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Mature Mutuals

The first Business study rates the most happening investment options to have emerged in the recent past: mutual funds.

A Study

Just like a Starbucks coffee store, where you can go nuts trying to decide whether to order a Guatemala Antigua Decaf, a Caffe Verona, or just a plain and simple Starbucks Breakfast Blend, for first-time investors tip-toeing into the Indian mutual funds market, choosing a fund to invest in can be hair-tearingly frustrating. At the last count, there were 341 mutual fund schemes, which come, just like Starbucks' coffee, in a confusing array of flavours: open- and close-ended funds, tax-saving funds, ice-skewed funds, cyclical stock funds, debt funds, diversified funds, sector funds... Enough to frazzle the most cool-headed investor. Yet, the flipside of the mutual fund proliferation is that the Indian mutual funds industry has matured, and so has the retail investor.

Time was when the Indian investor shunned mutual funds because the gains they offered were nowhere near what hot individual stocks could. But today, after wild swings and roller-coaster rides on the market, investors have realised that it may be much better to repose faith in professional fund managers with good track records, rather than trying to pick stocks on their own. On its part, the mutual fund industry has matured enough to cater to varying needs by offering investment options to every type of investor-be it corporate or an individual; a high risk-taker or a risk-averse investor.

To meet the rising expectations of investors, new variants are being created by asset management companies. Naturally, with the growing number of funds and schemes, competition has increased and funds are today marketed with the zeal of FMCG companies. Total investments in mutual funds have increased from around Rs 65,000 crore in January, 1999, to around Rs 1,05,000 crore in May, 2000-a stupendous growth of 61.5 per cent. Increasing brand equity, better service, and transparency has investors shifting preferences to private sector mutual funds, reducing the dominance of the Unit Trust of India (UTI).

However, before we analyse how mutual funds performed over the first quarter of 2000-01, a quick recap of the last one-and-a-half years: beginning 1999, the fortunes of the Indian mutual fund industry turned around, because of the bounce-back of the equity markets, as well as the tax sops provided to the sector by Finance Minister Yashwant Sinha. The market euphoria came after a long lull. As aggressively-managed private sector equity funds generated good short-term returns, investors' interest in equity funds revived. They could now get high returns, with the added bonus of tax-free dividends. Says K. Vijayan, 38, CEO, JM Mutual Fund: ''The performance of mutual funds, and the service provided, has proved to be the main attraction (for investors).''

With the onset of the new millennium, markets ran amuck as they followed the movements of the NASDAQ composite index. This was bolstered by the skyrocketing valuations for infotech and Net stocks. Other high-growth sectors like media and telecom followed suit and the markets touched new highs. Naturally, there was a mad rush among mutual funds to outperform each other. Open-end equity funds started generating returns that were better than the market's performance. These returns came as a windfall to investors who had invested in mutual funds during the early part of the rally. In fact, despite the subsequent sobering down and the recent decline on the stockmarkets, some of the funds have shown excellent returns over the last one year, clearly beating the market (KP Infotech-219 per cent; Alliance Tax Relief-193 per cent; KP Tax Shield-181 per cent; Zurich Tax Saver-146 per cent; Birla Equity-142 per cent). Comments Vivek Reddy, 37, CEO, Kothari Pioneer mf: ''The ability to manage risk on the downside and keep the underlying liquidity in mind is what separates the pros from the amateurs.''

The Ice Hype

What helped such funds beat the market was their early focus on Information, Communication & Entertainment (ice) stocks. Predictably, other funds followed their lead by pumping investments into the same sectors. Some examples: on March 31, 2000, ING Savings Trust had over 85 per cent of its corpus invested in ice stocks, while Alliance Equity had 77 per cent. Of the 46 open-ended equity funds (excluding sector-specific funds), 10 had more than 60 per cent invested in ice stocks, 16 had more than 40 per cent, but less than 60 per cent, and only 20 funds had an exposure of less than 40 per cent. Points out U.R. Bhat, 45, Director & CIO, Jardine Fleming am: ''With most of the benchmarks being 30-35 per cent (of the portfolio) in the ice sector, fund managers who were neutral on the sector, too, had to invest upto 30 per cent.''

New funds also focused on exploiting the market craze for ice and other New Economy stocks and, in the process, generated excellent returns over short periods. Almost every fund house launched a sector-specific fund and the payback was good. Alliance New Millennium closed for subscription on January 15, 2000, and its Net Asset Value (NAV) on March 7, 2000, touched a high of Rs 18.45-in just 51 days the fund had yielded a return of 84.50 per cent. Such a bonanza was a throwback to the early 1990s when Morgan Stanley's mutual fund IPO and UTI's Master Gain commanded a premium in the grey market.

So infectious was the ice craze that it even tempted the so-called balanced fund managers (See The Lure Of Equity). Balanced funds, which target low-risk takers, are by nature an appropriate mix of equity and debt and are supposed to be comparatively safe because of a high proportion of debt investment. Yet, some balanced funds got skewed towards equities, especially ice sector stocks. Of course, after the recent plateauing, these funds have reduced their equity exposure.

