Are you frustrated with poor returns earned by your equity shares and mutual funds over the last 5 years? You won’t find yourself alone. There are many investors who would share your story. Like you, they too have waited long for seeing meaningful returns on their investments in equities, done directly or through a mutual fund route. Impatient and restless investors have already shunned equity as an asset class. But now even the matured and disciplined investors have started wondering as to how long would be long enough to generate attractive returns on the investment. Through this article we attempt to sort out all your doubts about investing in equity assets especially under environment such as the prevailing one. How various categories of Mutual Funds have fared?
A flash back...
In order to gain more understanding about how to tackle the present situation, you must know a few things about development of equity markets in India and its impact on investors.
Two decades ago people in India used to believe that the equity market is the best place to gamble after casino. Investing in equities was considered a fast money making exercise wherein one has to have insider’s information to succeed. Until 1995 stock brokers were the only people to know the actual buying and selling price of stocks as there was no access to real time market value of stocks. However, as markets developed; processes improved too. With the launch of online trading platforms, having access to real time stock quotes is now within the reach of even the retail investors. Dematerialization of share certificates brought the much needed relief to investors worried about preserving share certificates. With these developments equity investment definitely became more transparent and easy. Mutual fund industry was shaping up on parallel lines.
Equity gained acceptance among investors and though slowly; it shed its status of next best thing to casino. This transformation witnessed an emergence of investment consultants. Some were just distributors selling their products which earned them good commissions and there were some genuine advisors too. However, there was one thing common in their presentations. Both advised their clients to hold equity assets with a time horizon of at least 3 to 5 years. This phrase became so cliché that even investors developed a blind faith in it as if the time lag would generate returns for them. This is not to say that this argument is a fallacy. It is based on past experiences and some assumptions which are not discussed in as much detail as it should have been, much before.
Why 3 to 5 Years?
It is believed that equity markets are the indicators of economic growth in a country. Every economy goes through cycles of peaks and troughs. In United States (which is the largest economy of the world), there have been 33 such cycles recorded since 1854 to 2009 as per data published by National Bureau of Economic Research, USA. Average time lag between the peak of one cycle and the peak other is about 55 months, close to 5 years. Similarly, average time lag between 2 troughs is about 56 months; again close to 5 years. The minimum time taken to reach from a peak to peak (or even from trough to trough) has rarely been less than 3years. Another theory (Monte Carlo simulation) suggests that losses may less frequently occur if the investor stays invested for longer duration. Therefore, concept of staying invested in equities with a minimum time horizon of 3-5 years has been backed by actual data and proven theories. The idea is to stay invested for the entire economic cycle. However, using this as rule of thumb overlooking some compelling facts is not advisable. It is imperative to study the relation between equity market cycles and economic market cycles to gain more insights about equity investing.
Equity market cycles Vs. Economic market cycles
Equity market cycles and the economic market cycles are closely interrelated only that they don’t move in tandem. Meaning, stock markets don’t bottom out when the economy reaches trough. Stock markets are always forward looking. They reflect the expectation about future course of economic development. In other words, markets reach their peak before the acme of an economic cycle is reached and start recovering before the lowest point in the economic cycle is reached. The novice investors (and even the mature in some cases) make a mistake of looking at present economic data for investing (or not investing) in equity assets. This is why usually investors do not earn in equities as they buy high and sell low. They usually take cues from other economic indicators which, more often than not, are lagging indicators such as unemployment data, corporate spending or inflation measured by consumer price index and so on. Bad stories about economy are abundantly available in a bear equity market phase and good stories in a bull market phase. Investors often miss the transitions in the equity market cycles as the data points fail to convince them. It would however be wrong to believe that transition from bull phase to bear phase and vice-a-versa is immediate. Markets may remain in a narrow range before markets take any direction decisively. Does this sound similar to the present situation of markets? Let’s find out.
Markets in India (and elsewhere too) lack the vigour to surpass the levels they achieved during the last bull market which peaked in 2007-08. However, they are far above from the lowest levels recorded during the last bear market phase. Furthermore, markets have been moving in a range of 10%-15% almost for past 3 years now. Such market phase is known as flat or non-trending market phase. In past 10 -12 years; we have witnessed only trending markets i.e. moving either up or down. But markets are directionless today. They rise on expectations and fall on fear but do not break the range. In other words, markets are indecisive about the future course of economic development and therefore refuse to go up or down. Such lull may continue till markets get fully convinced about the direction of the economy. Being a mutual fund investor you may be interested in knowing how mutual funds have been tackling the prevailing market conditions.
Performance of Mutual Funds
Stock selection and investment style are the two factors that have maximum bearing on the returns generated by various funds. All major equity indices have been flat and risk adjusted returns (as revealed by negative Sharpe Ratio) are poor. In comparison various mutual fund categories as a whole have recorded better performance. Among all categories, midcap funds and value funds have been the outperforming categories over 3 and 5 years respectively. Midcaps had relatively cheap valuation in August 2009 which has helped funds register better performance over last 3 years. On the other hand, value funds benefited from their style of management. The value stocks were left out in the multi-year bull market of 2002-08. Markets favoured the growth and value stocks had no performance pressure. In the market mayhem of 2008-09 sentiment shifted in favour of value. This highlights the fact that investing in mispriced stocks has rewarded both categories.
