Contain downside risk using value funds

Over the past year, when the stock markets have been sliding, the majority of value funds have provided sound downside protection. That is, they declined less than their benchmarks. Many of these funds have also provided good returns over the long term. The combination of these features makes these suitable candidates for all long-term portfolios.

Advantages of value funds

The biggest advantage of these funds is their ability to contain downside risk. Says Mrinal Singh, deputy chief investment officer-equity, ICICI Prudential AMC: "A value strategy means buying with a margin of safety. Those who follow the discipline of value investing buy stocks at attractive valuations. Doing so helps contain downside risk automatically." The ability of these funds to stem their fall in a bear market helps maintain investor confidence in equity funds at a time when growth funds are correcting sharply.

Value fund managers include high dividend-yield stocks in their portfolios. This yield is a type of annuity income that comes into the portfolio and helps prevent erosion of net asset value in falling markets.

The majority of funds in India are growth-oriented ones. They don't shy away from investing in high-valuation stocks or even from momentum-oriented investing. By investing in value funds, you can provide style diversity to the portfolio.

Some value funds in India, like Templeton India Equity Income Fund and PPFAS Long Term Value Fund, invest a part of their portfolio in foreign markets. These could help diversify your portfolio against country-specific risk.

Minuses, risks

One risk in value funds is value trap. Fund managers can't invest blindly in a stock with a low price to earnings (P/E) ratio or low price to book value (P/BV) only because its valuation is attractive.

"Sometimes, those low valuations are justified, as the fundamentals of the business are poor. Fund managers need to evaluate whether the low valuation is deserved or the market is being short-sighted and there is a case of mis-pricing," says Kaustubh Belapurkar, director-manager research, Morningstar India.

If fund managers fall into the value trap, the performance of their fund suffers.

Value funds also tend to underperform their growth counterparts in strong bull markets, such as those of 2000 and 2007 (though they do offer good risk-adjusted returns across cycles). "These funds are not for investors who feel they have missed out on a rally in a surging market," says Rajeev Thakkar, chief investment officer, PPFAS Mutual Fund.

A fund manager might pick up a stock he regards as a great value buy, but sometimes the rest of the market could take a long while to recognise the value of that stock and drive its valuation up. "If value recognition takes a long time, the internal rate of return on that will be lower than expected," says Belapurkar.

Selecting the right fund

The first requisite for selecting a value fund is a good record over the long term. That will tell you whether the fund has the ability to perform across market cycles.

The fund should also be consistent in adhering to the value style of investing. Fund rating agencies like Morningstar offer what is called a style box, a three-by-three box that pictorially depicts a fund's market cap orientation and investment style (value, blend or growth). By looking at historical style boxes, you can check out if the fund manager has consistently adhered to the value style. A relatively low average PE of the fund provides another indication.

There are two schools of value investing. One is the Benjamin Graham style of deep value investing, where the fund manager invests in low PE, low P/BV and high dividend-yield stocks. The second is the Phillip Fisher-Warren Buffett style, where the fund manager picks quality stocks at reasonable valuations. If a fund adheres to the first style, its performance can deviate widely from that of the market. "After examining the portfolio, choose a fund whose investment style is more in sync with your approach," advises Thakkar.

Prefer funds which follow a buy-and-hold approach and, hence, have a low turnover ratio.

What to do?

Investing in value funds requires you to have a longer-term investment horizon. "Money that you can spare for five to 10 years can be safely invested in a value fund," says Singh. Conservative investors could allocate 10-15 per cent of their portfolio to such funds for the style diversification they provide. Investors with a strong value-oriented philosophy may have a higher allocation to these.

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