Although ice stocks gave the funds handsome returns, the flipside was that they exposed mutual funds to increasing levels of risk. Though fund managers were expecting some correction in the ice sector, no one was actually prepared for the actual carnage that took place. And hope still abounds. Explains Ved Prakash Chaturvedi, 35, CEO, Cholamandalam Cazenove AMC: ''If a company is fundamentally sound and its valuations are appropriate, stock prices are expected to bounce back.'' So, the exposure of most of the funds to the ice sector is still quite high. Adds Reddy of Kothari Pioneer mf: ''Instead of a momentum-driven portfolio, there is a flight towards quality.'' Though the fund managers talk of re-rating of old economy stocks, the portfolios are yet to show a major shift towards that sector.

The Ice Crash

The major reason for the ice sector getting a beating was the very high institutional holding in the sector. A majority of mutual funds, institutions, and foreign institutional investors had invested most of their funds in ice stocks; some even divesting their old economy holdings to get a share of high-growth infotech stocks. When institutional holdings in a sector are negligible, it is usually re-rated and valuations rise rapidly. However, when institutional holdings are very large, the risk of a sharp decline is higher, primarily because any negative factor can trigger huge sell-offs by the institutions. In a sense, keeping valuations in check is a balancing factor.

The recent sell-off in ice stocks took place after a dramatic build-up of speculative positions, which resulted in even unknown infotech and media stocks quoting in triple digits. Some fund managers had also joined this speculative fraternity with a temptation to outperform the markets. Such build-ups inevitably result in a crash, as they are neither supported by fundamentals nor by real money. The ice-dominated funds also had to pay the price for having taken higher risk resulting in higher erosion in NAVs compared to the indices. Says K.N. Atmaramani, 59, CEO, Tata Mutual fund: ''When the return turned negative because of high exposure to ice, many fund managers moved to other sectors, including pharmaceuticals.''

The Winners

Of the 184 funds that have been studied (only funds with a life of more than one year were considered), 85 funds were not able to perform up to the expectations, given the level of risk assumed by the fund managers, while 99 mutual fund schemes earned more than the returns expected of them for the risk taken. Of the 44 open-and closed-ended tax saving funds studied, 26 were able to outperform their expected levels. Similarly, of the 65 normal open and closed-ended equity funds (excluding tax planning equity funds), 38 were able to outperform the market expectation. However, 60 per cent of balanced funds were unable to match the market expectation.

Alliance Tax Relief '96 tops among the equity funds-closed and open-ended. The scheme has returned 93 per cent on an annualised basis over last three years and its one-year performance is a staggering 193.62 per cent. Our study shows that superior stock selection skills of the fund manager of the scheme resulted in the scheme earning 121 per cent more than what was expected of it for the total risk incidental to the scheme. The next on the list is Kothari Pioneer Tax Shield-again, a tax saving scheme. These schemes have a three-year lock-in period required as per provisions of Income Tax Act, 1961, which has aided the fund manager in generating a superior performance. In fact, six out of the top 10 equity funds are tax saving schemes. Says S.V. Prasad, 40, CEO, Zurich Mutual Fund: ''With a small corpus and a lock-in fund, managers can be more aggressive in their investment style in the case of tax-saving schemes.''

Among the equity funds other than tax saving schemes, Kothari Pioneer Infotech topped in performance. The scheme, launched in August, 1998, was a trend setter, riding the rally in infotech stocks. In fact, it set an example for a rash of new infotech funds that followed in its footsteps. Runners-up Birla Advantage Fund, the star performer from Birla Mutual Fund, also focused sharply on ice stocks. This scheme has generated annualised return of 64.62 per cent over the last three years. In terms of risk rating, ING Growth Portfolio has taken the highest risk among the top 10 equity funds. Alliance '95 also figures in the list of top 10 equity funds even though it is a balanced fund. Because of its high exposure to equities (73.6 per cent as on June 30, 2000), we have classified it with the equity funds.

Among sectoral funds, infotech funds have been high performers. But because pharma and FMCG scrips have not done well recently, this has impacted the performance of the funds focused on these sectors. Among balanced funds, Zurich India Prudence Fund topped, earning 35.68 per cent over the last one year. Others on the list are JM Balanced Fund, UTI US '95, Tata Balanced Fund and Canstar CG.

Among the debt schemes, Kothari Pioneer Pension Plan generated the best performance. Being a pension fund, it has the benefit of having a long-term horizon. Also, its high exposure to equities (25.94 per cent) has resulted in a return of 16.59 per cent last year. In open-ended debt funds, the best performance was recorded by Templeton India Income Fund, followed by the Escorts Income Plus, Kothari Pioneer Income Builder Account, and Birla Income Plan.

Most of these funds have high credit quality papers in their portfolio. Templeton's fund comprises securities that are rated AA. Escorts Income fund, Kothari Pioneer Income Builder Account, and Birla Income Plan have invested 78-100 per cent of their funds in securities with similar ratings. The average maturity period of these funds is 3.5 years, which insulates them against interest rate hikes. However, they may be impacted negatively in case the rates drop further.

Although the mutual funds industry throws up a cornucopia of choices, investors have to realise the importance of choosing the right fund to match their risk-profile. Unless that happens, the correct risk-return equation cannot be achieved. Of course, fund managers too need to be aware of the risks that they are taking while selecting stocks and ensure that their strategies match the overall objective of the fund. Only then can mutual funds hope to be mutually beneficial.

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