Why A Falling Equity Market Is A Good Time To Build Your Mutual Fund Portfolio
Oct 19, 2018

Author: PersonalFN Content & Research Team

It is results season for India Inc. Public listed companies have started declaring their Q2 FY 2018-19 numbers.

As per Business Standard Result Tracker, 69 companies have already announced their Q2 results for this fiscal. They have collectively reported 28% revenue growth. However, net profit growth has been just about 2.3%—indicating that cost pressures are building up.

So, avoid getting swayed by the forward statements in the earnings. Sadly, the oldest trick in the book of ‘estimating earnings’ played out is that the near term estimates are being toned down while the future earnings estimates are increased

Participants in the Indian equity markets are rather cautious than optimistic about the performance of India Inc. Plus, there are concerns as regards India’s current macroeconomic scenario with a weak rupee and blazing international oil prices posing a risk to inflation, fiscal deficit, plus Current Account Deficit.

Moreover, the entire financial system in India is reeling under pressure, led by liquidity concerns and Asset-Liability mismatches.

Although there are upbeat estimations for India’s GDP growth it cannot be at the cost of stressed assets. The gross NPAs in the banking system as increased to around Rs 10.3 trillion (or 11.2% of advances) as on March 31, 2018, compared to Rs 8 trillion (9.5% of the total loan) as on March 31, 2017. And as per the annual inspection of RBI, many prominent banks in the private sector were found under-reporting NPAs. Although on a quarter-on-quarter basis the NPAs have reduced for Public Sector Banks (PSBs) reduced a bit, for the private sectors ones it’s up. The RBI, in its Financial Stability Report, has estimated that gross NPAs of scheduled commercial banks could rise from 11.6% in March 2018 to 12.2% by March 2019. And in the worst case scenario, it could hit 13.3%, says the report.

We only hope that India does not get swayed by irrational exuberance while striving for double-digit credit growth, or we could be in for BIG trouble and pain. 

Financials and macroeconomic data have always paved the path of bulls and bears, and now it appears that the bears are tightening their grip because data does not seem favourable. Plus, we are heading for Lok Sabha elections next year, in 2019.

(Image source: pixabay.com)

In this scenario will Foreign Institutional Investors (FIIs) continue to remain net sellers in India? And if yes, for how long, that remains to be seen.

So, there are multiple reasons for investors to be worried and the Indian equity markets are on a roller-coaster now.

About a couple of days ago, we wrote about why you shouldn’t discontinue your Systematic Investment Plans (SIPs) under falling markets.

[Read: Here’s Why SIPs Are Worthy To Handle Current Market Volatility]

In this article, we would like to explain why you should look at the current market volatility as an opportunity to build a long-term mutual fund portfolio.

You see, there are a few silver linings around the dark clouds…

  1. Valuation-wise markets have scaled down a bit

    The trail P/E of the S&P BSE Sensex and the large-cap index has eased to around 22x from their earlier highs. Likewise, of the S&P BSE MidCap and S&P Smallcap has reduced to 30x and 64x. This provides some margin of safety although considering these levels to be cheap would be an imprudent judgement.

    It would prove wise to take note of the famous quote “Be fearful when others are greedy and greedy when others are fearful” by the legendary investor, Mr Warren Buffett.  

    Hence be cautious but continue to invest in equities via SIPs in best equity mutual funds. This will help you mitigate the risk involved in the journey of wealth creation and accomplishing your financial goals.

  2. Fund managers are better equipped to take advantage of current market volatility

    You may be witnessing tough market conditions probably for the first time. But don’t get discouraged because volatility, no matter the degree of it, is the very nature of the market.

    Volatile markets with a bearish tone might be a new phenomenon for you, but for an experienced mutual fund manager with decades of experience, this is a routine and he/she could perhaps help sail the tide.

    Since valuations were unreasonable in the absence of corporate earnings growth for quite some time, fund managers were cautious and many of them were maintaining reasonable cash levels in the portfolio. Depending on the opportunity, they might deploy the cash which could possibly accelerate schemes’ returns in the long run.

