Mutual Funds: The Mutual Fund Circuit-Breaker

MUTUAL FUNDS
The Mutual Fund Circuit-Breaker

A Business Today-mutualfundsindia.com take on the hot and not-so-hot performers in a volatile second quarter.

A BT-Mutualfundindia.com study

In Britain, fund managers got a rude shock recently when their customers-in this case, trustees of a large corporation's pension fund-took them to task, suing them for negligence resulting in underperformance. It's a pity that investors in Indian bond funds can't sue the Reserve Bank of India (RBI). If they could, they would. Because, in the last quarter ending September 30, 2000, thanks to the RBI's liquidity tightening efforts (to prop up the rupee), the interest rate hike and the consequent drop in bond prices in the secondary market led to a fall in the Net Asset Values (NAVs) of debt-oriented mutual funds.

Bond funds are seen as zero-risk investments by retail investors and the sudden drop in values caught them off-guard. In fact, asset management companies (AMCs) had their task cut out for them-explaining the rationale and the logic behind the slump.

Managers of equity funds fared no better. The stockmarket went through a depressed phase during the quarter and notwithstanding the NASDAQ rally in July, 2000, and improved first-quarter results in the software sector, the Indian markets were down. Clearly, investing in either fixed-income securities, like bonds, or equities was a tricky business last quarter.

Volatility Hurts

But it is in times of volatility that mutual funds are a preferred investment vehicle. And that's exactly what droves of investors demonstrated last quarter. Instead of trying to pick stocks or debt instruments, they entrusted large portions of their investible funds to AMCs. The total inflow to the mutual funds industry during the period May 31, 2000, to August 31, 2000, was Rs.17,973 crore, which was Rs 3,448 crore higher than the outflow. Says Shekhar Sathe, 50, CEO, Kotak Mahindra Mutual Fund, who toured some 20 metros in the last three months talking to investors: ''There is a realisation that mutual funds do not eliminate risk but provide portfolio diversification.''

Most categories of funds saw positive inflow, but debt funds faced the pressure of redemptions, especially in August, when there was a net outflow of Rs 1,133 crore. Clearly, this was triggered by the drop in the NAVs of debt funds because of the interest rate hike. Significantly, the total assets under management which rose from Rs 1,04,032 crore as on May 31, 2000, to Rs 1,07,728 crore in June, 2000, dipped to Rs 1,02,849 crore by the end of August, 2000-a 4.5 per cent drop in just two months. Again, the chief reason for the dip was the decrease in the value of stocks. Equity funds lost around 18 per cent in terms of value in spite of positive inflows, while debt funds lost 4.44 per cent during the same period. But short-term debt funds, including gilt and money market funds, improved their share by over Rs 1,000 crore.

Like in the previous quarter (BT, August 7, 2000), private sector mutual funds continued to perform better and not only improved their share in the industry but also gained in terms of assets under management. Private sector funds now form 25.54 per cent of the total industry, up from 24.11 per cent as on May 31, 2000, although the UTI still accounts for a staggering 65.33 per cent.

Emerging Trends

Two major banks debuted with their mutual funds last quarter: anz Grindlays Bank formed an AMC and launched an income fund that mobilised Rs 258 crore, while HDFC launched three schemes garnering more than Rs 600 crore. HDFC's high brand equity helped it mop up that impressive corpus. It's logical for banks to venture into mutual funds. They already have a treasury and provide portfolio management services. Plus, they can draw upon their retail networks (branches) and customer base.

But the new trend that has emerged is of mutual funds leveraging their strong research base and expertise in managing funds to provide personalised portfolio management solutions to high net worth investors. Prudential ICICI Mutual Fund was the first one to announce a portfolio management scheme and has already mobilised Rs 12 crore. Others queueing up include Birla Mutual Fund, Kothari Pioneer mf, and Kotak Mahindra mf. An obvious fall-out of this: greater customisation of investment products.

Other trends? Well, the focus on ice continues, although the sector has taken a beating on the market. Fund managers still have faith in the growth potential of ICE stocks and continue to invest large amounts of their funds in them. Says K. Vijayan, 38, CEO, JM Mutual Fund: ''ICE sector still offers the largest growth potential and trading opportunity which is the key to realising gains.'' Diversification is still a distant theory for most of the fund managers. ING Growth Portfolio, for instance, continues to be the most infatuated with ICE stocks and has an exposure of over 83 per cent in the sector. It has a minuscule 5.03 per cent in the FMCG sector and the balance is in cash and equivalents. Other funds with large exposures to ice stocks are IL&FS Growth 64.17 per cent, Birla Advantage 64 per cent, Alliance Equity 60.2 per cent, and SBI Magnum Multiplier 58.41 per cent.

