5 ways to de-risk your equity funds, without cashing out

If you have a substantial portion of your net worth invested in equities, you are likely to be confused by conflicting advice right now. With the US Fed now announcing its dreaded taper, the bear camp will tell you that a crash is just around the corner, so it is best to stop your SIPs, sell your equity funds and sit on cash, until the liquidity-induced froth is blown off. But if you had followed such advice and exited equity funds any time in the last couple of years, you’d have lost out on wealth creation opportunities of a lifetime. 

The bull camp, consisting of hardened risk-takers, will tell you that with taper expected for so long, the bad news is already in the price. Therefore, it is best to ride the equity express while it’s racing along. But the problem with this strategy is that not all of us have the appetite or wherewithal to survive a crash that wipes out say 30% or 40% of our portfolio value.   

So, what should you do? Well, given that a correction is likely, but no one can predict the timing or quantum of it, it is best not to take drastic actions like stopping your equity SIPs, moving entirely to debt, selling your existing equity funds or deploying your incremental savings in cash or debt – as they can all backfire. 

However, if you have a portfolio that is mainly invested in equity funds and you’re worried about the risk you’re taking, here are five ways to lighten up the risk on your portfolio.

Cap your downside

When it comes to balancing risk and returns, all equity funds are not created equal. Some funds and fund managers are good at maxing out your returns in bull phases, while others are good at containing downside in bear phases. So, if you’d like to minimise damage to your portfolio from a correction and de-risk, consider a strategy of reducing exposure from aggressive fund houses and managers who excel at maxing out returns, and adding to those who are good at containing downside.

To assess whether the equity fund you are investing in fits better into the former or the latter description, our rolling returns tools can be quite helpful. This tool calculates the daily rolling return performance of funds segregated by category over the last six years, to identify the maximum and minimum returns over a defined holding period and also the instances of losses during this period.  

Using this tool as a guide (data as of November 8, 2021), you can look to switch from funds that offer high maximum returns to those that fare well on minimum returns and instances of losses. Using a 1 year rolling return analysis as a guide for instance, you find that the maximum one-year loss that Parag Parikh Flexicap Fund has subjected its investors to since May 2014, was about 21% while HDFC Flexicap lost as much as 37% in its worst year. Parag Parikh Flexicap also returned losses only about 7 % of the time while HDFC Flexicap reported 26% negative periods.  

In the midcap category, Axis Midcap Fund with a minimum 1-year return of a negative 17% and losses 14% of the times since 2013, has managed much better downside containment than say, ICICI Pru Midcap Fund which has seen minimum one year returns of a negative 35%, with losses about 23% of the time in the same period. Therefore, if downside containment is your main objective, you can apply the above filters to the funds mentioned in our Prime Funds Equity -moderate as well as aggressive category. Choose the ones that have the least downside risk. You can also read the ‘Why this fund’ where we specifically mention if a fund fares exceptionally well on downsides.

Add low-vol funds

If it is not just correction worries, but two-way moves in the market that make you queasy, look to reduce funds and equity categories with high return volatility and up exposure to those that offer a smoother journey. Conventional wisdom has it that if you’re worried about volatility, you should switch from mid-cap or small-cap funds to the safety of large-cap funds. 

But we don’t entirely advocate this strategy because mid and small-cap equity funds carry far greater wealth creation potential in the long run than large-cap funds. Your portfolio will lose this wealth effect if you exit mid and small-cap entirely; remember that timing when the tide will turn in favour of mid-caps and small-caps after a correction is tough. 

This apart, funds that follow a quality approach in the mid or small-cap spaces can sometimes combine higher returns with lower volatility than large-cap funds. To illustrate, between January 2014 and November 2021, DSP Small Cap Fund delivered an average one-year rolling return of 30% against 15% on the Nifty50. Its minimum one-year return however was the same as the Nifty50 (negative 32%). Therefore, it is best that you stick to your original allocation to this market-cap segment. What you can do to reduce the risk is to remove any excesses in allocation (compared to your original allocation) through rebalancing/profit booking and moving to more stable categories. 

Once you decide not to juggle between market caps, a good way to de-risk and reduce volatility in returns is to add funds that specifically showcase a low volatility portfolio. Passive funds mirroring the Nifty Low Vol 30 and Nifty Low Vol Alpha 30 are a good way to do this. You can check Prime Funds and Prime ETFs for options in this space. You can also read about the Low Vol strategy and Alpha Low Vol Strategy that we have discussed earlier. You can consider reducing your existing holdings from a plain vanilla large cap/large-midcap fund to this fund, or can swap your SIPs in large-cap/large-midcap funds to such low volatility strategic funds.

