Quarterly review – changes to Prime Funds and Prime ETFs

Prime Funds is our list of recommendations in equity, debt, and hybrid mutual funds that are worth investing in. Prime Funds narrows down your choices from the thousands of funds that there are into a concise list of funds that span different styles. Prime Funds are selected based on performance, portfolios, and investment strategies. 

In this review, we have made several additions and removals from our Prime list. We request you to carefully go through the report to stay updated.

Use the Table of Contents below to directly go to the section that interests you.

Equity Funds

Even as fears of a recession or a soft landing in the US remained high and crude threatened to push India’s deficit, the stock market closed the quarter ending September on a positive note. Though the Nifty 50 managed only sedate gains of under 3%, the Midcap 150 and Smallcap 250 indices showed no sign of relenting with returns of 13 and 17% respectively for the 3 months ending September 2023. 

The sharp rally in the mid and small-cap segment has no doubt caused concerns over the sustainability of the rally as many pockets in this market cap segment begin to look overvalued. In this context, we have made some changes to Prime Funds, to bring in more moderate risk funds that one can ride. Overall, we are approaching equity with some caution. Our fund changes are in line with this sentiment.

Equity – Moderate (Active)

We have brought in 2 funds in this segment considering that we prefer to add more large-cap oriented or diversified funds at this point than new additions in the mid and small-cap space.

You might be surprised that we have added HDFC Flexicap. After prolonged underperformance and years of receiving low ratings in our research, this fund has steadily climbed the ranks. A shuffle in management and also change in fund managers has forced us to take a closer look at the funds in this AMC.

With value strategies picking up, this value-biased fund began to outperform on a rolling 1-year return basis from early 2021 (a year after the March 2020 correction). However, given that this fund had a very volatile history, we did not pick it on initial signs of outperformance. It now appears that it has managed to sustain such performance. Also, with a higher-than-average holding in large cap stocks compared with peers, the fund is well-placed to contain downsides in a falling market. 

While long-term returns  still point to a history of underperformance, we believe the shuffle in the top management and change in fund manager since mid-2022 may have brought in some change in fund management style. To that extent, we will need to assess this fund based on its present performance rather than the past. The fund’s present overweight position in sectors with reasonable valuation such as IT, healthcare and energy also provide comfort in the present market. 

If you are adding this fund, do not let it form a large chunk of your portfolio. You can use it along with index funds that you may hold or with growth style funds. Investments are best done through SIPs.

We also added ICICI Prudential Focused Equity. This fund too has a large-cap orientation except that it has a more concentrated holding in stocks given its focused strategy. The fund has managed to pick high-growth sectors in a timely manner resulting in significant outperformance over both benchmark and peers in the focused category. The fund’s downside ratio suggests that it has also managed to fall less during declines. This feat is particularly difficult to achieve in a focused fund. The large-cap orientation may be helping such downside containment. 

As a focused fund, this fund should not account for a chunk of your portfolio. A focused approach may sometimes fail in some market conditions and will therefore need periodic review. This fund can complement any of the other value-oriented or contra funds in this category, given its growth tilt. Investments are best done through SIPs.

There are two other funds that we wish to take note of in this Prime Funds set – Mirae Asset Large Cap and Canara Robeco Flexicap. In our June quarter review,  we mentioned that Mirae Asset Large Cap was once again slipping after a recovery in the March quarter. But the fund now appears to have stabilised itself and steadily gained ground over benchmark since the end of July 23. While its high weight to HDFC Bank, due to the HDFC-HDFC Bank merger may continue to weigh a bit, the improvement in the IT sector, where it holds an overweight position, may be cementing its recovery.

Canara Robeco Flexicap, on the other hand appeared to be recovering well up to June 2023 but has once again marginally slipped below benchmark returns (rolling 1-year basis). It is worth noting that our comparison in this category is with the Nifty 500. With the fund holding higher large-cap stocks than most peers. When compared with the Nifty 100 index, it is just about keeping pace. We will keep watch over this growth-biased fund.

Equity – Aggressive (Active)

We started rating Franklin funds (after we stopped coverage for over 2 years) from July 2022. When we stopped coverage of Franklin funds, we took a call on their equity funds primarily based on performance. However, we have still kept an eye on the schemes’ performances. 

