Quarterly review – changes in Prime Funds, our mutual fund recommendations

If you have noticed the portfolios of dynamic asset allocation funds with a fundamental-only driven model, you will see them sporting net equity holdings of under 40% now. In a market where over 40% of the stocks have a price earnings ratio of over 50 times or no PE at all (i.e., the company is loss-making), dynamic asset allocation funds can draw little comfort in holding higher allocation to equity. 

But what about equity funds that don’t have the luxury of moving away from equity even if valuations are discomforting? They either go with the market wave (read: momentum) or stick to what they know best – hold high quality stocks with sound metrics but less fancied in a bull market. The latter approach can result in paying a price – underperformance. 

Which one of these a fund opts for is based on the fund manager’s conviction (plus the kind of pressure he/she faces from the fund house to deliver!).

Bull market underperformance

When a bull market extends, defying fundamentals and driven largely by liquidity, portfolios that are designed strictly by fundamentals tend to underperform. If your otherwise sound mutual fund holdings have underperformed in recent quarters, this will likely be the primary reason. 

In this quarterly review, we could see both of the above play out. Funds that were severe underperformers turned the corner with jaw-dropping returns, either because their long-underperforming stocks suddenly started moving up or these funds joined the ‘momentum party’. A few others that were otherwise consistently in the top quartile, took sharp hits and trailed their index or peers by a significant margin in the past 1-2 quarters. 

These will be times for you to wait, not because it is a virtue but because it will likely keep you sane in this dizzying market. In line with the waiting game, we have little to no changes in our primary picks in Prime Funds. However, we have added some themes that might interest you. We have also called out funds where you would have seen pronounced underperformance, and let you know what to do.

We will now move to the changes we have done this quarter and what you should do about them.

Changes in equity funds

#1 Change in passive fund classification

Up until now, we listed passive funds under a distinct classification. This set of funds were a mix of large-cap, multi-cap and mid-cap indices, not to mention global indices or differentiated strategies. From now, we are removing this separate section and re-classifying these funds under the Equity – Moderate and Equity – Aggressive categories, based on the nature of the index. That is, the Equity – Moderate and Equity – Aggressive sections will each have two subsections – Active and Passive. 

The reason for this reclassification is that one, you know what risk to expect from each of the index funds. While this was already explained under the ‘Why this fund’ explanation we give, putting it under the relevant Moderate/ Aggressive buckets makes it much clearer for you. Two, it helps you compare and choose between an active fund and a passive fund in each of these risk buckets, and use the passive funds in the right way for your portfolio. Three, it helps clear up the confusion that many of you seem to have in treating index funds as a separate allocation in your portfolio instead of considering it as part of your moderate or high-risk allocations.

#2 Fund addition in Equity – moderate: Passive

The Nifty Low Volatility 30 is an index that is built by considering the stocks with the least volatility in the Nifty 100. We have had the ICICI Pru Nifty Low Vol 30 ETF for a long while now in our ETF recommendations. The AMC a few months ago introduced the fund option for this index, where it will invest in its ETF. 

This fund is the ICICI Pru Nifty Low Vol 30 ETF FoF. We have added this index fund to the Equity Moderate – Passive category. The index scores in keeping downsides contained, which helps in longer-term outperformance against the Nifty 100 index. We have covered the performance and suitability of the ICICI Pru Nifty Low Vol 30 in detail in earlier reports.

#3 Fund addition in Equity – Aggressive: Active

In this category, we added ICICI Pru India Opportunities fund, a thematic fund that seeks to generate returns by investing in opportunities that arise from special situations. By adding this fund, we strayed from our norm in two ways: one, we added a thematic fund in the Equity Aggressive category instead of the thematic bucket. Two, we added an active fund that did not cross our minimum track record cut-off. 

The reason for such a departure is as follows: First, despite being classified as thematic funds under SEBI’s rules, ICICI Pru India Opportunities fund’s portfolio is quite diversified, as the ‘special situations’ theme can be played across market cap segments and sectors. The definition of special situations is quite broad as well. Such situations could be in the form of regulatory or policy changes, corporate restructuring, company going through a rough patch due to challenges in the industry or internally and expected to come out of it. It can thus be a good multi-cap diversifier in a portfolio.

Second, at a time when the market is peppered with ‘special situations’ be it on the regulatory front, or individual companies facing challenges, we did not want to wait till the fund develops a ‘track record.’ Third, the fund has a value bias that comes from owning stocks that are facing challenges, which provides comfort on the valuation front. We also find this fund doing better than many other thematic funds with a similar strategy in its performance so far. 