  3. SEBI’s mutual fund classification norms have made mutual funds clearly demarcate their offerings

    Unlike earlier, mutual funds have to adhere to strict market capitalisation norms which make it relatively easy for investors to pick a mutual fund category according to their risk appetite.

    When SEBI’s mutual fund classification norms weren’t in place, many multi-cap and mid and small cap funds increased their large-cap exposure under falling market conditions, which left many aggressive investors with no appropriate choices.  Now, this has been by far standardised by SEBI. Nevertheless, make it a point to invest in schemes from fund houses that follow strong investment processes and systems for you to hold only worthy mutual funds in your investment portfolio.

Before you build a mutual fund portfolio you must ensure that:

  • You have clearly identified your financial goals

  • And have determined the money you would require in future to satisfy them

  • You have decided how much to invest per month

  • You have in place a personalised asset allocation plan which is in line with your financial goals and the risk appetite

[Read: Why You Should Not Ignore Personalized Asset Allocation While Investing]  

Now let’s discuss the most important aspect…

Building a mutual fund portfolio

Selection of a right mutual fund scheme plays an equally important role in your success as an investor as the personalised asset allocation does.

You should use a combination of quantitative and qualitative parameters to shortlist worthy mutual fund schemes.

Quantitative Parameters

  1. Returns across time periods and risk analysis

    The mutual fund scheme needs to be ranked on quantitative parameters like rolling returns across short-term and long-term periods, such as 1-year, 3-years and 5-years, and on risk-reward ratios like Sharpe Ratio, Sortino Ratio, and Standard Deviation over a 3-year period.

    This is to analyse if the fund has shown consistent performance across various market periods with decent risk-adjusted returns. 

     [Read: Why Comparing Returns to Risk Is More Meaningful!]

  2. Performance across market cycles

    You need to ensure that the fund can perform consistently across market cycles: bull and bear. Therefore, compare the performance of the schemes vis-à-vis their benchmark index across bull phases and bear market phases and judge their consistency.

    A fund that performs well on both sides of the market should rank higher on the list.

Qualitative Parameters

  1. Portfolio Characteristics

    Adequate Diversification - The scheme should not hold a highly concentrated portfolio. The portfolio should be well-diversified and the exposure to the top-10 holdings should be ideally under 50%.

    Besides, expense ratio, portfolio P/E and dividend yield are some other factors to consider in the evaluation process.

    Credit Quality - For debt portfolios, you need to ensure that the fund does not hold a high proportion of low-rated (securities rated AA or below) or unrated debt instruments. A fund with a higher credit quality should be ranked higher.

    Low Churn - Engaging in frequent churning can result in trading and high turnover cost. Therefore, you also need to consider the portfolio turnover ratio and expenses, and penalty funds involved in high churning, i.e. those funds with a turnover ratio of more than 100%.

  2. Quality of Fund Management

    You also need to consider the fund manager’s experience, his workload and the consistency of the fund house. Therefore, assess the following:

    The fund manager’s work experience – He/she should have decent experience in investment research and fund management, ideally over a decade.

    The number of schemes managed – A fund manager usually manages multiple schemes. Thus, you need to check if the fund manager is not loaded with a large number of schemes. If he is managing more than five open-ended funds, it should raise a red flag.

    The efficiency of the fund house in managing your money – Assess how consistent the fund house has been in managing it schemes and the proportion of the total AUM actually performing. Find out if only a few selected schemes are doing well. A fund house that performs well across the board is an indication of sound investment processes and risk management systems in place.

Read about PersonalFN’s comprehensive mutual fund rating methodology here.

Watch this video:

Yes, we know that following an exhaustive process and is a lot for an average investor. It involves a lot of number crunching and much of the data is not easily available at one place. But, if you do need to narrow down on the winning mutual funds for your investment portfolio, these factors are imperative.

Editor’s note:

If you are looking for worthy mutual fund schemes to build a SOLID mutual fund portfolio, PersonalFN is offering you simplest and potentially the best way to identify the best schemes that can create significant wealth for you. Subscribe to PersonalFN's FundSelect mutual fund research service.

PersonalFN is currently celebrating 15 years of wealth creation for mutual fund investors. Unlock FundSelect anniversary offer here!

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Happy investing!

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Oct 21, 2018


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