Quarterly review – changes to Prime Funds, our fund recommendations

If there’s one trend that equity funds don’t seem to be shaking off soon, it is the performance divergence. Over the past few review cycles, we have been highlighting how up-and-coming funds have soared well past the earlier steady performers. Taking stock of the underperformers, the nature of market movements, and returns we have made some key changes to our equity funds in this review cycle. 

On the debt side, we have been very active with our changes over the past year to build recommendations that can cover any interest rate changes that unfold. Therefore, we have held back from changes in debt funds this review cycle.
Here are the changes we have made to Prime Funds in this March 2022 quarter review cycle.

Equity funds

The Nifty 50 and Sensex hit their peak in October 2021 while the mid-cap and small-cap indices hit a couple of months later. Questions over higher interest rates and the inflation trajectory had already begun to draw FPIs away from our markets. And from February, the war-driven chaos sent commodity prices spiralling and equity markets correcting. FPIs selling rapidly rose, though domestic institutional buying provided some support. 

Though markets appear to have calmed somewhat in the past week or so, the cloud of higher inflation across the board, supply chain snags, and the impact on consumption and industry still hang – both in our own markets and globally. The same holds with interest rates.

We have refrained so far from making very drastic changes in equity funds in Prime Funds. One, we had been sceptical about the outsized fund performers in a bull run because we were unsure about their ability to sustain returns if markets corrected. Two, funds we picked have sound strategies driven by fundamentals, which take time to play out. We did not want to penalise funds for placing stock quality above returns. 

And barring a few, our equity fund recommendations have panned out well; funds have beaten their benchmarks, or many that were underperformers have since rebounded. 

Still, a few factors are making us redraw our approach to fund recommendations:

•  We were hesitant to add funds that started performing post 2020. We were not sure whether these bull market funds would sustain performance. But the past 6 months have offered a window into understanding how these funds managed volatility and correction. Those that won our confidence on this front have been added to our list now.
• Similarly, this volatility together with the run-up over the past two years helped gauge whether earlier strong performers but current underperformers are holding up. Funds that were unable to pick up even over this period mean opportunity loss. We therefore decided to remove such funds from our list. 
• We also took a relook at our philosophy of being very long term with funds that have sound portfolio fundamentals. We realised that quicker churns in sector preferences and a rapid rise in stock prices make it harder to rely only on long-term, fundamentally-driven, buy-and-hold funds. Funds that are more tactical by nature, or which quickly churn portfolios, or are momentum-driven are better-placed to deliver when the market does.

Therefore, changes we have made this quarter in Prime Funds keeps the above points in mind.

Equity – Moderate

Kotak Flexicap is a fund we have been watching for a performance improvement – and discussing in our reviews! – for about three quarters now. As we noted in our review last quarter, the fund did seem to be recovering, especially with short-term returns improving against the Nifty 500 and the Nifty 200 (since it’s predominantly a large-cap fund). 

However, the fund has since lost that edge. Its lag compared to the Nifty 500 TRI remains wide at 5-7 percentage points, and this gap shows no signs of narrowing on a sustained basis. Therefore, we are removing Kotak Flexicap from this Prime Funds category. Given its long-term performance, strategy, and attempts to improve, you can hold all investments made in this fund.

If you have SIPs in the fund, stop them. Continue to hold all investments made so far in the fund. For those who hold the fund as part of your Prime Portfolio, please wait for our alert. We will give you the necessary changes to make.

We are adding PGIM Flexicap to this category. This fund is the most aggressive in this set, both in terms of market-cap allocation and strategy. The fund follows a quality, bottom-up approach. It can shift its portfolio rapidly and often sees high churn. This opportunity-driven strategy has helped the fund score exceptionally well on the upside. PGIM Flexicap beats the Nifty 500 TRI over 90% of the time on a rolling 1-year basis over the past 4 years; on a longer 3-year return too, its outperformance over the index is strong. However, its volatility is also on the higher side and it is not the best at downside containment.

PGIM Flexicap can be used by moderate to high-risk investors as part of long-term portfolios of at least 5-7 years. It is best paired along with lower-volatile funds from this Prime Funds bucket, given its higher risk. Do not let it be the only moderate-risk fund in your portfolio.

