We are about to see off calendar year 2012 in next few weeks. It’s been quite an eventful year as far as equity markets are concerned. So far in this year, investors have made decent gains in equity markets. At the beginning of 2012, not many were confident that markets may yield close to 20% returns in a year. Of course, with any bad news coming in, there is always a possibility that gains may get erased within few weeks, but looking at the current market sentiment; it looks unlikely.

During the year, we have seen many mood swings of the market. We started the year on a sombre note. However, like in a limited over cricket match; slog overs have been helpful in accelerating the scoring rate. Since September, the market has been humming a sweet melody for domestic as well as global investors. India has been one of the best performing markets over last 3 months. In this article we will discuss the cause of the recent surge in equity markets and also expound on how equity mutual funds have fared against this backdrop.

Defying all negatives on the domestic front such as weaker rupee, persistently high inflation, anemic growth and deteriorating state of fiscal management; markets seem to be buoyant these days. Nothing much has changed on the global front either. Eurozone still faces all those problems it has been going through for last 2 years; as European leaders dillydally to come out with formidable resolution. On the contrary, certain things are now threatening to go beyond control. Anti-austerity campaign is ragging through the southern Europe. There have been instances of demonstrations against austerity turning violent in Spain and Portugal. GDP growth in the Eurozone continues to contract. Chinese growth too cooled off as its third quarter GDP growth numbers have been below 8% which is considered a worry for the dragon economy. Given the higher consumer spending and revival in the housing market, US economy has been doing comparatively better but at the beginning of September it was warming up for presidential elections. Having said this; the rally that happened in Indian equities looks exceptional and startling too.

What has triggered the Rally?

There have been two main factors that have funneled the rally. The first factor is global, while the other factor is domestic.

In United States, Federal Reserves (Fed) gave in to strident demands for another round of Quantitative Easing (QE). The Fed committee of 12 members almost unanimously (11 Vs 1) voted in favour of QE3 whereby the policy has been made more accommodative. The committee agreed to buying mortgage backed securities worth $40 billion every month for unspecified duration. This money, although with a delayed effect, is inducing rallies in risky assets including emerging market equities and India has been no exception to it.

On the domestic front, the central government had been sharply criticised by a slew of industry experts, economist and corporate for most part of the year. It sagged under the pressure of challenging economic environment and overall lull in the economy. While expectations were that the government will take giant steps to turbocharge the economy by reviving the process of reforms; it struggled, and struggled badly. Congress, the single largest party of UPA-2 looked spineless even before some of its own allies. But in an attempt to save its face, it started sending chills down the spine of those allies. Swallowing a bitter pill, the government took some tough decisions which threated to damage its political image. In September, it took steps like hiking diesel prices by Rs 5 and restricting the usages of subsidised LPG cylinders to 6 per family a year. The diesel price hike is expected to slash subsidy bill of the government by about Rs 20,000 crore. The much awaited decision on Foreign Direct Investment (FDI) in multi-brand retail and aviation was finally taken by the government. The limit of FDI in multi-brand retail has been raised to 51% while that in aviation to 49%. The reforms have further been extended to Insurance and the pension sector. The Cabinet gave nod to increase FDI limit in Insurance from current 26% to 49%. The government has also agreed on amending the Pension Fund Regulatory and Development Authority Bill, 2011. Even the Competition Act, 2002, and the Foreign Contracts (Regulation) Amendment Bill, 2010, which awaited the overhaul, got the cabinet approval. These were enough of developments to send positive signals to global investors.

Importantly, the timing of these initiatives couldn’t have been better than this; for more than a reason. For most part of the year rupee remained under pressure due to risk of higher fiscal deficit along with increasing current account deficit and partially due to strengthening dollar. While diesel price hike would help in achieving fiscal prudence; new initiatives were expected to bring in more money to Indian shores. Fed-released money would find its way into emerging markets. There needed some “good news flow" in the domestic market to act as a catalyst. Indian government acted just in the nick of time. The foreign money has flown into India on these announcements. The conditions were conducive for foreign investors to pour in money. Furthermore, the expert panel working on General Anti-Avoidance Rules (GAAR) also recommended GAAR be deferred by another 3 years. The message was clear; the government needed flow of foreign capital into India, and that precisely has happened. In September alone, Foreign Institutional Investors (FIIs) pumped in close to Rs 20,000 crore (net) in Indian equities. The monthly returns in broader markets for September have been about 9%.
 

Index Returns

(Source: ACE MF; PersonalFN Research)  

Who benefited from the rally?

