True to label: See what you buy, and buy what you see
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Have you ever been disappointed when you bought a diet drink, only to be frustrated that the ingredients are as unhealthy as the regular drink? One of the most comforting things about the most-loved consumer brands is their consistency of delivery. When you buy them, you get what you sign up for. Why should the same not be true of mutual funds, particularly given that investing is not about a single transaction but a long-term experience?
For years, mutual funds have enjoyed ambiguity around definitions and labels. What ‘mid-cap’ meant could be very different for two different fund houses; ‘infrastructure’ funds could carry banking exposure; and funds with conservative risk profiles could carry aggressive fixed-income risk.
For an investor, it then becomes important to identify ‘true-to-label’ funds—funds that clearly define what they do and stick to it, both in the offer document and in spirit. While the new scheme merger classifications by the Securities and Exchange Board of India (Sebi) will help define these labels, there are a few principles that investors can look out for.
Committed asset allocation
Each fund fits a defined asset allocation in an investor’s portfolio—whether market-cap driven for equity schemes, or credit- and duration-driven for fixed-income schemes. And it is important to ascertain whether a fund has stuck to that asset allocation regardless of short-term market movements. A short-term fund that has a mandate to invest in 2-3 year maturities, should not see average maturities spike up to 4-5 years just because interest rates are falling. Similarly, a large-cap fund should not be tempted to add small-cap exposure to the portfolio in bull markets to generate incremental alpha, because that changes the risk profile of the fund. While the new Sebi limits have provided significant boundaries on fund asset allocation, there are areas of flexibility provided. For instance, large-cap funds have to have 80% in large-cap securities and 20% of the portfolio is flexible. Those flexible components should also be managed in the spirit of asset allocation of the fund.
Risk profile of the fund
True-to-label funds will abide by the risk profile of the fund, in both what is documented and what is not. For instance, equity savings funds carry both equity and debt exposure but the exact nature of investments in equity and debt is not specified. However, since this is a fund category meant for conservative investors, the equity component should not carry aggressive mid-cap exposure and the debt component should not carry significant duration or credit exposure. While this may be allowed under the committed allocation, such aggressive investments are against the spirit of the risk profile of the fund.
The reverse problem is often true in thematic funds, which often invest in stocks clearly outside the mandate and risk profile of the theme, when the theme is going through a rough patch. While the fund documents may allow it, infrastructure funds investing in banking or consumer names when infrastructure is going through a rough patch is dangerous for an investor, because the fund will materially underperform expectations when infrastructure revives.
No drift in investment style
Like market-cap range, style is part of the label of a fund and style drift can hurt mutual fund returns. It can be a result of many things but the most common reason is fund managers jumping ships too often while chasing returns. Managers tend to be ‘style chasers’ during bull years, which appears to benefit their performance, but can pose a significant risk if the portfolio’s focus changes too often. For example, if a fund with value investment style drifts to GARP (growth at a reasonable price) style, because the growth theme is outperforming value, the investor may not be getting what she signed up for.
Not only is it important to follow a label consistently and do what you say, it is equally important to effectively say what you do. A fund is true-to-label when it communicates its investment approach clearly to its existing and prospective investors. This starts with having a name that is consistent with the label of the fund, as well as fund communication that is simple but not oversimplified. Arbitrage funds and mid-cap funds are both classified as equity funds, for instance, but their purpose and risk profile are starkly different and the communication should reflect the different purposes of the schemes.
Investors would have heard this often: “Please read the offer documents carefully before investing.” Investments, unfortunately, are not a one-time purchase but an experience that is repeated again and again. A focus on and move towards more true-to-label funds is important to ensure that the experience after investing is what one signed up for before investing.
Radhika Gupta is the chief executive officer of Edelweiss Asset Management Ltd