We are removing Motilal Oswal S&P 500 from our passive segment as the fund cannot take fresh investments due to the current RBI restrictions. We will likely reinstate this fund once the limits for investments are relaxed by RBI. Until such time, continue to hold your current investments in the fund, as it provides broad based exposure to US markets.

Equity – Aggressive

In this category, we have introduced a few changes keeping in mind the need for investors to earn superior returns when they decide to take risk. It is now increasingly clear that very few funds can deliver alpha over a sustained period of time in the mid and small cap space. Besides size becoming a deterrent, slips in performance (due to few calls going wrong) also makes it hard for funds to make a quick comeback as peers overtake. 

So, some amount of churn or tactical calls to buttress your portfolio returns may become inevitable. With this in mind, we have added a couple of aggressive funds that we think would fit those who are looking at high returns with high risk. These are funds that we may decide to take out at any time if we see any warning signs of performance slackening. Please read the ‘Why this fund’ details for every fund you choose from Prime Funds, for suitability.

Besides this, we have removed an international fund that is presently barred from taking fresh money due to RBI’s restrictions on international investing. We have given an alternative for it. Now for the changes and reviews.

We have added Mahindra Manulife Midcap Unnati Yojana to our aggressive category. This midcap fund has been quite nimble, managing to deliver index beating returns over rolling 1- and 3-year periods. On a rolling 3-year return basis it beat its benchmark 100% of the time. Only one other fund in the midcap space boasts of this record. It held ground both in the March 2020 correction as well as the recent one in March 2022. However, we do think it is still yet to be sufficiently tested on the downside. 

Laden with a portfolio of stocks that are linked to economic growth, its investment style does appear cyclical. Hence, volatility should be expected. This fund is only for those who can stomach risks. A new fund house with limited track record and the possibility of losing fund managers to large AMCs remain risks. Hence, temper your exposure. Use the SIP route if you decide to invest.

We have introduced a new ‘Equity Aggressive – Tactical’ category to allow you to ride market momentum where you prefer it as a strategy. We will place funds that we identify as being great performers but those that may or may not make the cut in terms of the fundamentals we look for in a portfolio. 

In this segment, we are adding one fund - Quant Active – a multi-cap fund that churns its portfolio constantly to ensure it rides stocks that gather momentum. It appears to follow a momentum-driven strategy based on economic, sector and market conditions. Its performance and risk profile are closer to midcap funds despite being a multi-cap fund. It has managed to contain declines well in the recent correction as well.

With only a little over half a dozen funds in the multi-cap space, this fund is head and shoulders above the peers in terms of consistency in outperformance in the last 1 and 3 years. It scores well even when compared with the midcap category average. However, this pick is a clear deviation from our philosophy of picking funds with a long-term potential. In fact, we think there are stocks in the portfolio that would not make the quality cut in our filters.

We may decide to take tactical calls on exiting the fund at a later date, if warranted. This fund is suitable only for high-risk investors who can review their portfolios regularly and act on calls when we suggest. Use SIP route. Being a small AMC, its continuity under similar management will be a big risk. Exposure is best kept to 5% of your portfolio.

In our equity passive space, the Motilal Oswal Nasdaq 100 FoF has not been able to take fresh investments owing to RBI’s restrictions. We are therefore introducing Kotak Nasdaq 100 FoF as an alternative. This fund invests in iShares Nasdaq 100 UCITS ETF. Since the cap on foreign investment is not hit in this category yet (FoFs investing in foreign ETFs), this fund is still available for investments. You need not exit the Motilal Oswal Nasdaq 100 FoF. In fact, you can choose to wait for the RBI to relax the restrictions and restart investing in the Motilal Nasdaq 100 fund. We are only providing an alternative for those who wish to invest afresh.

A fund in the equity aggressive category that we wish to draw your attention to is DSP Midcap. There is no change in our call, just an update. We have been noting the underperformance of this fund and expected its portfolio changes to help it recover gradually. From an underperformance of about 20 percentage points in the last quarter (rolling 1-year return), it has narrowed to about 8 percentage points now. This is suggestive of a climb back. We will continue to watch over this improvement and are encouraged by this development.