The graph above demonstrates the sectoral indices that have arrived as the top 5 performers over last 1 year. Among broader market indices, S&P CNX Nifty and BSE 200 have generated 21.7% and 22.3% returns respectively in last 1 year. However, the performance of sectorial indices is not consistent with that of the broader indices. This shows that although there has been a broad-base rally in the market some sectors have benefited disproportionately. The table given below sheds light on returns generated by various indices over the period of last 3 months as well as last 1 year.
 

		Returns (Absolute)
Indices	Number of scrips in the index	3 Months	1 Year
BSE Realty	12	33.4%	27.2%
BSE Consumer Durables	10	27.9%	42.3%
BSE BANKEX	14	21.9%	41.6%
BSE AUTO	10	16.6%	28.2%
BSE MIDCAP	246	14.8%	22.6%
BSE FMCG	10	12.8%	49.4%
BSE-200	200	12.8%	22.3%
S&P CNX Nifty	50	11.9%	21.7%
BSE METAL	11	7.5%	1.3%
BSE Health Care	17	6.4%	31.2%
BSE Power	17	5.7%	2.3%
BSE OIL & GAS	10	1.3%	1.2%
BSE IT	10	2.7%	7.1%

(NAV Data as on: November 30, 2012)
(Source: BSE India, ACE MF; PersonalFN Research)  

And to your surprise there come some interesting facts. Real Estate sector which was beaten down brutally for last 2 years has been one of the best performing sectors over last 3 months. The 1 year return of BSE Reality index has been lower than the return it generated over last 3 months. This, in other words, suggests that the current rally has helped the index recover and record positive returns for the time period of 1 year. The same goes true for BSE Power and BSE METAL index as well. On the other hand, some sectors such as FMCG and Information Technology (I.T.) have been left out of the current rally. The returns generated by BSE FMCG over last 3 months and 1 year differ sharply suggesting that the sector has been performing across 1 year period. The same goes true for Pharmaceuticals and healthcare sector as BSE Health Care depicts the similar trend. However some sectors,like Power, I.T., and Oil and Gas have generated lacklustre returns over last 3 months as well as 1 year time period.

Given the above highlight on performance, let’s see how equity oriented mutual funds have performed.
 

How Mutual Funds Have Fared??

	Returns (Absolute)
	3 Months	1 Year
Average Returns of Equity oriented Funds (Including Sector funds)	11.9%	22.3%
Average Returns of Equity oriented Funds (Excluding Sector funds)	12.0%	23.1%
Percentage of Funds outperforming BSE 200 (When Sector funds included)	44.5%	49.5%
Percentage of Funds outperforming BSE 200 (When Sector funds excluded)	45.3%	52.9%
BSE-200	11.9%	22.3%
S&P CNX Nifty	10.6%	21.7%

(NAV Data as on: November 30, 2012)
(Average returns is the simple average of returns generated by actively managed equity oriented schemes.
Out of 292 schemes considered for analysis, 47 have been the sector funds)
(Source: ACE MF; PersonalFN Research)  

As given in the above table, the average returns generated by all actively managed funds have been nearly in line with those generated by BSE 200 but have been slightly better than returns earned on S&P CNX Nifty. The picture doesn’t change much when sector funds are excluded. Although sector funds focused on Banking and FMCG rose sharply; those focused on I.T. and phama and healthcare have dragged down the returns. This may give you an impression that, on the whole the performance of mutual funds has been satisfactory. However only around 45% schemes have managed to outperform BSE 200 index in the last 3 months and around 50% over the period of 1 year; thus indicating that more than half of the total schemes have been lagging BSE 200.

Reasons for Ordinary Performance

Before you recall any average performing or underperforming scheme in your portfolio and blame your fund manager for posting returns which are more or less similar to those generated by broader market indices; it is important to check out why mutual funds have failed to deliver higher returns. Many investors understand that mutual funds reduce the risk by way of diversification, thanks to growing awareness but it is equally important to understand its implications. Let’s now see which sectors have mutual funds preferred for investing.
 

