Wouldn’t you love to buy equities when markets are at a low and sell them when markets are at a high? As basic as this stock market mantra is, it’s easier said than done. It is hard to resist temptation when markets are near their peak and it’s tough to find the courage to jump into equity markets when they’re falling.
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There’s an alternative. If you do not mind taking the mutual fund (MF) route, dynamic (equity-oriented) funds switch your money between equity and debt markets. Apart from the existing six such schemes in the market, two new schemes were launched in November 2010. Pramerica Asset Managers Pvt. Ltd launched Pramerica Dynamic Fund (PDF) and Principal PnB Asset Management Co. (AMC) Ltd launched Principal Smart Equity Fund (PSE). Should you look at them?
Playing on both sides
Dynamic funds switch between different asset classes, depending on their attractiveness. Even hybrid funds do that, but they can’t switch rapidly between asset classes—they’re typically true to one asset class such as equity in case of balanced funds and dip their hands sparingly in other asset classes. Dynamic funds aim to switch aggressively between equity and debt and are more opportunistic.
In rising equity markets, they invest more in equity and less in debt and cash. But when markets start to fall, these funds sell equities and get into cash. “Investors do not take full benefits of rising markets because at higher levels, they do not book profits adequately. Also, at lower levels, people hesitate to invest in equities; they aren’t sure when they should invest; they miss the rally,” says Rajat Jain, chief investment officer, Principal PnB AMC. These funds switch dispassionately, he adds.
Take the case of Franklin Templeton Dynamic PE Ratio Fund of Funds (FTDP). When the Sensex was around 10,000 levels in March 2009, FTDP had invested 91% of its corpus in equities. Now that the Sensex is around 20,000 levels, it has only 30% invested in equities; the rest is in debt.
Not all dynamic funds are alike. Some such as HSBC Dynamic Fund (HDF) switch between equity and cash depending on how their fund manager perceives the markets. Others such as FTDP look at indicators such aas the Nifty’s price-earnings (P-E) multiple to determine how heated the markets are. Apart from determining their asset allocation, they also differ in terms of how they invest. For instance, FTDP is a fund of funds scheme (that invests in other funds) and splits its corpus between Franklin India Bluechip Fund (a large-cap equity scheme) and Templeton India Income Fund (an income scheme); both schemes from its own fund house.
After determining its equity and debt split, UTI—Variable Investment Scheme—Index Linked Plan (UTIV) manages its equity component passively. It invests its entire corpus in shares of companies—and in exactly the same proportion— as they lie in the Sensex. Others such as HSBC Dynamic Fund allow their fund managers to determine the equity and debt split and also to pick and choose equity and debt scrips in which the scheme would invest in.
Freedom at a cost
Schemes such as HDF, which actively manage the equity-debt switch, usually restrict the fund manager’s freedom to exit equities—even in the face of excessive market volatility—and sit on cash. “To be able to exit equities and sit entirely on cash is a very bold move that can go horribly wrong, if the fund manager has the freedom to do so. If the markets jump back, the fund manager is caught off-guard and underperforms badly,” says Nilesh Shah, deputy chief executive officer, ICICI Prudential Asset Management Co. Ltd. Therefore, though ICICI Prudential Dynamic Fund (IDF) has not explicitly stated the parameters that will determine its equity-debt split in its scheme information document, internally the MF looks at the price-to-book value (PBV) ratio of the Nifty. Higher the PBV, lower will be its allocation to equity.
Tushar Pradhan, chief investment officer, HSBC Asset Management (India) Pvt. Ltd, is cautious, too, when it comes to the fund manager’s freedom in dynamic funds. Though he joined the MF only in June 2009, he is mindful of how badly the fund house was punished for sitting on excess cash between March and May 2009. During that time equity markets rebounded and shot up; fund houses such as HSBC MF with high cash levels lost out miserably. “Unless you have a view that the Indian equity markets are going to fare very badly in years to come, there’s isn’t merit in having too much cash in a portfolio,” says Pradhan.
At present, HDF goes a maximum of 20% in cash (10% only for all other HSBC equity-oriented schemes) as a “tactical call” if the fund manager has a negative view on the market. On the other hand, if fund managers have freedom to choose the equity-debt split, most prefer to be heavy in equities to be able to retain the equity tax advantage; schemes that invest at least 65% of their corpuses in equities qualify as equity schemes and do not impose long-term capital gains tax.
Do dynamic strategies work?
To check whether dynamic fund strategies work or not, you’ve got to first check the level of flexibility with which these funds can switch between equity and debt. For instance, of the six dynamic funds present in the Indian MF industry, only two schemes— FTDP and UTIV—can switch completely to cash. Both these have been around for more than five years. Of the two, FTDP has a better track record; it gave a return of 17.75% in the past five years. UTIV managed to give just 3.73% in the same period. Newly launched PDF and PSE, too, can completely exit from the equity markets and sit on cash.
“Typically, dynamic funds underperform pure equity funds in continuously rising equity markets because these funds sell equities and get into cash as equity markets go up,” says Arvind Bansal, vice-president and head (multi-manager investments), ING Investment Management (india) Pvt. Ltd, that manages ING OptiMix Asset Allocator Multi Manager FoF (IOMM). In 2007, on the back of rising equity markets, FTDP returned 27.42% against 40% returned by balanced funds on average. The fund got saved in 2008 when equity markets crashed; it lost 25% against an average loss of 37% by balanced funds. Overall, though, the fund seems to have got its act in place; it returned 18% in the past five years against 15% category average returns by balanced funds. IDF has done well across time periods, but that is mainly because it restricted its cash levels to up to 35% and actively managed its equity portfolio.
PDF aims to be different. It doesn’t just limit itself to one parameter such as the equity market’s P-E multiple. It takes into account several parameters such as fundamental (earnings growth, inflation, interest rates), liquidity (money supply, currency valuations) and volatility (details from the derivatives market) parameters to arrive at its stated equity-debt split. “To ascertain whether the markets are overheated or not, it is necessary to look at a whole host of factors and not just P-E,” said Vijai Mantri, chief executive officer, Pramerica Asset Managers. However, K.N. Sivasubramanian, chief investment officer, Franklin Equity India, Franklin Templeton Asset Management India Pvt. Ltd, says: “The need of the hour is to have simple products. Nifty’s P-E (FTDP refers to it) is derived by the P-E of individual companies from within Nifty, which makes it a good indicator. FTDPEF’s model has been tested through markets cycles and is reflected in the fund’s performance.” While PDF’s formula ascertains its present equity exposure at about 70%, FTDP’s equity exposure at present is 30%. Time will tell who is right and who’s not.
What should you do?
A well-managed dynamic fund can absolve you of the headache of timing the markets, if at all you get affected by market volatility. If that’s your concern, it bodes well if your dynamic fund depends on a formula that ascertains its equity-debt split. In future, expect more exotic funds—such as PDF and IOMM—to be launched. “We at HSBC too are reviewing our products and contemplating to introduce an algorithm or some parameter that the fund manager can follow blindly. In this case, the fund manager can fully focus on picking and choosing scrips. The headache of asset allocation will then be left on a formula that will also be sufficiently back-tested,” says Pradhan. He says that dynamic funds are tricky to manage and fund managers have to be very careful. “If we go by short-term volatility and shift to cash, but the market rises for the next two years or so, we burn ourselves badly.”
Opt for dynamic funds only if you have the appetite to invest for at least five years. “It is a fill-it, shut-it, forget-it product,” says Shah.