Tricky Times Ahead For Mutual Fund Investors

Tricky times lie ahead for Mutual Fund investors. The NIFTY closed past the 10K mark, the 10-year G-Sec yield has already dropped nearly 150 bps in the past year and a half (this is good for long term debt funds), and credit spreads have already compressed significantly in recent times.

With AMFI’s ubiquitous ‘Mutual Fund Sahi Hai’ campaign making waves, and the levels of retail awareness increasing, the industry has witnesses stellar inflows in debt and equity oriented funds alike, off late. It is estimated that the retail folio count now stands at 52.31 million, with new ones being added every day. Nearly half of all equity inflows in the last fiscal happened through the SIP route, further underscoring the burgeoning levels of retail interest in the product. Phrases like ‘inflection point’ and ‘quantum leap’ can be heard frequently.

Positive sentiment and impressive business numbers notwithstanding, a few points are worthy of consideration at this stage.

First – the equity markets. It’s a known fact that the broad rise in stock prices over the past couple of years have been accompanied by very poor earnings growth (the key driver of stock prices in the long run). This has led to an overall Price to Earnings Ratio that’s looking fairly high right now, at 25.5X current earnings. Some pundits believe that the P/E ratio isn’t giving us a completely accurate picture of the way things stand today (which is true), and that one now needs to turn their attention to other ratios such as P/BV or Market Cap to Book Value. However, markets can be fickle. There’s no saying when it’ll run out of patience in the absence of concrete earnings growth – the short term disruptive impact of GST may even exacerbate this. If that were to happen, we may see a correction as markets revert to a more rational earnings multiple (a phenomenon called ‘mean reversion’ which tends to play out uncannily).

If the famed mean reversion syndrome were to play out one more time, how would first time, unadvised investors who are taking the lump sum (instead of the SIP) route react? This is yet to be seen. Not to say for sure that the markets are due for a heavy correction immediately, but it’s a fact that the risk-reward scales have tilted somewhat, and an element of caution is warranted for investors deploying their moneys into equity mutual funds at 10K Nifty levels.

On the debt side, most new investors lack awareness on how they work, with many harbouring the misguided notion that they function ‘just like bank deposits’. While a further rate cut of 25-50 bps may be on the cards in the medium term, the party is unlikely to continue unabated beyond a 6% yield – 40 bps odd lower than the current rate. At that stage, accruals will drive returns, and portfolio credit risk will need to be carefully considered while making investments. We’ve already seen some high-profile downgrades taking their toll on returns from a few debt funds. If fund managers begin taking on undue credit risk in the pursuit of alpha, returns from debt funds may come down too.

The Bottom Line? Mutual Fund investors need to plan their next moves carefully. Within equities, stick to diversified funds with a large cap tilt. Take the SIP route for best results and hang on bravely even if and when markets correct. If investing lump sums, stagger them over the next 6-12 months using STP’s (Systematic Transfer Plans). If you’re holding a 100% equity portfolio at this time, begin de-risking and taking profits by switching to short term debt funds. Consider a Dynamic Asset Allocation Fund such as ICICI Prudential Balanced Advantage Fund, if you prefer being hands off and are happy taking on a moderate level of risk in exchange for balanced returns in the long run. If you’re a debt fund investor, reset your expectations. Double digit returns will be hard to come by, and high yields may be accompanied by inordinately high default risk. Aim for 8 % to 8.5% returns from debt funds that have good credit profiles and portfolio average maturities that are in the 3 year-ish range.