Strategy/thematic

Our additions in this Prime Funds have been timely to capture different opportunities – in commodities, infrastructure, IT, consumption, banking. Therefore, we are not adding any funds here. However, we are consolidating this list.

One, we are removing SBI Banking & Financial Services. The fund has seen marked underperformance compared to other banking sector funds. Its concentrated portfolio is heavily dependent only on banks  - HDFC Bank and ICICI Bank in particular - with smaller exposure to other segments in the financial space. In our view, ICICI Pru Banking & Financial Services, also part of Prime Funds, is a broader play on the theme. Hold investments made in the SBI fund and do not exit.

Two, we are removing Baroda BNP Paribas India Consumption. This consumption-themed fund was wide-ranging in terms of the sectors it chose to play the consumption opportunity. However, the fund’s performance compared to other consumption funds has paled, partly due to the more large-cap, banking and staples-focused portfolio. We are also cautious due to the mergers between the Baroda and BNP Paribas fund houses. Exit investments made in this fund. The other consumption fund in our list – Nippon India Consumption Fund – has held up in performance.

Hybrid funds

Our recommendations here cover the entire range of hybrid fund categories. We have made only one addition here and one classification change.

Hybrid – Low Risk

ICICI Prudential Balanced Advantage was originally in this bucket. We had moved it to the Hybrid – High Risk segment in the September 2020 review as it turned aggressive on the unhedged equity allocation it took during the volatile period in early 2020 which upped its volatility and hurt its short-term downside containment. Over the past several months, though, the fund has been far more conservative in its allocations and volatility. Therefore, we have moved it back into the Hybrid - Low Risk segment.

Hybrid – Moderate Risk

In this bucket, we have added Edelweiss Balanced Advantage. The fund is among the most aggressive in the balanced advantage category, with unhedged equity (i.e., equity that is not covered by derivative calls) going up to 75-78% against the 43% that is the average for the category. This aggression reflects in its returns with average 1-year returns beating the category by nearly 4 percentage points; the fund is also a consistent outperformer in the category. However, it also has high volatility and poorer downside containment.

The fund is better suited to deliver debt-plus returns in portfolios rather than as a downside containment move. Investors can use it as the hybrid exposure in long-term portfolios to reduce pure equity allocation. It is avoidable for near-term goals, given its aggressive nature.

Debt Funds

The yield up-move for the 10-year G-Sec from 6.4% at the beginning of January 2022 to 6.9% has caused quite a bit of turbulence yet again in debt funds as prices of debt instruments fell to readjust to higher yields. Yield to Maturity (YTM) of debt funds have slowly but steadily been on the rise. 

Until such time the higher coupon rates from newer instruments adequately compensate for the capital loss arising from rate up-move, you will continue to find debt funds volatile and low yielding. The only way is to wait it out. We have already positioned our Prime Funds to capture the returns post this transition by adding more shorter duration options as well as select credit risk options, over the last two quarters. We have no changes in this quarter.

However, for those with income needs, we have been urging you to look at our deposit options as well as use the FD tool to pick deposits from other banks. Besides, beginning 2022, we introduced select calls on G-Secs/SDLs and private bonds for our Growth subscribers looking for more nuanced income options. Do check them.

Prime ETFs

Prime ETFs is our list of ETF recommendations in equity, debt and gold. We’re sneaking in the update to our ETF recommendations in this review report – since we’ve made only one addition 😊

Debt & Gold

In this review, we have added a debt ETF – the Bharat Bond April 2023 ETF. This is a passive debt ETF that mimics an index built with only AAA PSU bonds with underlying instrument maturity in 2023. The top-quality portfolio makes it a low-risk option and yields can be higher than similar-term bank deposits. This apart, the very short-term horizon limits market price volatility. The ETF has reasonable trading volumes and tracking error. It is a useful option to meet very short-term goals or for liquidity in ETF portfolios. It can be used along with other deposits or very short-term debt funds as well for short-term requirements.

You can find the full Prime Funds list here.

You can find the full Prime ETFs list here.