As the second half of 2010 dawns and the markets take a free fall, we realise that the year so far has not been good for equities. The Sensex, after the initial run-up during the past week, has pared all the gains, and for the year till date has almost ended flat. While the Sensex is up just 1.2% from the beginning of the year, equity funds have done relatively well, managing a return of 5.2%. The star performer this year has been FMCG funds, which gave a return of 21.8%, followed by pharma funds and gold ETF, which gave a return of 20.5% and 12.6%, respectively. With six more months to go, expect a shuffle in the return charts.
Every year, finds our comprehensive 11-year study, mutual funds have a new champion. For instance, in 2009, it was technology equity funds that stole the limelight, giving an average return of 116%. A year before that, it was the long-term gilt funds, when the Lehman crisis pulled down equity markets globally.
In 2003, when the equity bull run kick-started , equity diversified funds gave the best returns of 107%. The highest returns till date in any single year has been from technology funds, in 1999, when they gave a return of 477%.
Why are we mentioning these? It is to highlight that investor returns is a greater function of one?s ability to make the ?right? asset allocation choices (or that of fund category as in equity funds, debt funds and so on) than just choosing the best performing fund within a category. This is what our research shows.
And as the experience suggests, better portfolio strategy is to diversify across asset classes/fund categories. Our analysis shows that by doing so, an investor could have enhanced his returns by 3% annually over the last 11 years. On an asset-weighted basis, mutual fund investors got an annualised return of 18% over the last 11 years. They could have got 21% had they spread the investment equally across all the asset classes. And these returns could have been earned if they picked a fund in each fund category that just about manages ?average? returns. In other words, even if one picks a fund among the top 50 percentile within a fund category, one is better off.
Assume an investor has an uncanny ability to pick the best fund category every year. And he churns portfolio year after year. For example, say on January 1, 1999 he invests Rs 1 lakh in technology funds. It will become Rs 5,77,400 by the end of the year. He sells the entire portfolio to invest in long-term gilt funds, the best performing category for the year 2000. By following the above process, his Rs 1 lakh portfolio will swell to Rs 3.7 crore by end of 2009. In other words, his annualised returns would be 71% over the last 11 years.
Of course, this scorecard is that of an alpha investor, who hits the bulls eye ? year after year. But in reality, mutual fund investors are rather tail catchers. They tend to invest after seeing the returns. Assuming that he invests equally into all asset classes, and maintains that proportion year after year, he could have made a decent return of 46.4% in 2009 and -20.9% in 2008. Over the 11-year year period, Rs 1 lakh would have grown to Rs 7,85,140, giving him an annualised return of 21%. This is much lower than the performance of the mythical alpha investor who manages 71% pa, but slightly more than the current returns of mutual fund investors.
But as the data shows, predicting the champion fund category is difficult with no discernible pattern. Even the common logic are turned on its head. Take, for instance, the 5-year returns of all equity indices. Theory has it that mid-cap indices should do better than large-cap indices over the long term. But data for the the last five years shows otherwise. While the Sensex gave an annualised return of 20.3%, it was 15.9% for the BSE Midcap. Ideally, the BSE 500 index should have given better returns than that of BSE 200 and BSE 100. This is because of assumption that smaller-sized companies should manage to grow their earnings at a faster pace than large companies. But it is exactly the reverse; BSE 100 outperformed BSE 200 and the latter outperformed BSE 500.
Again, the popular myth that sector funds give high returns over shorter-term has been busted. This used to be the case when ?sectoral rotation? was probably popular in Indian markets. Post-July 2008, global cues is affecting all stocks?making the word ?decoupling? a defunct word. All popular sector indices?over the long term?has managed to beat the Sensex returns. Be it consumer goods, oil & gas, power, Bankex, auto and metals. Only FMCG and consumer durables and healthcare have underperformed the market.
This brings us to an important point that the investor needs to spread his investments over different baskets to ensure he doesn?t miss the bus. It is also true that the assets under management of the worst performers are small, indicating that investors are already staying away from bad performers. But in the end, by choosing a best-performing fund, an investor is not necessarily getting the best returns. Best returns come when the investor invests in the fund category gives the best returns. And by doing that, even if he manages to choose an average fund (he could be right half the times), he can earn better returns.
Go for broad asset allocation?equity, debt and cash component?based on your risk appetite. And within each asset class, mix and match your preferences. For instance, in equities, you could invest in large-cap, mid-cap, index funds, in an aggressively managed fund, if need be. If possible diversify across fund houses to reduce fund manager risk.