The fund is a high-risk option, with the risks stemming from both its theme and the limited track record. The fund is suitable only for long-term portfolios of 7 years or above and should not form more than 5-10% of your portfolio. This cannot be a substitute for mid or small-cap funds in the Equity -aggressive category. We may also decide to take more active calls in the fund, when required. Investments can be in lumpsum or SIP with restricted exposure.

#4 Fund additions in Strategy/ thematic

We added two funds here. The first is DSP Healthcare. It is true that we missed the early rally in pharma when it began in end-2019 (we had not launched our research platform then). We never had the courage to pick the segment again given where valuations stood and the rally that took off. Now, with the sector cooling off a shade in the past 3-6 months, we see some opportunity to get in. 

DSP Healthcare is a sector fund that seeks to take exposure to both domestic and global healthcare (up to 25%) stocks. It is among the more diversified healthcare funds with an additional edge of exposure to US-based healthcare stocks. It focuses on medical device companies in the US as opportunities in this space are few in India. To give some background, the US Medical Equipment Index has a lower correlation to the Indian BSE Healthcare index. The fund itself is relatively new and does not have sufficient track record to assess performance, but currently competes well with similar top sector funds from Nippon India and Mirae Asset AMCs. The US diversification adds to the DSP fund’s uniqueness. 

As a sector fund, it needs a high risk appetite. Exposure should be curtailed to 5% of your portfolio. Consider averaging over a 6–12-month period at least as the relatively high valuations in this sector can cause a correction if liquidity dries up. Else, invest more on dips if you are an active observer of the markets. The fund needs a minimum time frame of 5-7 years. 

The second fund is Nippon India Consumption. The consumption theme is a relatively more secular one, and consumption appears to be reviving after the lockdown-hit slump. The relatively more ‘defensive’ nature of the core consumer stocks, such as FMCG, also lend some heft to the theme. 

Outside of FMCG, though, consumption extends to several sectors. Media, entertainment, financial services, recreation, home improvement, automobiles, retail, and much more all fall under the consumption theme.

Nippon India Consumption is among the older funds in the consumer theme. It compares well with other consumption funds across metrics. The fund’s portfolio is an eclectic mix of stocks across consumption pockets. While its top holdings are more concentrated, especially towards FMCG stocks, the fund is still well-diversified. 

Our other recommendation in this theme is BNP Paribas India Consumption. The Nippon fund is less reliant on financial exposure than the BNP fund and sports somewhat more direct consumer plays. You can invest in either of the funds, and the theme can be held for the longer term as well.

#5 Fund removal in Strategy/ thematic

We have removed UTI MNC from our theme bucket in this review. The MNC theme is among the poor performing themes in this bull rally and it didn’t help that some of the FMCG, IT MNCs in UTI MNC’s basket delivered tame returns. We had introduced this fund in this category anticipating a market correction as MNC funds hold up well in such market phases. However, this scenario did not play out. We think you will be better off taking fresh exposure to other diversified strategies than miss the rally, while it lasts. 

Stop SIPs, if any in the fund but continue to hold investments made so far as this can still help contain downsides in the event of a correction. Fresh lumpsum investments can be avoided as well.

#6 Taking note of underperformance

As we explained at the outset of this report, several funds that were otherwise consistently at the top have slid lower as previous underperformers served up stellar returns.

One of these is Kotak Flexicap which has lingered below the Nifty 500 TRI since about August last year. The reasons remain that top picks have not been the outperformers in this rally. These stocks are otherwise sound and do fit the fund’s ‘value’ bias, such as Larsen & Toubro or Bharat Electronics. Others, such as Hindustan Unilever are more defensive bets that can help should markets take a breather. The fund has got several calls right, such as picking up Infosys and ICICI Bank, or cement stocks or steel plays.

Given the nature of the market rally and the uncertain position it is in now, against the fund’s strategy and portfolio, we’re still inclined to wait it out with this fund. The underperformance has not worsened, suggesting that there is an attempt to turn performance around. Shorter-term returns over periods such as 1 month and 3 months show that the fund is trying to improve, with some periods of outperformance over the index; this is yet to firmly sustain. That said, performance may yet take time to fully move back above the index unless the market scenario changes very quickly. 

The other is DSP Midcap, which has an even starker 1-year underperformance over its benchmark and peers. What we said in the beginning of this report applies well to this fund. DSP Midcap missed the bull rally by staying away from stocks that shot up – and a good number with inferior financial metrics or business fundamentals. If you ran a screener on this fund’s portfolio, you would find that the fund has not compromised on quality or growth metrics.