There has been a marked improvement in some of the equity schemes from the AMC since we started rating them again. While we stand by our stance on the extremely poor way in which the AMC dealt with its debt fund crisis, we have kept an open mind when it comes to performance of equity. Do note that issues of liquidity do not arise in most equity funds, and the AMC has also weathered the confidence crisis in its equity funds.

With this background (for those who know the history of the events in the AMC), we are adding Franklin India Opportunities fund to our Prime list. This go-anywhere fund (classified as thematic under SEBI category) started seeing underperformance since December 2021 and the same started widening as more value-oriented funds did a better job in the market. 

However, since April-May 2022, the fund has made several changes to its portfolio – be it going significantly overweight on capital goods and underweight on financials or reducing IT over 2022 and gradually increasing it now. These changes appear to have held the fund in good stead and aided returns. Its rolling 1-year outperformance over the Nifty 500 TRI is now about 13 percentage points. While the fund’s market cap orientation is similar to a multicap fund, its significant outperformance places it closer to midcap funds in terms of return profile. The fund can therefore be a substitute for those not wanting to directly handle the volatility of midcaps.

Do note that this is still a thematic fund and any wrong sector calls can impact performance significantly. Ensure that this fund is not the core of your portfolio. In terms of market cap this fund is a lot more aggressive than other ‘opportunities fund’, in Prime Funds, from ICICI Pru. While there is very low overlap between the two, we do not recommend holding both given the high risk profile of both the funds. We may also decide to remove this fund from our recommendation if the market turns too volatile.

In this Prime Funds set, we are removing PGIM India Midcap Opportunities. The fund’s portfolio remains a high quality one but unfortunately it becomes necessary for mid and smallcap funds to capture a strong rally well. In this regard, the fund’s portfolio lagged peers significantly. Close to a third of the stocks in its portfolio have underperformed the Nifty Midcap 150 TRI. And where there was outperformance, it appears that the fund booked profits a bit prematurely, not capturing the rally well.

For example, in stocks such as Gokaldas Exports and Stove Kraft, it exited the stocks in early 2023 and missed out on the rally in the next 6 months. On the other hand, in stocks such as Schaeffler India and Clean Science and Technologies it has seen underperformance after it accumulated. It did get the right calls in stocks such as Dixon Technologies.

While this does not mean that the fund’s portfolio lacks quality, what is concerning is the high margin of underperformance. Such margin is typically never easy for funds to close in and outperform. Hence, we are concerned about the opportunity loss in such funds. We will watch performance and are moving the fund to a hold. You can continue to hold investments already made, but avoid fresh investments/SIPs and you can stop existing SIPs running as well.

Do note that the mid-cap category as a whole has been struggling to beat the Midcap 150 index. This could be because of the broad based rally in the segment, even as funds stick to select stocks.  So, at this juncture, we would prefer a midcap index fund for continuing any SIPs you earlier had in PGIM Midcap Opportunities. Lump sum investments are not recommended, even in the index fund, at this point.

As mentioned in our earlier quarterly review, we have been watching the performance of PGIM Flexicap. While underperformance is not stark, we are more keenly watching whether the new CIO Vinay Paharia is able to cement the fund’s performance. We will alert you if there is any deterioration. Investments can be continued for now.

Hybrid funds

These funds have come more into play following the change in taxation of debt funds in April this year. Multi-asset funds especially have markedly shifted into using derivatives to retain favourable taxation. Given this pervasive use of derivatives across the hybrid categories except aggressive and conservative hybrid, it is essential to look at relative equity risk among funds even within a category.

We have earlier added to the Hybrid - Low-Risk set for those looking to replace part of their debt portfolio with these funds. In this quarter, we are adding to the Hybrid - Moderate risk set.

Hybrid Equity – Moderate Risk

In this Prime Funds set, we are adding HDFC Balanced Advantage. This fund, though being in the balanced advantage category, does not use derivatives to hedge equity risk. This makes HDFC Balanced Advantage more like an aggressive hybrid fund, blending 65-70% equity with debt. This, along with the higher volatility and lesser ability to contain downsides than the balanced advantage category, is the reason the fund is classified under the Moderate Risk Prime Funds bucket.

HDFC Balanced Advantage has seen returns pick up strongly over the past several quarters; this improvement has pushed returns above the average for the aggressive hybrid category. Performance is also better than HDFC Hybrid Equity, the fund house’s actual aggressive hybrid fund. Its consistency in beating the Nifty 50 Hybrid Composite Debt 65-35 index in the longer-term 3 year periods has therefore steadily improved over the past year, and is now at levels similar to some of the top aggressive hybrid funds.

