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What was your fund manager doing...

Not since the technology crash of 2000 have an equity fund manager's investment strategy been tested—and the perils of running a concentrated portfolio exposed.

Rachna Monga | Print Edition: August 24, 2008

For the first time in five years of investing, Amit Gupta, a 31-year-old banking professional in Mumbai, didn’t sign a cheque for an equity fund. Stung by an erosion of 45-50 per cent in his fund portfolio in just six months, Gupta doesn’t plan to make fresh investments in funds. Instead, he plans to allocate money for directly buying a small basket of stocks, even if that means spending more time on research and constant monitoring of share prices.

Crashing stock markets
Crashing stock markets
Gupta isn’t a great advertisement for the mutual fund industry, which, for its part, is doing its bit to introduce more Indians to the equity cult (mutual fund penetration, after all, is still just 5 per cent in the country). What’s worse, Gupta wouldn’t be the only investor who is losing faith in funds.

When close to half of the net asset value (NAV) of an equity fund erodes in some seven months, telling investors that mutual funds are a less risky way of investing in stock markets makes little sense. To put it plainly, a host of schemes has performed worse than the mainline market indices.

Between January 2008 and July 25, Indian stocks, as represented by the Sensex and the S&P CNX Nifty, fell 30 per cent. The diversified equity funds category lost 35 per cent. Only 29 of 163 equity funds could outperform the Sensex or S&P CNX Nifty Index. The report card isn’t that gloomy when funds are compared against the broader market index, such as the S&P CNX 500 Index that fell by 36 per cent.

Yet, only 85 funds could manage to beat this index.

Testing times

Not since the technology crash of 2000 have an equity fund manager’s convictions and investment strategy been tested—and the perils of running a concentrated portfolio exposed.

Comparisons with indices may yield sweeping and simplistic results, but the fact is that most equity funds are complex animals: their portfolios are often a mix of large-cap and mid-cap stocks; some fund managers tend to move in and out of sectors over the short term; others like to take contrarian calls; and the more adventurous lot even fancy exposure to derivatives. The short point, however, is that most of these strategies have come a cropper in a volatile market.

 
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Nilesh Shah, Deputy MD, ICICI Prudential AMC
Nilesh Shah, Deputy MD, ICICI Prudential AMC
Nilesh Shah, Deputy MD, ICICI Prudential AMC, acknowledges that fund houses missed a trick or two. But he points to a “fundamental difference” in this time’s wealth erosion vis-a-vis the tech wreck at the turn of the century.

“In 2000, it was our call (of the fund community) on the businesses that went wrong. This time, there is no business that has vanished or company that has gone bust. We erred on the valuation aspect of the business,” explains Shah.

Sukumar Rajah CIO (Equities), Franklin Templeton
Sukumar Rajah CIO (Equities), Franklin Templeton
Adds Sukumar Rajah, Chief Investment Officer (Equities), Franklin Templeton Investments: “In the recent rally till January 2008, valuations of stocks/sectors had not moved up as much as they had in the technology boom of 2000. The underlying drivers, though, are similar—unrealistic growth expectations and speculative activity.”

Business Today’s analysis of fund strategies and investing themes reveals that funds that chased “hot” sectors like real estate and banking were hit the hardest. Those that had a more moderate game plan, with a fair sprinkling of stocks from “defensive” sectors (like consumer goods and pharmaceuticals), along with those who chose not to sit on excess cash, got away with relatively less damage to their NAVs.

Here are some of the strategies that worked best in a falling market.

International diversification

The theme that worked like a charm was international diversification. As Indian (and Chinese) stock markets proved to be the worst performers among emerging markets, it made ample sense for managers to invest overseas. Funds that did this, like Fidelity International Opportunities, Templeton India Equity Income Fund and ICICI Pru Indo Asia Equity Fund (retail option), lost just 22-25 per cent during January-July 2008. These three funds have a mandate to invest up to 30-35 per cent in overseas stocks.

Fidelity’s fund exposure was spread across companies in Australia, South Korea and Franklin’s fund had bought into Mexican and Russian equities. What also helped these three funds outperform their peers, along with the market indices, is their reluctance to bet the house on the high-growth, volatilityprone sectors. None of them, for instance, had exposure to real estate or construction.

In fact, Rajesh Singh, a fund manager at Fidelity, warned investors in the fund house’s newsletter of December that he was wary of momentum plays and was underweight on sectors such as utilities, real estate and power. “In the utilities space, we remain wary of ‘vision’ stories that carry with them significant execution risks… real estate stocks look expensive and we see a significant oversupply risk over the medium term.” Funds riding the “opportunities” theme lost between 34 and 41 per cent. When markets are peaking, the focus inevitably is on momentum, and the temptation to stay away from the safe but humble returns of defensives is very real. That explains why most funds—not even many of the socalled contrarian ones—were not willing to court pharma stocks in the December-January period. UTI Contra and the Tata Contra Fund were the only ones to have pharma stocks making up more than 5 per cent of their portfolios. Unsurprisingly, UTI Contra lost the least in the contrarian category—31 per cent as against a 42 per cent hit for DBS Chola Contra, the worst loser in the peer set of eight.