NAV Data: August 27, 2012
|Category Average ||3 Years (%) ||5 Years (%) ||Std. Dev ||Sharpe |
|Midcap Funds ||10.1 ||4.9 ||5.65 ||0.07 |
|Value Funds ||8.3 ||7.5 ||5.15 ||0.06 |
|Multi-Flexi-Opportunities Funds ||6.5 ||4.7 ||5.09 ||0.03 |
|Large Cap Funds ||5.7 ||5.0 ||4.85 ||0.03 |
|BSE SENSEX ||3.9 ||3.6 ||5.39 ||-0.01 |
|BSE-200 ||3.7 ||3.7 ||5.47 ||-0.01 |
|BSE-500 ||3.6 ||3.2 ||5.49 ||-0.01 |
(Source: ACE MF, PersonalFN Research)
(Returns are compounded annualised)
*Scheme only with 5 year track record are considered
|Mutual Fund Category ||Total No of Schemes* ||Schemes with double digit returns** |
|Multi-Flexi Opportunities ||49 ||5 |
|Midcap ||27 ||2 |
|Large Cap ||35 ||1 |
|Value Funds ||20 ||6 |
**Schemes those have generated double digit returns over 3 as well as 5 years are considered
NAV Data: August 27, 2012
(Source: ACE MF, PersonalFN Research)
(Returns compounded annualised)
Within each category, difference in the returns generated by the top and the bottom performer varied considerably. The deviation in the returns generated by the top and the bottom performer in mid cap category has been about 22.1% CAGR over last 3 years while that in multi-flexi opportunities funds category is the highest (23.0% CAGR) over the similar time period. This again highlights how mutual funds within a category differ in their return potential. Further analysis shows that very few funds have managed to maintain consistency in returns. Table above reveals that value funds have been the most consistent ones. As many as 30% of them have managed to generate double digit returns over both 3 and 5 year time period. This percentage is surprisingly low for large cap funds. The primary reason is large caps are often matured companies with no frequent surprises in earnings and they are tracked in and out. This leaves very little margin to get a mispriced bargain. (Source: ACE MF, PersonalFN Research)
Thus, picking mispriced stocks has been a difficult exercise even for professional fund managers and how long the same fund would keep digging deeper and deeper for mispriced stocks, it has its own limitations. This makes one thing clear, unless the broader market rises; chances of mutual funds (of course with some exceptions) generating outstanding returns are farfetched.
What should you do now?
It would be imprudent to abandon equity investments at this juncture. The possibility is high that all the good work done by you (by being patient and disciplined) over last 5 years may go in vain if you rush to exit or stop investing. By opting for SIPs, investors have invested across economic and equity market cycles. Most investors are frustrated by the fact that fixed deposits have fetched higher returns in last 5 years. This would be another topic of debate whether they have generated any real post tax returns (over and above the rate of inflation) but even most of the equity funds have failed to do so. This is probably the time to get some basics right.
True that equity may generate about 15% CAGR returns (as many of you expect) for years but it is not wise to expect markets to go up 15% every year. Gains in equity markets have always been sudden but high enough to compensate for all those years when they generated poor returns as can be seen in the chart given below.
We considered CAGR returns generated by BSE Sensex at every 5 year interval calculated for each day starting from August 27, 1992. For example, CAGR returns as on August 27, 1997 are with reference to investment done on August 27, 1992 and so on. If you consider a period of 10 years between August 1994-August 2004 markets were range bound and generated no meaningful returns. Thereafter there was huge rally in equities which took markets to unprecedented levels. Now imagine how nasty the decision could have been to exit equity assets in August 2004 thinking that they were no more attractive (and some other asset class has been attractive for past 5 years).
If you believe that you would exit now and re-entre when markets break the range; chances are that you may miss again. Market movements are so quick that they have a potential to knock your socks off. Year 2009 saw a turnaround in equity markets but most of the gains were made over just 2 months. BSE Sensex rose massive 75% to rise from 8160 on March 9, 2009 to 14,284 on May 18, 2009. It was a recovery in true sense as markets kept going up even after such a sharp move. But it’s difficult to believe that someone who missed this rally would have re-entered the market getting convinced with the market direction. Most of us would have waited for a big correction. You would be surprised to know that there have been only 66 trading sessions (in last 20 years) in which the BSE Sensex has risen more than 4% in a single trading day. You must stay invested for such extraordinary days.
Exiting from equity mutual funds for the reason of low returns may be a bad idea at this juncture. The markets in India are down for variety of reasons. Today, Indian economy is grappled with the problem slower growth and higher inflation. Global markets are not supportive either. Sovereign debt crisis in Europe and unconvincing recovery in United States has shaken the investors’ confidence in risk assets such as equities. However markets are range-bound despite all the bad news coming from the troubled developed market economies. This indicates that markets have factored in all these negatives. We reiterate markets are forward looking.
At present the global economy has been propped up with massive government interventions. The world is suffering from inaction syndrome. Status quo has now become a commonplace. Excess debt which created the consumption boom in west is pilling-up by every passing day. Instead of paring that debt; developed world economies are creating even more of debt. For example, Germany is getting itself poorer to keep some of its spoilt allies afloat so that they don’t become a cause of disintegration of Eurozone. Germans have a self interest in keeping the euro alive. Markets are awaiting some firm and decisive steps on such issues. A break up of Euro may be a trigger which may see the markets bottoming out. If at all this happens, it may badly impact the investor’s sentiment initially. It may ruin some “too big to fail" organisations. But when the storm settles global economy will have clarity. Markets need clarity. In other words, if the debt was the root cause of the prevailing economic downturn; then reduction in debt could be a solution, a firm and the decisive one.
Therefore you would be better off focusing on your asset allocation instead of worrying about returns earned on equity investments. Asset allocation crafted to suit to your personal needs and observed in the strictest sense would help you avoid noise.