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Is your mutual fund speculating on market direction? - Outside View by PersonalFN

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Is your mutual fund speculating on market direction?
May 2, 2014

The Indian Meteorological Department has forecasted below average rains this monsoon. But as far as Indian equity markets are concerned they are already flooded with incessant inflows of foreign capital. Now that election is underway and we being just a fortnight away from much awaited results, speculations about the outcome have reached the point of culmination. Almost all pre-poll surveys are anticipating BJP-led NDA to form the new government. Advancing stock market indices suggest that even investors are anticipating NDA to win. However, it is almost certain that markets may encounter extreme volatility over next few weeks. Let's find out if your fund manager is ready to manage volatility effectively.

As far as mutual funds are concerned, most of them appear to be optimistic about the on-going market rally. After doing detailed analysis, PersonalFN found that about 3 out of every 5 predominant equity oriented funds either raised their equity exposure or kept it almost unchanged in the March quarter. On the other hand, approximately 2 out of 5 funds raised exposure to debt and cash. Well, this shows that there is a possibility that your fund manager might be riding the stock market momentum.

Past experience...

In 2009, there were projections that India might not get a clear mandate. Investment climate was also not conducive as the global economy was surrounded by all sorts of bad news. Recession had hit most of developed economies. Developing economies also felt the heat, but they were comparatively less affected. Had India really got a fractured mandate, markets would have experienced massive selling pressure. On this backdrop, equity mutual funds became ultra conservative and many of them raised cash exposure significantly. In the interim, stimulus packages announced in developed economies started flowing into emerging markets. Indian equity markets too joined the global rally. Subsequently mutual funds slightly reduced their cash exposure, although it was still high as compared to normal level. Beating all estimates the Congress led UPA won comfortably and markets hit the upper circuit twice that day, resulting in trading coming to a halt. Those funds which had lower cash in the portfolio had benefited immensely in the rally. But that didn't give them the permanent advantage. Those who continued to identify sound stocks for their portfolio were the only ones to succeed over longer term.

Are mutual funds prepared to counter volatility this time?

At a broader level, mutual funds appear to be positive about the sustainability of rally and might be expecting Indian economy to recover, going forward. They have increased the exposure to rate sensitive sectors such as financials and auto while reducing exposure to defensive sectors such as information technology, consumer non-durables and pharmaceuticals in the March quarter. It is also believed that, valuations in the consumer non-durable space have become expensive and appreciating Indian rupee may affect earning potential of Indian I.T. companies. On the contrary, there is a recovery in the engineering and cyclical sectors such as auto and banking, on the hope that the BJP led NDA Government would give impetus to economic growth of the country whereby these sectors would be the beneficiaries. Valuations don't appear to be a concern right now as far as these sectors are concerned.

Over the short term it may be difficult for even the most consistent mutual fund to arrest the downfall if some unfavourable election result spoils the market mood. Those focusing on individual companies and not playing the market momentum excessively may find it relatively easy to bounce back in that case. However, those moving to extremes may continue to reel under pressure for considerable time. At 19X P/E multiple calculated on trail earnings, market valuation is not cheap and unless corporate earnings grow, markets may find it difficult to sustain such valuations.

Can volatility be managed by taking aggressive cash calls?

PersonalFN is of the view that, aggressive cash calls play a role in the success of mutual funds but their importance shouldn't be over-estimated. For example, even after predicting a market direction correctly a mutual fund would generate ordinary returns if the stock selection is not right.

Why aggressive cash calls don't work always?

When you raise your cash exposure, you minimize the risk of loss on valuation of assets. If equities fall, net asset value of the fund would go down, but in the reverse scenario net asset value would go up. This means, if you are certain that markets will fall, hiking cash exposure may protect you. But in stock markets nothing is certain. In other words, taking cash calls and trying to time the market is one and the same thing. This puts additional burden on the fund manager of being right every time and with every call. With years of experience in mutual fund research PersonalFN feels that funds that stick to their investment objectives and follow sound investment processes are the ones who perform consistently. Those who are over-relying on market timings and not focusing adequately on stock selection do not go far.

What should you do now?

Nobody knows what will happen over next fortnight but mutual funds seem to be convinced that BJP led NDA will be able to form the Government at the centre. How can you protect yourself if mutual funds go wrong in their prediction? Well, the answer is simple. Avoid speculation and stick to your broader investment plan and your asset allocation. Treat the current market rally as the final opportunity to exit from mutual funds that are weak and unpromising. To fetch attractive returns, it is imperative to identify a winning mutual fund.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

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.

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