a predominant large-cap allocation can offer stability to an investor's portfolio. Such large-cap funds are geared to negotiate market cycles better.

Balanced Funds are equity-oriented hybrid funds having a mix of equity and debt instruments in their investment portfolio. These funds offer a good tactical allocation between equity and debt (usually 60% to the former and 40% to the latter), and are a good alternative when equity valuations have deviated significantly from the mean. These set of funds provide stability in a volatile market environment. At the same time, they have the potential to generate superior capital appreciation over longer periods, from significant allocation to equities. Hence, balanced funds offer the perfect mix of stability and growth for a moderate-to-high risk profile investor.

At the current market peak, Moderately High Risk funds will be your best bet. These funds will offer reasonable stability with good long-term growth.

Please note, the moderately high-risk category of funds is only better equipped to manage risk. But you need to invest as per your risk profile in a systematic manner while you endeavour to achieve your investment goals. You need to choose the right scheme prudently. You need to look at the performance of the schemes over the long-term and not fall for their short-term performance.

More importantly, you need to start saving regularly towards your goals. Investing in equity requires discipline, patience, and perseverance. If you are expecting quick returns, avoid investing in equity

Many undermine the power of regular and long-term investing. Consider this:

If you had started a Systematic Investment Plan (SIP) in an equity fund at the market peak in 2008, you could now be sitting on double-digit returns. Had you invested in the Sensex (total return index) via a SIP on the 1^st of every month, from January 2008 to March 2017, your investment would have grown at a compounded rate of 11.25%. This means, your investment of Rs 5,000 each month across the 111-month period i.e. a total investment of Rs 5.55 lakh, would have nearly doubled to Rs 9.50 lakh. And don't forget, you started at the market peak.

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Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.