Shed momentum for equal-weight, value or contra

What rises the most must also fall the most. When a bull market has been in progress for considerable time (like this one has been), winning stocks and sectors gain immense popularity and begin to occupy sizeable weights in the bellwether indices and mutual fund portfolios. Given the pressure to outpace their benchmarks and peers on a quarterly basis, very few funds and managers usually dare to go against momentum in extended bull markets. That Indian MF benchmarks too are momentum-driven, with stock weights assigned based on market cap also adds to the popularity of momentum-based strategies. 

Should markets reverse sharply though, the same momentum sectors and stocks are likely to be the ones to correct the most. Faced with a correction, most investors would rather sell highly profit-making positions than loss-making ones. Momentum stocks and sectors also tend to become over-owned in bull markets, making them more vulnerable to a correction than out-of-favour stocks. 

Therefore, one good way to de-risk your equity fund portfolio from a market fall would be to switch from funds following a momentum style of investing to those following a value or contrarian style or funds with a value-oriented approach. Value funds typically buy fundamentally sound companies that trade at a discount to their intrinsic value in the markets. Contra funds buy stocks that the markets actively dislike at a given point in time, owing to the sector or company being in the dog-house. They may also back stocks that have been temporarily battered owing to company-specific events or external risks. 

While the recent returns of value funds are unlikely to be great, you can find value or contra style funds with good long term records. Apart from funds that specifically designate themselves as value or contra, look for fund managers running vanilla flexicap/multicap funds who lean towards these styles of investing.

To verify if a value/contra/flexicap fund is indeed managed in the value style, run a check on its Portfolio PE. A fund that is serious about the value style of investing is likely to feature a portfolio PE that is well below the Nifty50’s current PE of 26 times. You can check ‘why this fund’ in our Prime Funds equity moderate and aggressive categories to see which funds have a value/value-oriented approach. 

For those of you who want to de-risk the momentum impact on your portfolio, a good option is equal-weight index funds. Equal weight funds mirroring the Nifty 50 for instance, reduce the momentum component in your portfolio by periodically reducing weights in stocks with rising market cap and adding weights in those with falling market cap, within the index basket. You can consider swapping SIPs in your large-cap (or large-cap oriented) funds, for instance, to such equal-weight large-cap indices, or investing any fresh surplus you may have in such funds.

Reduce concentration

In a falling market, funds with higher sector or stock specific concentration are likely to take a bigger beating than their more diversified peers. One way to reduce the downside risk to your equity fund portfolio therefore, is to reduce funds with concentrated sector or stock weights with ones that set lower caps to their sector or stock weights. This argues for reducing from focused equity funds to vanilla flexicap/multicap funds with a good record.

Adding hybrids

Finally, you can also de-risk on your portfolio by switching one fund out of your existing portfolio or replacing one SIP with a hybrid equity fund in place of a pure equity fund. Hybrid equity, balanced advantage and dynamic allocation funds fit the bill here. Balanced advantage funds shield against downside by juggling between pure equity, derivative and debt assets, is a good way to lighten up on risks without completely losing out on equity participation. However, the category offers a wide variety of products which use very different combinations of equity, derivatives and debt. Do read this article on balanced advantage funds to know how they can fit you. You can pick hybrid fund options from Prime Funds.

What to keep in mind

The strategies above are intended only if you are bothered by the sharp equity up-move, and you hold an equity-heavy, high-risk portfolio and you wish to reduce the equity risk without moving to debt. Do also remember that this will mean forgoing some amount of return if the rally carries on. The strategies highlighted above will help de-risk your equity allocation – you can use any of them or a combination based on your portfolio and the extent you want to reduce risks. 

However, do keep the following tenets in mind while using these strategies: 

• We assume that you are working to a predetermined asset allocation between equities, debt, gold and other assets that suits your goals and risk profile. Stick to this plan and make the above changes within your pre-decided equity allocation. 
• First weed out poor/inconsistent performers that have gained in this bull market, and use this to shift to funds based on the strategies given here. You can use our MF Review tool to run this check. Ensure that your switches or replacements, even with your SIPs, do not result in wholesale portfolio shifts. 
• All switches and replacements carry tax implications. Do consider short term/long term capital gains tax implications before acting on the above calls.  

Otherwise, a regular portfolio rebalancing – bringing your asset allocation back to the levels you initially started out with will do the trick of removing the froth from your portfolio.