The rally over the past year was driven by commodities, value stocks some power ad capital good stocks and select cyclical stocks. DSP Midcap did not own these meaningfully and had marginally underweight exposure to financials (which it has mostly bridged now). And those it owned, be it Federal Bank or City Union Bank did not perform. What seems right about its portfolio is that it holds stocks with sound balance sheet and a healthy earnings growth – although they simply refuse to gain from the current liquidity-driven bull rally. 

While the fund still manages to keep itself above its benchmark on a rolling-3-year return basis, its 1-year performance may leave you worried. We observe from rolling 1-month returns that the margin of underperformance over the index is reducing in recent times. While we are confident that a correcting market will quickly bring this fund back in form, we may otherwise have to watch for a few more quarters to see if the fund is able to course correct.  You can continue staying invested in the fund until we have any update.

The summary of the funds added and removed is below.

Changes in debt funds

We have made no changes in debt funds for the following reasons. 

First,  at this time, the direction the debt market will take is uncertain. The tug-of-war between inflation, interest rates markets expect, and the RBI’s efforts to prevent rates from rising too much and hurt growth persists. 

Second, the funds we recommend across time-frames are among the best in their categories. We find few options outside these that are consistent enough in terms of strategy or portfolio to merit an inclusion, especially given the uncertainty over where and how much rates can move. 

Third, the narrowing spreads between top-rated debt and government debt also don’t offer much in terms of new fund opportunities. To ensure you get decent returns in these uncertain times, we have cautiously added a credit risk fund as part of our debt longer-term recommendations. In shorter-term recommendations, we have included funds that take marginal, controlled risks to offer better returns.

Fourth, with the increase in the bank deposit insurance and the sweeping changes in the way the deposit insurance works, high-returning deposits of the smaller and/or riskier banks become attractive propositions. In the shorter-term timeframes, these deposits become especially competitive compared to debt funds.

In the debt space, therefore, note the following points:

• Where there are specific pockets of opportunities, we will issue calls on these. Our recent highlighting of the opportunity in SDLs and ways to play them are an example. We will continue to look for such higher yields that you can lock into, especially if rates turn lower making specific target-maturity funds/ETFs attractive.
• You can include short-maturity funds (3 months to 1.5 years and 1.5-3 years buckets in Prime Funds) in your portfolio, even if you have a long-term horizon. These funds are the best-suited at times when rates are uncertain as they will reflect any change quickly.
• Do not exit your longer-term debt funds. They are not wrong funds to hold, provided you have the right timeframe for it. These funds will simply take longer to reflect any rise in interest rates. They will be low-returning in the short term. You need to hold through this period. If you have additional surplus to invest, you can choose to add short-maturity funds if you’re concerned over the current low yields.
• In the above context, we’d like to make note of SBI Magnum Constant Maturity, part of our 5+ year Prime Funds bucket. This fund’s double-digit returns have dwindled down to less than 5% for the past year. This is not a worrying trend, and comes as the duration rally peters out. As the likelihood of further rate cuts fade – the 10-year Government bond yields have moved to 6.3%-levels this year from the sub-6% levels they were earlier. High returns from these funds is not the norm. Constant maturity funds will go through phases of underperformance as the rate cycle transitions out of a downward phase. The reason for including constant maturity funds in long-term portfolios is simply to cushion equity risks, avoid risks of a fund taking wrong duration or credit calls, and offer a fuss-free, semi-passive, long-term debt component.
• You can add on fixed deposits that offer higher rates to supplement your fixed income allocation. We have updated Prime Deposits to include such options, so do refer for recommendations. If you already are interested in any bank’s deposit programme, run a check on its financial health using our Bank FD tool before zeroing in.

Finally, a short note on our Prime ETFs, our ETF recommendations. We have made no significant changes in ETFs. We have removed one ETF only – ICICI Pru S&P BSE 500 ETF. The ETF had poor trading volumes, though it still kept tracking error controlled. Volumes were improving, until the trend took a turn over the past few months. The 3-month average traded value was just about Rs 13 lakh a day. This makes it hard to deploy investments, and therefore we have pulled it out of the recommended list until we see a steady improvement in volumes. If you already hold the ETF, continuing holding as tracking error is low. If you still wish to make additional investments in the ETF, spread it out over several days and invest small amounts only each time.

The Prime Funds list can be accessed here.

The Prime ETFs list can be accessed here.