Quarterly review: changes to Prime Funds, our fund recommendations

When a small-cap fund served up 1-year returns in excess of 100% while another stayed far below at 77%, when a multi-asset allocation fund had less than 40% allocated to equity while another had nearly double that – you know fund managers differ a lot in their opinion about the market and the opportunities in it. 

To some extent, markets took a breather after hitting a peak in October 2021, making the quarter just gone by quite sedate. But while short-lived, this dip served to show us that our fund choices and our reasoning for these continue to hold up. We sat tight on our equity fund recommendations and continued so in the December quarter, given the market scenario.

On the debt side, though, we have been far more active – both over the past few review cycles and in this one too. The prolonged low interest rates have not helped returns. But we have been adding different opportunities to set you up for a rising rate scenario, and we have added more such funds this time around, too.

Here are the changes we have made to Prime Funds in this December 2021 review cycle.

Equity funds

We have, in our previous reviews, highlighted the wide difference in equity fund returns and especially in the riskier market-cap segments. While this gap continues to hold, the brief corrective period that we saw in the past quarter served to show us that our fund-recommending philosophy will hold up. As we explained in our 2021 performance review, prizing downside containment helped performance in the December 2021 quarter.

With equity markets recovering quickly and sharply from that dip, the trend of abnormally high returns in some funds is unlikely to fade away anytime soon. But we’re still staying cautious on making quick changes to our recommended fund list. For one, funds we have picked are those that stick to stock and market fundamentals to build their portfolios, and these have been the ones to do well over time in earlier cycles. Two, funds that have swung with this rallying market can quickly lose steam should the tide turn – and the current pricey valuations are a key risk factor.

Therefore, apart from the Strategy/thematic Prime Funds category – a space where we have been quite active – we have made no additions or deletions to Prime Equity Funds. However, we are highlighting the performance of a few funds.

Equity – moderate: Performance update only

In this Prime Funds set, Kotak Flexicap continues to be an underperformer. However, we’re taking comfort in the fact that its performance has begun to improve against the Nifty 500 TRI. Against the Nifty 200 TRI – since it’s more large-cap than anything else – it has bridged the gap quite significantly to about 2 percentage points. As we have explained in earlier reviews, a few stock calls that are sedate performers, such as HDFC Bank or TCS, weigh on this fund. The fund is also not a quick portfolio churner, allowing its picks time to play out. We’ll continue to watch the fund for an improvement in performance.

Equity – aggressive: Performance update only

In this Prime Funds set, SBI Focused Equity, which we had highlighted earlier as an underperformer has turned right around and is now a strong outperformer against the Nifty 500 TRI as well as other focused funds. The fund’s local-global mix has helped performance, and its bottom-up, off-beat portfolio also paid off. The fund has returned to being among the top performers in the focused category.

DSP Midcap, which is lagging the Nifty Midcap 100 TRI and other midcap funds, continues to be a laggard. But the slow performance improvement we noted last quarter is continuing on, going by short-term 1 and 3-month performance. This fund’s key characteristic is to stay steady and contain downsides very well which pays off over a long period of holding. This trait, given the current heated-up mid-cap space, and the recent performance improvement – all continue to hold the fund in good light.

Our more conservative approach in the high-risk space has also seen our small-cap picks lose out against their bolder peers. Axis Smallcap, was behind the Nifty Smallcap 100 TRI earlier in the year, and by a large margin. However, performance has improved recently and the fund is holding above the index now. It has also reduced the lag with the category. The fund’s ability to take cash calls and contain downsides keep its long-term returns up; despite underperformance on a 1-year basis, the fund continues to beat category and peers on longer 3-year returns.

SBI Smallcap, too, has been underwhelming when compared to peers. The small-cap space, in general, over the past year has seen some very big, very quick moves in stocks that don’t always make the cut on fundamentals. The fund’s picks in the more unfavoured themes in consumer durables, other consumer plays, hotels and so on haven’t helped; it is also less concentrated in its top holdings than other chart-topping peers. This fund, too, is reducing the performance gap against index and peers. Given its tendency to hold an off-beat, stock-specific portfolio, its intact long-term record and recent improvement, we continue to keep the fund on our list.

Sector/thematic: Fund addition

In our strategy/thematic calls in Prime funds, apart from commodity, our IT call did well in 2021. With markets remaining in the overheated zone, we do think a defensive bet like IT would continue to find favour in the market. Towards this, we have added one more fund from the IT space – ICICI Pru Technology Fund.

This IT sector fund invests in IT companies in India and also takes exposure to global IT stocks. Some of these stocks include product companies such as Salesforce and Freshworks – the likes of which are unlikely to be found in the Indian listed space. Currently, the fund holds about 10% in global stocks. The risk-return profile of ICICI Pru Technology is more aggressive than Tata Digital and the former can fall more in a down-market. This fund is suitable for those looking for IT exposure in both local and global stocks. If you already hold the Nasdaq 100, you may not need this.

Hybrid funds

We have made only one change this quarter. In our view, the hybrid funds already on our list - which spans arbitrage, equity savings, balanced advantage, and aggressive hybrid – are among the best in the category at doing what they are meant to. Therefore, we have expanded the list to add only one more option in the arbitrage space in this review.

Hybrid Equity – low risk

While the return profile of arbitrage funds have remained lackluster, their post-tax return still attracts attention in this low interest rate scenario (given the higher tax in debt for less than 3-year holding). We therefore decided to add one more arbitrage fund for those specifically seeking such options to park short term money with tax efficiency.