Sectorial Exposure of Equity Oriented Mutual Funds

Sector	% Exposure
Banking & Finance	25.7%
Information Technology	9.3%
Engineering	9.2%
Consumer Non-Durables /FMCG	8.5%
Healthcare & pharmaceutical	8.3%
Auto	5.9%
Construction /Real Estate	1.6%
Consumer Durables	0.5%

(Sectorial Exposure is as per the last disclosed portfolios of equity oriented mutual funds put together)
(Note: Weightage of only select sectors has been displayed)
(Source: ACE MF; PersonalFN Research)  

Table above gives us an idea about sectorial preferences of mutual funds as per the last disclosed portfolios. Banking and Finance has been the single largest sector which forms about 1/4th of the assets equity mutual funds hold collectively. The sectorial exposure pattern of mutual funds resembles remarkably with that of S&P CNX Nifty in case of more than one sector. Many schemes, especially the diversified equity oriented ones have largely followed the sectorial pattern of S&P CNX Nifty with overweight or underweight on certain sectors. With a few variations, in most cases, the top 5 sectors of the portfolio of mutual funds are from within Banking and Finance, Information Technology, Consumer Non-Durables, Healthcare and Pharmaceuticals, Auto and Engineering. Diversified equity funds with overweight on interest rate sensitive sectors like Banking and Finance and Auto have benefited from the rally. But they have paid price for being exposed to Information Technology, Consumer Non-Durable and Healthcare and Pharmaceuticals.

Are Mutual Funds lazy?

Portfolios held by most of diversified mutual funds are identical as far as sector allocation is concerned. What’s more, as said earlier many of the sectors from within the top 5 sectors of mutual funds have not participated in the broader market rallies. This leaves a lot of room for speculation about the benefits of active fund management. Well, this needs to be analysed at two stages. First, we should consider what made mutual funds hold more or less similar sector exposure and why those sectors might have missed the current rally.

Here’s why?

A fund manager of an actively managed equity diversified fund can follow top down approach, bottom up approach or a combination of both. One who follows the top down approach considers attractiveness of asset classes from the macroeconomic perspective and then drills down to industries and sectors that look attractive. While in bottom up approach, the utmost importance is given to company specific factors such as competitive strengths of company, its management, sound financials and so on. This approach allows fund managers to buy stocks even from those sectors which don’t look attractive, provided a company has a muscle to weather all negativity and emerge stronger. On the other hand, a combination of these two approaches requires fund managers to first identify attractive sectors and then invest in strong companies within those sectors. Many fund houses today, follow a combination of top down and bottom up approach in their diversified equity fund segment. When market conditions are bullish, a number of mutual funds look to participate in momentum and at times when markets are weaker; they try to re-align portfolios to make them more defensive.

Till September, markets were moving sideways and were expected to consolidate at lower levels due to lack of positive triggers. However, as government spearheaded the effort to get reforms on fast track; markets suddenly turned blissful. Moreover, cheap foreign money started flowing in Indian markets. The sectors which rallied sharply from September are the ones which were expected to be the beneficiaries of re calibrated process of reforms. These reforms are eventually expected to bolster the sagging economic growth. Therefore, sectors which benefit when economy recovers or grows rapidly have rallied.

Prior to rally, mutual funds, except those following pure bottom up approach, had constructed their portfolios to suit to weaker markets; by taking high exposure to defensive sectors such as I.T., Consumer Non-Durable etc. One more point of consideration is, staying with broader markets in terms of sector allocation may reduce the risk involved with a contra call going wrong. This answers two questions mutual fund investors may have at this point in time. Those following bottom up approach concentrate long term prospects of stocks ignoring short term momentum. They wait for re-rating of the stock which may happen even when there is no strong momentum in the market. While those following a combination of top down and bottom up approach; look at attractiveness of the sector from medium to long term perspective.

True that, those sectors which have rallied so far have been shunned by mutual funds but calling it laziness in fund management or shortcomings of fund management would be an overstatement. A rally in some airline, retail and consumer durable stocks is mainly on account of announcement of allowing FDI in retail and aviation. However, this doesn’t bring any benefits directly. After all, a foreign player may also think a number of times before buying a debt laden loss making company. Even if we consider it as a possibility; a buyout is a long process. How many foreign retailers have announced to open shops in India following the announcement? Rally in rate sensitive sectors such as real estate may not last long if RBI doesn’t cut rates. Furthermore, the sector specific factors may add to worries. Balance sheets of many realtors look stretched and it is appropriate to remain less exposed to this sector (1.6%) looking at vulnerable fundamentals, which many mutual funds did and missed the rally.

In a Nutshell

Markets have so far rallied on news, announcements and hopes. If things do not turn out as expected; the markets may retreat and sectors which have had a dream run so far may witness sharp selling pressure. Mutual funds which play momentum have to time all their entries and exits. On the contrary, those who stick to their strategies even when it is tempting to play momentum; may benefit in the long run. It is necessary to distinguish between good returns and bad returns. That’s the difference between speculation and a good investment. It is one of the primary reasons why select mutual funds always manage to outperform their benchmark in the long run. Having said that, it is equally important to avoid funds which fail consistently, across the timeframes and market phases. A good mutual fund may not win at every stage but it can still be a winning candidate in the long run. What matters is the right selection.

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