Another trend: balanced funds moving from volatile equity investments towards debt instruments. Only two balanced funds-Alliance '95 and SBI Magnum Balanced Fund-continue to invest more than 60 per cent of their corpus in equity. In fact, because of its skewed portfolio (which is heavily weighted in favour of ice stocks), SBI Magnum Balanced Fund emerges the worst performing balanced fund in terms of NAV appreciation.

Absolute Returns

At a time when the Sensex fell by 13.86 per cent and the S&P Nifty 13.58 per cent, it wasn't surprising that no equity fund could post a positive return. Of the 145 equity funds under review, 103 outperformed the market by falling less than the market, while 42 fared worse than what the market did.

Tata Pure Equity, the best performing open-ended equity fund, reduced the effects of a volatile market by going for small exposure spread across numerous scrips. Even its largest holding is less than 2.50 per cent of the total corpus. And, although it has 47per cent in the worst-hit ice sector, by booking profits at every rise, Tata Pure Equity's fund manager Shyam Bhatt has kept things on an even keel. The top holdings of Tata Pure Equity: Infosys Technologies, NIIT, Wipro, ITC, and HCL Technologies. On the flipside, IL&FS eCom had the unenviable distinction of being the biggest loser. Its huge exposure in volatile scrips such as SSI, Zee Telefilms, NIIT, and Satyam Computers made it more prone to sharp movements. Explains Vibhav Kapoor, 46, CEO, IL&FS Mutual Fund: ''Sector funds will always be more volatile and an investment horizon of two to three years is advocated.''

Among balanced funds, Canpremium emerged as the clear winner and was the only equity-based fund to generate positive returns for the quarter. Canpremium's low exposure in equity helped: just 25 per cent of its assets are blocked in equity.That's a contrarian call in a market where most balanced funds keep their equity exposure at 50 per cent plus. At the other extreme is SBI Magnum Balanced, which is so skewed towards ice sector, besides a 68 per cent equity exposure, that it resembles an equity fund. With a portfolio that included volatile it stocks like SSI, Aftek, HFCL, and Zee, it wasn't surprising that SBI Magnum Balanced saw its NAV plummet 13.8 per cent.

The Report Card

Of the 234 funds studied (only funds with a life of more than one year were considered), 31 were not able to perform up to the expectations, given the level of risk assumed by their fund managers, while 123 mutual fund schemes earned more than the returns expected of them for the risk taken. Of the 76 tax saving schemes studied, 42 funds were able to outperform their expected levels.

The overall performance of open-ended funds was better than close-ended funds. In the open-end category, 54.5 per cent of the funds were able to outperform; in the closed-end category, only 49.45 per cent of the funds were able to post a better performance against their respective expected values. Similarly, out of the 75 normal open and closed-ended equity funds-excluding tax planning equity funds, 39 were able to outperform the market's expectation. However, 31 per cent of balanced funds were unable to match the market expectation.

The performance of debt funds was more discouraging. Of the 54 studied, 22 were able to outperform their expectations. And, of the 21 debt funds with some equity exposure only 33 per cent matched investors' expectations. There were 33 pure debt funds in the study of which 45.45 per cent posted satisfactory returns.

THE METHODOLOGY

A good risk-adjusted performance measure should consider the entire risk associated with the fund and should be able to compare the performance of the portfolio with certain well-defined benchmarks. The Eugene Fama model has the above characteristics, as it compares the performance (in terms of returns) of the fund with the required return, which is commensurate with the level of risk associated with the fund. The difference between the actual return of the fund and the required return for a particular risk-level is a measure of the performance. It's called Net Selectivity.

The Debt funds are ranked on the basis of excess return per unit of risk where risk is measured by the standard deviation of the rate of return. The ratio is widely known as Sharpe's Reward to Variability Ratio.