Nippon India Arbitrage scores as much as its peers in terms of beating the category average over periods of rolling 1-year returns. It also has fewer instances of falls over 1-week return periods thus making it ideal for any addition to a short-term portfolio. Please note that this fund, like other arbitrage funds, may underperform short-term debt funds once rates move up.

Debt funds

As many of you know, we do not go by SEBI-defined categories when we rate funds or review/recommend them for a particular purpose. We club similar categories for more accurate assessment of choices and performance.

We had, until now, been clubbing the floating rate funds together with ultra-short, low duration, and money market funds as they all had similar maturities. However, floating rate funds are gradually seeing longer or varying maturities, reducing their comparability with ultra short and similar funds. Therefore, we have moved floating rate funds to rate them along with short duration and banking & PSU funds from this cycle onwards. So, if you notice a rating change in your funds, do not be alarmed.

Moving to the changes this quarter, we have been more active in adding to our debt fund recommendations as has been the case in the past few reviews. While current yields are still far from attractive, the interest rate cycle is on the cusp of an upward move. To this extent, returns and yields may improve. We have introduced a few funds in the debt section to add to the ones already set to capture yield improvements.

Debt - very short term 3 months to 1.5 years: Fund addition

At present this category does not provide yields that can compensate you for inflation. We have, in our report of November 2021 on where to invest in debt given you alternatives to invest in. However, those options require a lock in. Hence, this category remains the only option for liquidity if you need to invest short-term money and redeem at any time, or need to wait for yields to harden in longer duration funds.

So, we decided to add one more fund here – Nippon India Low Duration - with marginally higher yield than some of the peers. This fund has managed to secure a yield-to-maturity that is about 70 basis points higher than the Money Market fund from the same fund house. This yield comes from high coupon papers with 1-3 year maturity across AAA bonds and around 5% each in SDLS and AA-rated papers. We think this marginal risk is helping the yields without upping the overall risk profile.

A quick note on Axis Treasury Advantage – the fund has seen an AUM decline in the past 3 months. While this can be concerning, the fund’s AUM is still sizeable and comfortable at around Rs 9,000 crore. Given that these categories do see institutional money, a big outflow is not surprising. We are keeping a watch on AUM levels. At this time, there’s no cause for worry or alarm.

Debt - Short term - 1.5 to 3 years: Fund addition & fund exit

In this category, Axis Banking & PSU Debt has been among the most consistent on a risk-adjusted basis, even if its returns have not been top-notch. However, due to its roll-down strategy – where it gradually reduces its portfolio maturity - the fund’s average maturity is now less than 1 year. For this reason, we do not think it will fit investors entering this fund afresh for 2 year and longer goals. We will also need to wait and watch the tenure to which the fund rolls back (increases maturity) once it completes its current rolldown strategy. Therefore, we removed Axis Banking & PSU Debt for fresh investments in this time frame.

If you invested in the fund, continue to hold it for the time frame for which you started out. The fund remains a quality fund. To reiterate, we are removing the fund because it no longer suits the purpose for investors entering now. For those who entered earlier, the fund remains a suitable one.

We added Axis Short Term, a fund with similar long-term average rolling returns but where the average maturity profile is more certain (currently at 2.38 years). Hence, when yields move up, you will be better able to capture the full impact of the rate rise for the 2 year-tenure with Axis Short Term.

Debt – Long term – above 5 years: Fund addition

As stated in our Debt outlook for 2022, we do think that some amount of credit risk would be needed to get better yields and there are opportunities in the credit space. Towards this, we have added one more credit risk fund – HDFC Credit Risk – for portfolios of 5 years and above. This fund is very similar to ICICI Pru Credit Risk, the other credit fund in our list, in terms of various metrics. However, risk-return profile of ICICI Pru Credit Risk would be a notch higher than HDFC Credit Risk primarily because the former has higher exposure to papers with credit rating of below AA-.

In other words, HDFC has a marginally lower risk profile. However, its average 3-year return at 8.5% is head and shoulders above the category average of 5.3% as many funds were hit by defaults in earlier years even as the 2 funds mentioned above survived those phases well. The worst 3-year return (from 2018-21) for ICICI Pru Credit Risk was 7.9% while it was 6.8% for HDFC Credit Risk. Like any credit risk fund, this fund is suitable only if you have high risk appetite even in debt. Risk of downgrades and defaults cannot be ruled out. Else, skip this category.

Changes to Prime ETFs

Yes, we know that this is primarily about changes to Prime Funds. However, we’ve made a couple of additions to Prime ETFs, our ETF recommendations that we’d like you to note. These changes aren’t big enough to necessitate an entire article 😊

Prime ETFs – themes & strategies

In this Prime ETF category, for those looking to invest in gold, we had two gold ETF recommendations – Nippon India Gold BeES and HDFC Gold ETF. In this review, we’re removing HDFC Gold ETF and instead adding SBI Gold ETF. SBI Gold ETF improved on both traded volumes and tracking error, pulling it above HDFC Gold.

The second change in this Prime ETF set is the addition of Bharat Bond ETF – April 2031. This joins the other April 2030 Bharat Bond ETF in the list. In the passive debt space, the ETF offers a good option for long-term portfolios. Do note that short-term performance may be poor as the rate cycle ticks upward.

You can access the full Prime Funds list here.

You can access the full Prime ETF list here.