Brace yourself for another turbulent year ahead in equities and MFs

The year that has gone by has delivered a double whammy to mutual fund investors. Returns from equity funds were disappointing (see table). Even debt funds offered only limited comfort due to a volatile interest rate environment. The IL&FS crisis pitchforked credit risk to the forefront. The coming year may also be a turbulent one, owing to global liquidity tightening and the general elections. Investors need to keep the faith and keep their investments going even if the scenario turns bleak.  

Disappointing year for equity investors: The bull run of prior years had driven equity valuations to exorbitant levels. According to S Naren, executive director and chief investment officer, ICICI Prudential Asset Management Company (AMC), “We believe rich market valuation is the core reason for underperformance.” Corporate earnings have been lacklustre for many years. While earnings showed signs of revival in the July-September quarter, it remains to be seen if this will sustain.  

Interest rates were being hiked and liquidity was being tightened by central banks both in India and abroad. The US Federal Reserve hiked interest rates four times in 2018. Rising interest rates affect equity performance negatively.   

Brent crude rose to a high of $86.74 per barrel in October, causing the rupee to plummet, and raising fears of a wider current account deficit this financial year. As India’s macro-economic outlook worsened (and interest rates in the US turned more attractive), foreign institutional investors (FIIs) pulled money out of the Indian equity markets. They have withdrawn about Rs 384 billion year-to-date. 

Large-caps proved more resilient: Large-cap equity funds fell less than mid- and small-cap funds. “From a valuation perspective, mid and small caps were more richly valued as compared to large caps. So, when the market correction ensued, these richly valued pockets saw most of the correction,” says Naren. The macro-economic environment too played a part. “When interest rates are rising, mid- and small-caps tend to be impacted more than large-caps,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.      

The coming year may also be volatile: With the US Fed planning to continue rate hikes (it has spoken of two hikes) and other global central banks also reducing liquidity, and trade wars between the US and China, FII flows may remain volatile. Crude oil, which has fallen to around $54 per barrel, could shoot up again, especially if the Organisation of Petroleum Exporting Countries (Opec) cuts production. Within India, the general elections slated for mid-2019 will affect sentiment, both before and after. 

Avoid market timing: Avoid exiting the markets before the elections, with a view to entering them after they are over. “Historically, election years have proved to be volatile times for equity markets. Through the last three election years – 2004, 2009 and 2014 – the one strategy that has worked well is investing through SIPs and STPs. We see 2019 as a year of accumulation, from a three-year perspective,” says Naren. Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India, offers similar advice. “Stay true to your asset allocation and stay invested for the long term to ride out short-term volatility,” he says. Dhawan suggests investing a part of your equity fund portfolio in international funds to counter volatility in the domestic market. 

A portion of your large-cap allocation, say, 25 per cent, may go to index funds or exchange traded funds. “There are years, like 2018, when the majority of fund managers do not manage to beat the index. An allocation to passive funds will enable you to have a good overall experience in such years,” says A Balasubramanian, chief executive officer, Aditya Birla Sun Life AMC. 

Shorter-duration debt funds fared better: Interest rate movements were volatile in 2018. Rates rose for most of the year, only to correct over the past couple of months. FIIs have withdrawn around Rs 502 billion from the debt market in 2018. 

Longer-duration funds performed poorly (see table). “In a rising interest rate scenario, higher duration funds get impacted more.  Shorter duration funds invest in shorter maturity bonds. As these papers mature, their corpus gets reinvested in higher-yield papers in a rising rate scenario, so these funds tend to perform better,” says Balasubramanian. 

Watch out for both duration and credit risk: The high volatility in interest rates witnessed in 2018 holds lessons for investors. “Do not treat debt funds as fixed deposits with better tax treatment. These funds can also be quite volatile. It is becoming harder even for fund managers to predict interest rate movements. This year showed that besides domestic factors, even external events, such as the sudden and sharp rise in crude prices, can impact bonds,” says Dhawan. 

Many investors were putting money in credit risk funds just because they had given high returns in the past, unmindful of their higher risks. “The IL&FS crisis brought home the fact that there are no free lunches and credit risk does exist. Investors who do not have the stomach for such risk should invest only in funds that hold AAA-rated papers,” says Belapurkar. The recategorisation exercise has made it easier for investors to select debt funds based on their duration. However, the regulator has not specified how much credit risk funds can take in each of these categories, so investors need to watch out for it themselves. 

While interest rates have softened in the past months, they could reverse, so investors should avoid taking too much duration risk in their portfolios. 

Investors with moderate risk appetite may adopt the following asset allocation in their debt portfolios in 2019: About 10 per cent may go into liquid and ultra-short term funds, 70 per cent may go into short-duration funds (and lower duration corporate bond funds), and 20 per cent may go into dynamic bond funds. Risk-averse investors may avoid the last category. 

Large-cap equity funds fell less
  Category average returns (%)
Category    YTD 3-year 5-year 10-year
Large-cap funds     -4.32 9.44 13.01 15.23
Large- and mid-cap funds    -8.72 10.81 16.97 17.77
Multi-cap funds    -7.20 9.62 15.19 17.47
Mid-cap funds    -13.48 9.12 18.60 20.68
Small-cap funds   -18.58 8.82 20.10 19.15
ELSS funds -7.64 10.11 15.55 17.00
Source: Ace Mutual Fund

Lower duration debt fundd fared better
  Category average returns (%)
Category    YTD 3-year 5-year 10-year
Liquid funds    6.72 6.93 7.63 7.48
Ultra-short duration funds      5.95 6.95 7.75 7.73
Low duration funds    6.96 7.48 7.90 7.55
Short duration funds    5.97 7.08 7.73 7.79
Medium duration funds    5.65 7.62 8.69 7.57
Dynamic bond funds    5.65 7.31 8.55 7.28
Corporate bond funds    5.60 6.95 7.85 7.18
Credit risk funds    5.14 7.44 8.43 7.51
Source: Ace Mutual Fund

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