WF: Market timing is seen as the biggest impediment in investors realising the full wealth creation potential of equity funds. In this context, are auto-timing solutions (P/E based, P/B based etc) a better option for retail investors? One of the simplest and most popular auto rebalancing products is the balanced fund. How do you evaluate the merits of balanced funds vs valuation model based auto-timing solutions?
Peshotan: You are right regarding investor psyche to time the market. Very few follow Warren Buffet's golden words of "Be Fearful When Others Are Greedy and Greedy When Others Are Fearful." This is because Indians have a lower risk tolerance as they are used to easy and assured returns from traditional investments. They shy away from equity investments mainly due to fear of the downside but are ready to stay invested during the upside. Historical trends clearly prove this point that positive net inflows in equity funds go hand in hand with positive returns while negative net inflows (redemptions) are generally seen when markets are in the red.
As a solution to the latter, mutual funds have launched asset allocation funds or auto-timing solution based funds which provide the upside in equities but also help to cushion the downside through a debt allocation. The fund's allocation between equity and debt (some even have gold) is dynamically changed based on quantitative attributes like say a PE ratio. Accordingly equity allocation is high when PE ratio (valuation) is low and vice versa when valuation is high. Many of these funds have wide allocation swings between 0-100% equity and 0-100% debt depending upon the PE ratio.
For those with a slightly higher risk appetite, balanced funds, with a higher equity allocation may work better. The primary advantage here is that the equity floor is higher at 65% which not only provides tax benefits associated with equity funds but also the potential for higher returns in the long run. I would say that asset allocation funds and balanced funds are 'simple to follow' multi-asset class funds which provide readymade diversification to reduce risk. However, as investors move up the learning curve, they may opt for the larger variety and flexibility offered by pure equity and debt funds by allocating them as per their risk appetite and investment horizon. Advisors may help to choose these funds besides periodically rebalancing them.
WF: Is business traction for the broader hybrids range satisfactory or is the industry continuing to witness significantly larger traction for pure equity funds? Is there a case for the industry to more vigourously promote its wide range of hybrids?
Peshotan: Pure equity funds will always rule though their inflows may swing as per market cycles. A clear advantage of pure asset class funds (equity or debt) is the sheer variety that they offer. For example, in equity funds, you have funds based on market cap (large, mid, small, multi-cap), funds based on style (value or growth), funds based on themes and sectors, diversified equity funds, besides special categories like ELSS and international funds. This variety is not possible to be provided in a hybrid fund which would mainly provide plain vanilla equity and debt combinations. Hybrid funds, which offer a readymade diversification, may be preferred by beginners with smaller fund sizes and a low to moderate risk appetite.
Here I would like to add that one also needs to look at factors like taxation and exit loads while rebalancing in pure equity and debt funds as taxation would be asset class specific while exit loads would be fund specific. This would not be the case with balanced funds as they would enjoy tax benefits of an equity fund (if equity component is more than 65%) and exit loads too would not apply for rebalancing between equity and debt.
WF: What are some of the other ideas that AMCs can consider in terms of product construct, to encourage investors to take a genuinely long term view with their investments?
Peshotan: Among other ideas that need to be encouraged, 'Home country bias' is something that immediately comes to mind. What this means is that investors typically prefer to invest in mutual funds that have a domestic portfolio. This could be because they understand the local market better and are psychologically more comfortable with the same. However, to maximise long term returns, it is essential that investors not only diversify across asset classes but also diversify geographically especially into developed markets like US and Europe. Such investments could be marginal but a beginning needs to be made.
Many investors are not aware that when the INR depreciates vis-à-vis the USD, such portfolios would stand to gain. International fund exposures also help investors meet goals like overseas education for their children which is often fraught with the risk of the INR depreciating in the long run and the cost of say US education rising faster in INR terms than in USD terms. Hence my message to investors would be to add international funds to their portfolio besides the existing asset classes - equity, debt and gold.
WF: How does one build an equity portfolio through mutual funds?
Peshotan: While we may have read and heard many stock stories about how some stocks have grown multi-fold over 10, 20, 30 and more years, let me admit that it is easier said than done. Firstly one needs the foresight to choose the right stocks and portfolio; secondly and more importantly, one needs the perseverance to stay invested for longer time frames. Mutual funds are hence a good bet not only to have a well-researched portfolio chosen by professionals, but also from the perspective of variety and convenience.
Mutual funds offer variety as they are available across asset / sub-asset classes, styles, risk appetite, investment horizon, etc. They offer convenience with a minimum investment of as low as Rs.500 per month in a systematic investment plan (SIP) with the latter offering the facility of regular and disciplined investing for longer time frames. Other 'systematic' facilities like Systematic Transfer Plans (STP) and Systematic Withdrawal Plans (SWP) add to the 'convenience' aspect. Tax efficiencies are another important advantage.
If one is a beginner, he can opt for a balanced / large cap or diversified equity fund and build size. With some scale and market experience, he could adopt a core and satellite approach where satellite funds are tactical (based on underlying market trends) while the core funds (large cap and / or diversified) are strategic and long term. For example, in the latest bull-run, small and midcap funds could have constituted as satellite funds while they could have been infrastructure funds in the 2007 bull-run, IT funds in the 2000 rally and defensive funds like Pharma and FMCG during bear phases. The satellite funds basically help to provide a 'kicker' to the returns provided by the core funds. One may use the services of advisors to choose the right funds.
WF: How does one build risk appetite in the equity market?
Peshotan: I believe many investors learn it the hard way. They start with direct equities (some even with derivatives) lured by the quick returns and then move to mutual funds after experiencing losses. As far as risk appetite is concerned, it is generally observed that investors have a higher appetite for equity (risk) in a bullish market and the same investor may shift his allocation to debt (lower risk) in a bearish market. This typically happens when one invests sans an advisor as the latter can guide investors to stay invested even in a bear phase to benefit from rupee cost averaging as well as the power of compounding. Investors without hand holding generally tend to mature only after learning from multiple market cycles before shifting to regularity and long term investment consistency through equity mutual funds. As I said earlier, this process could be faster for those who are advisor driven as they benefit from continuous communication as well as guided investor education campaigns.
While investor education plays an important role to build risk appetite, it would find scale only when investors themselves experience wealth maximisation which in turn would lead them to convince others to join. So it has more to do with 'investor returns' than only 'market returns'. Hence, there are no short cuts to building risk appetite in equities. It would be the same time-tested long term consistent investing route which will create wealth for investors and help to build their risk appetite.
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