Returns: Yt=[(NAV(t)+div-NAV(t-l))/NAV(t-l)]*100, where NAV(t)=NAV of the current period 't' and NA V(t-l)=NAV of the preceding period (t-1)
Average Return: Ri=å Yt/n where return on yt=the fund on a particular time 't' and N= Number of observations
Return on market index: Xt=[(It-I(t-1))/It]*100, where It=Value of the index on day 't' and I (t-1)= Value of the index on day (t-1)
Average return on market index: Rm=åXt/N
Average daily risk-free rate of return: Rf=9.5/365. 9.5 per cent is the return given by banks
Total risk of a mutual fund scheme: b'=sA''/sm, where sA''=standard deviation of the returns of scheme and sm=standard deviation of the returns of market index
Required rate of return commensurate with the given level of risk of the mutual fund (b'): R'=Rf+ b'(Rm-Rf)
R' is then compared with the actual return. For this purpose Net Selectivity is calculated: Net Selectivity =(Ri-R')
Sharpe's reward to Variability Ratio: Sp=(Ri-Rf)Ói

Risk Ranking
The schemes can be classified into three categories:

High risk: top one-third of the risk scale

Average risk: middle one-third of the risk scale

Low risk: bottom one-third of the risk scale

The top five positions in the equity segment in the second quarter are dominated by public sector funds and have only one representation from private sector funds. These include three funds from the UTI, one from SBI Mutual Fund, and one from Kothari Pioneer Mutual Fund. The top four funds are from public sector category and have been new entrants in the list of performers. All four were new additions to the list as they were not analysed in the first-quarter report because they had not completed a full year's track record of NAV declaration.

UTI Growth Service Sector Fund tops in the equity funds category, posting a return of 174 per cent in the past one year and an annualised return of 140 per cent since its inception in June, 1999. Though the fund has posted a negative return of 19.75 per cent in the quarter under review, it still ranks the best on the basis of superior stock selection skills over a longer period and has posted a performance that is 150 per cent more than what was expected.

Among the equity funds other than tax-saving schemes and sector schemes, the top three performers were Alliance Equity Fund, ING Growth Portfolio, and Birla Advantage Fund. All three schemes are skewed towards the ice sector and hold 60.2 per cent, 83.02 per cent and 64 per cent in ice, respectively. SBI Magnum Balanced Fund and Alliance 95, balanced funds by objective, appear among open ended equity funds because of their high levels of exposure in equities.

Among balanced funds, Birla Balanced Fund topped the list, followed by Zurich India Prudence Fund, and the uti us 95. Birla Balanced has 59 per cent of its assets in equity, of which 43 per cent is held in infotech stocks. Canpremium, the only balanced fund that has posted a positive return in NAV in the last three months, ranks seventh because of the high fluctuation of its NAV. The fund has posted the highest beta value-the measure of risk in the study-among all the three balanced schemes considered. Explains K.V. Hegde, 55, Managing Director, Canbank Mutual Fund: ''The performance of Canpremium has been consistent irrespective of market volatility because nearly 70 per cent of the assets are in debt instruments.''

The study ranks debt funds in terms of reward-to-variability ratio. Investors don't expect debt funds to exhibit volatility in their NAVs and hence the risk attached to the schemes are measured by the standard deviation of the rate of return. The top three debt funds were Escorts Income Plan, followed by Birla Income Plus, and Reliance Income Fund. All three are relatively old funds that have achieved consistent returns over a long period. Another distinct advantage: these funds created their portfolios in a high interest rate regime and hold high credit quality papers. For instance, 81 per cent of the corpus of Escorts Income Plan is held in AA and securities rated higher. Birla Income Plus and Reliance Income Fund hold 98 per cent and 91 per cent of their respective portfolios in AA and higher rated papers.

The average maturity of all of the three debt funds are in the range of 2 and 2.25 years, exhibiting the low interest rate risk attached to them. Among the monthly income plans, Alliance MIP holds the top position among the debt funds that have some equity exposure and the third position when ranked among all debt funds. Naturally, the debt funds that have some equity exposures in their portfolios have received poor rankings owing to the high risk attached. Says Vijayan of JM Mutual: ''Those who managed the maturity of debt investments well have come up trumps.''

In the gilt funds category (schemes that invest in only government securities), JM G-Sec Regular Plan has topped, followed by Tata Gilt Securities Fund, and Templeton G-Sec Fund. Less risky by definition, the gilt funds have been far less volatile than the funds that are at the top of the heap.

That it hasn't been a great quarter for investors in mutual funds is quite evident. Both equity funds as well as debt funds lost value. Yet, that may not be a good enough reason to cry off the mutual funds. For, although they did not perform well during the last quarter-thank the vagaries of the equity market and the interest rate firm-up for that-they did pretty well in terms of long-term performance. The lesson for the investor: don't judge a fund by its short-term performance; good funds may disappoint you in the short-term but reward you over a longer period. Patience, therefore, is the key to prosperity.

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