How equity funds leverage a few good months for outperformance

Equity investments are inherently volatile.
Equity investments are inherently volatile.

Summary

Despite market volatility, people should stay invested for the long term to benefit from such outperformance

Financial experts have for long touted the benefits of long-term investing, especially where it concerns equity mutual funds. Yet, a large number of retail investors continue to exit the markets after a short duration. According to data from Association of Mutual Funds in India (Amfi), 51.4%, or more than half, of the investments held by retail investors have an average holding period of just more than two years.

The exits are mostly attributed to market volatility. For instance, India’s stock markets have had to navigate choppy waters in October amid increasing global geopolitical tensions, such as the Israel-Hamas war, and economic turbulence caused by rising inflation and a steady rise in US bond yields. The resultant market volatility pulled down the S&P BSE Sensex by 3%. The BSE 150 Mid Cap Index fell 3.3% and BSE 250 Small Cap Index declined about 2.7%.

Such volatility is a deterrent for many retail investors who are wary of negative returns. Equity investments are inherently volatile. But over longer periods, this volatility tends to even out. Just a few months of sharp outperformance by equity funds can deliver outsized returns for the investor. But if an investor exits early, he or she ends up missing out on these very months.

The critical months

A recent study by Morningstar India, an investment research firm, has captured the number of best-outperforming months across actively-managed funds in the last 10 years. It has termed these months as critical months—without the outperformance in these months, the fund would either perform in-line or underperform the benchmark. In yjr last 10 years, just five months—or 4.2% of 120 months—accounted for outperformance of all actively-managed equity funds

The study found that half of all equity funds or funds in 50th percentile of outperformers had four or fewer critical months to deliver outperformance vis-à-vis their benchmarks (see graphic). In other words, out of the 120 months in ten years, these funds’ outperformance can be attributed to 3.3% of months or even less in some cases.

For the 75th percentile, outperformance was attributable to seven or fewer critical months. For funds in the 25th percentile (bottom 25%), it was attributable to two or fewer critical months.

In small cap funds, funds in the 75th percentile had seven or fewer best-outperforming critical months to beat their benchmarks. In large- and mid-cap category, funds in the 75th percentile had nine or fewer best-outperforming critical months to beat their benchmarks.

 

(Graphics: Mint)
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(Graphics: Mint)

Long-term horizon

For any investor to predict when these best-outperforming critical months can occur is next to impossible. “Strong outperformance can also come from days when markets open gap-up. So, even five days of 1% gap-up opening can add 5% gains to a fund’s performance. And if the fund is managed well, it can even outperform this," points out Amol Joshi, founder of Plan Rupee Investment Services.

The Morningstar study shows that the top-10 performing funds had 14 critical months that drove their outperformance against their benchmarks. So, of the 120 months in 10 years, 11.7% of months accounted for these funds’ outperformance.

Experts say instead of timing the market, investors holding equity funds should try to spend a longer time in market, to ensure they participate in these best-outperforming months.

“If you think you have identified a skilled fund manager, the best course of action is to buy in or rupee-cost average with systematic investment plans, regardless of the moment, and hold on to the fund over long periods of time. The obvious, and perhaps even the most important corollary, is that a fair amount of patience is required to adhere to such a program," says Kaustubh Belapurkar, director – manager research, Morningstar India.

“A good manager may take a long time before critical months materialize," Belapurkar adds.

Case study

Canara Robeco Bluechip Equity Fund was the best-performing actively-managed large cap fund in 2020. Its best-performing or critical months came in February 2020 and March 2020. While the returns were negative in both these months, it was better than the benchmark BSE 100 Total Return Index.

In terms of geometric excess return, which measures a fund’s proportional outperformance or underperformance versus its benchmark, the fund had 1.041 geometric excess return in both these months. This excess return was the highest in the 12-month ending December 2020.

If an investor had missed even one of these months, the fund’s performance for the entire year would have been in line with the benchmark (i.e. geometric excess return of 1). If the investor had missed both of these months and entered only in April 2020, the investor returns would have underperformed the benchmark returns. At the same time, if the investor had exited early in January 2020, he would have missed a period of strong outperformance delivered by the fund.

To be sure, not all investments can be kept for long periods like 10 years to get as many outperforming months as possible. Investors can divide their investments across long-term, medium-term and short-term. For medium-term goals of three- to five-years, investors can consider any of the hybrid fund categories which invest in equity and debt in different proportions. For short term goals, debt funds are suitable as they are not as volatile as equity investments. Investments in equity funds can be kept exclusively for long-term goals and unless there is any emergency, investors should avoid making early withdrawals from such funds.

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