The funds that lost the least were the ones that neither plunged headlong into hot stocks nor increased their cash position during January to June, but had exposure to defensives such as pharma. In the January-March period, funds such as Templeton India Growth, HDFC Equity, and Quantum Long Term Equity, didn’t have more than 5-6 per cent cash in their portfolios. Still, they managed to control the losses as they were among the least losers.

Sukumar of Franklin Templeton believes a strategy of limiting exposure to momentum sectors and not attempting to time the market with a high cash position might result in short-term underperformance, but helps in delivering better returns over the long term.

Sukumar would know what he’s talking about—Franklin Templeton is one of just two fund houses that weathered the bear market of 2000, too (the other house is Zurich Mutual Fund’s scheme, which was later taken over by HDFC Mutual Fund). 

Sandeep Kothari Portfolio Manager, Fidelity Investments
Sandeep Kothari Portfolio Manager, Fidelity Investments
Sandeep Kothari, Portfolio Manager at Fidelity Investments, says that instead of staying with cash, his funds shifted focus towards more liquid stocks even as they pruned holdings in mid-cap stocks.

But there were fund houses that did use cash as a cushion. Mihir Vohra, Senior Vice President and Head of Fund Management (Equities), HSBC Asset Management (India), is known for his style of moving in and out of sectors as and when valuation equations change. In between entering and exiting, he doesn’t mind sitting on cash until he finds an opportunity.

Till end-2007, HSBC Equity Fund was bullish on cement, construction and industrial goods, which accounted for 15-18 per cent of its portfolio. By end-June this year, it had brought that holding down to 5 per cent. Exposure to banks has halved to 7 per cent over this period.

 Dream themes

How the better performers kept their head above water.

  • International diversification: As India was one of the worst-performing markets, funds that invested overseas fared better

  • Lower the risk, lower the loss: Aggressive investing in sunrise sectors like real estate and infrastructure works well when markets are up; but when they fall, these funds are hit the hardest. Those with exposure to defensive sectors like FMCG and pharma were less badly-hit

  • Selective stock-picking helps: Just because real estate is a high-growth sector doesn’t mean all stocks in it will promise sustained returns. Smart fund managers learn to be selective

  • Spotting changing flavours early: No sector is a favourite forever. Managers who caught on to the new flavour of the season fast (and discarded the old favourites) fared better

The cash portion went up from 5 per cent to almost 20 per cent, which helped restrict the fall in NAV to 28 per cent. “When you play the valuations game, there is always a risk of booking profits early as markets could favour certain sectors for a longer period than you think. So, we didn’t really take a cash call but booked profits at regular intervals between January and June,” says Vohra, who doesn’t like to take his eye off valuations, apart from fundamentals.

Sitting on cash the safest bet

Clearly, sitting on cash as the indices slid was a resort for many managers. Towards the end of January, only 17 equity funds held more than 10 per cent of their assets in cash. That number went up to 51 by March and to 63 in June. Some funds even had cash holdings of 25-30 per cent.

Sanjay Sinha CIO, SBI Funds Management
Sanjay Sinha, CIO, SBI Funds Management
The funds that got truly ravaged were the theme-based and the mid-cap-focussed ones. JM Financial’s three funds were among the top losers. On a small asset base, JM HI FI’s NAV eroded by 53 per cent and the Emerging Leaders Fund was down 48 per cent. Indeed, both of them are thematic funds and had raked in superb returns in 2007. As on December 31, construction and industrial goods were the top sector preferences in most of the funds of JM Financial. “Our investment style in these funds was to take aggressive and concentrated bets. It paid off well in 2007, when we significantly outperformed the broader markets. In the context of the recent fall in markets, our losses are marginal,” shrugs Sandeep Sabharwal, Chief Investment Officer (Equities), JM Financial Asset Management. He added that the funds had a midcap bias and suffered due to a sharp correction in that space. But his funds continue to believe in the construction sector as Sabharwal feels the concerns about its prospects are overblown.

More funds hit rock-bottom

Another set that hit rock bottom was SBI Funds Management’s Magnum Global (a mid-cap fund) and Emerging Businesses funds. Both were heavily biased towards infrastructure, and were down 43 per cent and 47 per cent, respectively.

Sandeep Sabharwal, CIO (Equities), JM Financial
Sandeep Sabharwal, CIO (Equities), JM Financial
Sanjay Sinha, Chief Investment Officer, SBI Funds Management, explains that the turnout of events defied economic logic. “When the subprime crisis in the US came out in open in January, it was expected that commodity prices will fall due to a slowdown in the US. So, we had built a portfolio around engineering stocks assuming that margins will expand due to a fall in raw material prices. But commodity prices kept going up, thereby upsetting the earlier calculations,” he says. Sinha has reduced his holdings in infrastructure stocks, but remains bullish on the sector’s prospects.

Other funds are in damagecontrol mode. ABN AMRO Asset Management’s three equity-oriented funds, which figured among the top 20 losers, were overweight on mid-cap stocks in the capital goods sector. K.C. Reddy, Chief Investment Officer, who came on board in June, says that attempts are being made to rebalance the portfolio towards stocks that can perform better in a tough environment.

Reddy’s challenge—and for that matter the challenge for the entire fund manager community— is to find that right basket that can outperform the market.

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