Options galore, multiple risks

Today, with more than 1,200 mutual fund schemes to choose from, Indian investors are awash with choices—from funds that invest in index options to ones with themes such as lifestyle, infrastructure or capital preservation.

But, have these innovations really paid off for investors? Using data provided by Value Research, Mint took a close look at the funds. Here are some broad findings:

Does it pay to be a contrarian?

Contra funds make money by adopting a contrarian strategy. Instead of going with the herd mentality of buying certain popular stocks, contrarian fund managers identify out-of-favour stocks, or those that are expected to perform better in the long run. In other words, these funds try to take advantage of the seemingly irrational behaviour of investors in certain stocks and sectors.

In a contrarian strategy, the fund manager often takes a call completely different from where the market is heading. For instance, if everyone is buying real-estate stocks because of high growth expectations, a contrarian fund invests in some other sector. Or bets against the sector by not investing in it for the present.

Since the success of SBI Mutual Fund’s Magnum Contra, five mutual fund companies have launched their own versions of contrarian funds in the Indian market. Today, they collectively manage assets worth Rs2,700 crore.

The strategy, however, doesn’t seem to have yielded good returns for the investor. In the past one year, three funds have posted negative returns against the Sensex or the Nifty. At a time when the overall market has gone up, contrarian fund investors haven’t seen any appreciation in their investments. Even between June 2006 and February 2007, when the markets went up sharply, or during the sharp downturn between February and March this year, contrarian funds didn’t do as well as expected. Among them, Magnum Contra and DBS Chola were two of the better-performing funds. The Magnum Contra scheme has performed well across time periods. “The fund has changed its focus from mid-cap to large-cap stocks. Moreover, our contrarian calls on the engineering sector last year worked in our favour," says Sanjay Sinha, chief investment officer, State Bank of India. But the fund’s heavy exposure to the construction sector, one of the better performing sectors, during 2006 makes it look less like a contrarian fund.

“While some, and not all the contra funds, have been taking contrarian calls, the strategy hasn’t produced great returns for investors," says Dhirendra Kumar, chief executive officer of Value Research.

R. Rajagopal, head of equities at DBS Chola Mutual Fund, however, argues that because of the very nature of a contrarian fund, which buys underperforming stocks, the returns come slowly. But these deliver better returns over a longer period of time, he says. “Contrarian funds can play a supplementary role in a fund portfolio," he adds.

As of now, most contrarian funds in India have their bets laid on energy, technology and health-care stocks.

Did multi-cap management work?

As mutual funds found themselves straitjacketed into being large-caps or mid-caps, a multi-cap variant was introduced to invest and reshuffle the portfolio between large-, mid- or small-cap stocks, but within a certain limit.

So, unlike other equity funds, these have the flexibility to take advantage of the upside potential in the stocks across market-capitalization. For instance, as the stocks of companies with mid- or small-market capitalization haven’t been performing well, these multi-cap funds have tilted their exposure to large-cap stocks in the past few months.

But, despite a seemingly broader mandate, multi-cap funds have performed just as well or badly as the broader market or other diversified equity funds. While mid-cap stocks have been outperforming large caps for a long time, the trend reversed in the past one year. As a result, even these multi-cap funds have considerably reduced their exposure to mid-cap stocks in the past year.

With its mediocre performance (see table), the Franklin India Flexi Cap fund stands out in this category: It may not have gained as much in a rising market, but in a falling market, it hasn’t lost as much as its peers.

The fund has followed a disciplined strategy of restricting exposure to mid-cap stocks to around 28-30% on average.

“Considering the fluctuating performance of large- and mid-cap stocks, I would recommend a multi-cap fund as compared to a pure large-cap or a pure mid-cap fund. Multi-caps are in a better position to take advantage of the ups and downs in stocks across market-caps," says Kumar.

How good is the idea to lock the money in three or five years?

Ever since mutual funds were stopped from charging expenses related to the launch of a new scheme, there has been a mad rush for closed-end equities, as these were allowed to levy such initial issue expenses from investors. As many as 11 equity funds have already been launched in 2007 alone, in addition to the 13 last year.

These funds are closed-end because investors cannot withdraw money before a certain period—usually three or five years. The rationale behind this strategy is that these funds can take a long-term view while investing as they don’t face frequent redemptions from investors. Kumar, however, says he believes these funds don’t offer any particular benefits. “If the lock-in is the reason for a superior performance, then tax-saving equity funds, which, by default, have a three-year lock-in period, should have done exceedingly well compared to a diversified equity fund," he says.

Tax-planning equity funds, which are similar to diversified equity funds in their nature, posted a 38% return in the past five years compared with the latter’s 40% figure for the same period. “I don’t associate any specific performance attributes to these funds. This concept can only work well if the fund is investing in mid- and small-sized companies," says Dhruva Chaterjee, an analyst with Lipper, which tracks the industry.

Although most closed-end equity funds are new and don’t even have a one-year track record, their performance during sharp market swings has been as good as that of open-ended diversified equity fund. For instance, UTI’s Wealth Builder Fund, among the best performers in the past six months, posted superior returns compared with the other open-end equity funds from the UTI family. But these had an equally bad run during the volatile time between February and March this year.

While most of these funds just invest in stocks, some have a different mandate. For instance, Franklin India Smaller Companies Fund, one of the first to be launched in this space, has had a rough patch so far. In the past one year, it has lost 6%.

The fund’s mandate is to invest in small-cap firms, which have been underperformers in the market.

Or, take the Standard Chartered Enterprise Equity Fund, a Rs1,500 crore fund launched as an initial public offering (IPO) fund. It was to invest in IPOs of companies and earn returns by selling these IPOs on listing. However, since the IPO pipeline dry up, it has been investing in blue-chip stocks to generate returns.

Did arbitrage work?

With Rs3,000 crore of aggregate assets, the nine arbitrage funds have done exceptionally well in the market. These attempt to earn returns by investing 70-80% in stocks that have a price differential between the cash and futures market. If there aren’t enough arbitrage opportunities, then these funds also have the flexibility to park the money in debt instruments or cash.

Arbitrage funds do invest in equity-linked instruments, but they don’t aim to generate equity-like returns.

They aim to provide returns better than a bond or an income fund. In that sense, these have lived up to their expectations: On an average, these funds have posted around 80% returns in the 52 weeks ended 8 May. This is well above the returns posted by a long-term, short-term or even cash fund.

Does hedging help?

Reliance Equity and Tata Equity Management Fund are two prominent funds in this category that promise to use hedging strategies to generate returns. These aim to be less volatile in a falling market as they can sell stocks in anticipation of a downward trend. This strategy seems to have worked well during the bad times. During the last two volatile periods of May 2006 and February 2007, the two funds fell by only 23% and 12%, respectively. In fact, Reliance Equity was among the 10 funds that lost the least in this period. Also, its one-year return of 9% is much above the category average of 2.80%.

However, investors don’t seem to be happy with their performance during good times.

“After all, the fund promised to work in all market conditions," says Hemant Rustogi, chief executive officer, Wiseinvest Advisors Pvt. Ltd, a Mumbai-based mutual fund advisory firm. During the run-up from June 2006 to February 2007, Reliance Equity fund was up 45% against an average equity fund’s gain of 58%.

Remember, if you are stuck with a fund where you cannot even recover your original investment, it makes sense to hold on to it till you get some gains. But whether it’s a contra, multi-cap or a closed-end fund, experts suggest these should not be the core holding of your portfolio. Kumar actually suggests you take the ‘fund of fund’ route. It is a fund that invests your money in other schemes, of the same family or even of other fund houses.

Write to us at businessoflife@livemint.com

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