Equity Funds: How to pick an equity fund that’s right in bad times

September 9, 2020 1:30 AM

A fund should do as well as the market index during good times and better than the market index in bad times to be worthy of investment choice

Equity mutual funds can be put into four different categories to analyse relative performance. Equity mutual funds can be put into four different categories to analyse relative performance.

By Parthajit Kayal

Picking the right equity mutual fund is an overwhelming task for retail investors. There are many types of funds such as large-caps, mid-caps, small-caps, multi-caps, etc., available to match the varied risk appetite of investors. Choosing funds based on just one, three, five or even 10 years performance may not be the right way to deal with this.

Good performance in the past does not guarantee the same for the future. Therefore, we may need to look beyond that and evaluate the funds based on their relative performance in good and bad times. A sharp fall in the equity market due to the Covid-19 pandemic and subsequent fast recovery gives us a unique platform to evaluate mutual funds based on the same criteria.

Performs in line with benchmark index
Equity mutual funds can be put into four different categories to analyse relative performance. The first category of funds moves with the market broad indices. When the market index goes up substantially, these funds also go up. Similarly, when the index goes down, these funds move down almost in a similar proportion. A majority of this type of funds requires minimum stock picking skills. Their portfolio will be more or less in line with the market index.

Investors will be better off buying a low-cost index fund than going for active funds of such types.

Performs like FDs and bonds
The second type of funds does not lose much when the market index goes down. However, they also do not gain much when the market index goes up. These types of funds are less risky compared to the market index but don’t bring sufficient returns over the years. A fund with a defensive investment style and lack of proper stock picking skills fall into this category. Investors looking for a medium- to long-term investment should avoid this type of funds. Choosing government bonds, fixed deposits, and gold could possibly be a better investment choice over this type of mutual fund.

Beats the index in bull and bear markets
The third type of mutual funds does not fall with the same magnitude when the market index falls but gains a lot (more than the market index) when the index goes up. This type of funds give you better protection than the market index in the time of crisis but also brings you handsome returns in good times. High-risk funds with better stock picking skills fall in this category. Medium and long term investors with sufficient risk appetite can go for this type of funds.

Match the index in bull but beats in bear markets
The fourth type of funds doesn’t fall much when the market index goes down. However, they are able to capture good returns when the market index does well. Funds of this type are defensive in terms of investment style but managed by a manager with excellent stock picking ability. These funds may bring a relatively lower return than that of the third type but provide much better protection during any crisis.

In the bull period of the equity market, all funds do well. It doesn’t require much stock picking skills. Probably the variation in the investment style justifies the difference in returns among funds.

However, the test of bad times is essential to evaluate a fund. Along with the right investment style, stock picking ability makes the difference during a crisis.

A fund should do as well as the market index during good times and better than the market index in bad times to be worthy of investment choice. Clearly, the first two types of funds do not justify the same and therefore should be avoided. Investors are advised to consider only the third and fourth types of funds. If they have more risk appetite they are better off choosing the third type. Investors who give more importance to capital protection may select the fourth type of funds.

Choosing the right funds for investment is never an easy job. As we don’t have an investment platform that provides this kind of measures, investors need to carefully make their own calculation and evaluate funds under these four categories before putting in their hard-earned money.

The writer is an assistant professor, Finance, Madras School of Economics

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