Equity fund myth shattered

As we pause to take stock after the astounding 50 per cent rise in the Sensex, are there any lessons from this rally for mutual fund investors? You bet there are. Whether it’s a bear market rally or the beginning of a new bull phase, the unexpectedly strong rally in stocks over the past couple of months still has several cues to offer on how investors should construct their long-term portfolio. Here are some myths about equity funds which this upsurge has shattered:

Cash is king: Cash may be king when equity funds hold it in a choppy and directionless market. But when the tide turns, cash can effectively curtail your ability to reap the benefits of equity investing. Take the current stock price rally. As the Sensex rallied nearly 50 per cent from its March lows, only a small fraction of actively managed funds have managed to keep pace.

That only 12 of the 175 diversified equity funds matched or bettered the Sensex in this rally clearly tells the tale. After the many false alarms of last year and the strong conviction that recovery was a long way off, an unprecedented number of Indian fund managers have taken cash calls on their portfolios over the past year. That has clearly caused the majority of funds to miss the bus.

Funds which have remained more or less fully invested from houses such as Franklin Templeton, Fidelity and HDFC have delivered much better participation in the rally than funds which were high on cash.

We can spot a recovery: Is this a bear market rally or a new bull phase? Even as fund managers are still engaged in this furious debate, the market is already up 50 per cent and quite a few individual stocks (even the fundamentally sound ones) have doubled in value.

This rally proves that even in a real recovery (just assuming this isn’t one), by the time there is sufficient hard evidence to convince the naysayers, the markets may well reach levels that are too high to provide any comfort for new investors. That suggests that equity fund managers are probably no better placed to “spot” a recovery and move back into stocks ahead of it, than individual investors.

That, in turn, means that the only way to reap the full rewards of equity investing is to stay invested through difficult periods and to put in fresh money when things appear bleak. Waiting for confirmation of a recovery may actually expose you to more, and not less, risk of value erosion.

Mid-caps will underperform large-caps: During the bear phase, large-cap stocks were expected to be a safer investment proposition as they were likely to be the first to recover, with mid-caps expected to catch up only slowly. The speed and momentum of this particular rally has proved that it doesn’t take all that long for mid-cap stocks to catch up.

Therefore, investors with a long term horizon need not worry too much about focussing only on large cap oriented funds. Looking for funds with both large and mid cap exposures may in fact be a good idea.

Expect a 12-15 per cent return from equity funds: Should I take equity-related risks just for 12-15 per cent return? Why shouldn’t I stick just to bank deposits? Well, breathtaking gains made by individual stocks and the even market itself in this rally provides a convincing answer.

Even investors who stuck only to index stocks have made impressive returns over the past couple of months, with the Sensex gaining 50 per cent in a couple of months. That proves that equity markets continue to have the ability to reward investors handsomely for risks taken. And the returns tend to be the highest when the markets “revert to mean” from a period of extreme pessimism. This suggests that the case still remains strong for young investors to allocate a portion of their long term portfolio to equities.

All this suggests that three key approaches on equity fund investing. Don’t move in and out of equity funds, based on the outlook for the markets or the economy. Don’t be afraid to take allocations to mid-cap oriented funds. And finally, have some index funds in your portfolio to ensure participation during an unexpected rally.