The fund can be used as a lower-risk way to invest in equity for timeframes of at least 3 years or more. It is not a substitute for debt funds, nor does it sport the same risk profile as balanced advantage peers (it has a higher risk profile).

Debt funds

Debt funds have emerged from the low-return phase they had been in with returns and yields climbing across the board. The Reserve Bank has held rates unchanged since February, after a series of rapid rate hikes and domestic inflation cooling off. However, the rate cut cycle has not kicked off yet, and the steady rate scenario may persist for a while, given the US Fed’s hawkish stance and spiking US bond yields.

There may be tactical opportunities to play in debt funds (which we have issued multiple times over the past year😊). But in your debt portfolio, it is still best to continue to remain invested in funds you hold, stick to your timeframe when adding funds for fresh investments, and if you have a long-term timeframe, hold funds across maturities (pick from Short Term, Medium Term, and Long Term Prime Funds buckets) to manage any rate cycle.

In this review, the changes we have made to Prime Funds are below.

Debt – Very short term: 3 months to 1.5 years

In this Prime Funds set, we are adding HDFC Low Duration. This fund takes some credit risk of about 7-8% of its portfolio to generate portfolio yields and returns that are higher than other very short-maturity funds. HDFC Low Duration has delivered above-average returns compared to very short-maturity funds, and is consistent in beating the category as well. It can, however, be slightly more volatile. The fund is suitable for timeframes of 3 months and longer and can be held alongside other very short maturity funds that take no credit risk.

We are removing Nippon India Money Market. The fund is a quality performer and has been consistent in delivering above-average returns. We are removing it in order to include funds with higher yields; the fund’s current YTM, compared to the other Prime Funds is on the lower side. These funds are meant for very short-term timeframes – and therefore, for fresh investments, if a better alternative presents itself, going for these would be a smarter move. Please note that we continue to have a Buy call on Nippon India Money Market in general – it is in Prime Funds that we want to specifically include higher-yielding opportunities. If you have invested in the Nippon fund, please continue to stay invested and do not redeem. The fund has had strong yields earlier, when you may have invested, and has still delivered above-average returns.

Debt – Short term: 1.5 years to 3 years

In this Prime Funds set, we are adding ICICI Banking & PSU Debt. We are adding this fund now to capitalise on the potential rally that a rate cut cycle later down the line can bring in, in addition to the existing healthy accrual yields. The fund has also deftly managed its portfolio to snap up different opportunities in floating rate bonds, different maturities, and instruments. The fund is suitable for a 2-3 year timeframe, and is best invested along with a pure short duration fund.

We are removing Axis Short Term from the list. The margin of outperformance in returns between this fund and the category average has been gradually shrinking over the past couple of quarters. While it is still outperforming and portfolio yields are above average, the other funds in the Prime Funds list have shown better performance and yield potential. Please note that we continue to have a Buy call on it; as explained above, we have removed it from Prime Funds in order to include better opportunities and keep the list concise. Continue to hold existing investments already made in Axis Short Term and do not redeem. You can also continue your SIPs in the fund.

Debt – Medium term: 3 to 5 years

In this Prime Funds set, we are removing Kotak Corporate Bond. The margin of outperformance of the fund with the corporate bond and medium duration categories has been shrinking over the past few months. The fund’s current YTM also holds just about the same level as the category average. The Prime Funds list already features the top few corporate bond funds and the Kotak fund’s recent performance does not match up to these. This apart, these other funds in this Prime Funds set all sport different portfolio maturities spanning both short and medium terms. This offers a good variety in choices even without the Kotak fund.

Hold all existing investments made in this fund, and do not redeem. Fresh investments can be made in other funds in this set and SIPs, if any, can also be diverted to fresh funds.

Debt – Long term: Above 5 years

In this Prime Funds set, we are removing Edelweiss Banking & PSU Debt. We had added this fund as a tactical play in the September 2022 quarter review, and to add diversity to funds in this set. The factors working in the fund’s favour were its long maturity and roll-down strategy that can offer both capital appreciation opportunities as the rate cycle turns and accrual through its other bond holdings. The fund’s performance, especially given the period earlier when yields briefly dropped, has not been quite up to the mark of other funds with a similar strategy and long maturity funds. While the fund does offer differentiation in long term portfolios, its current bout of underperformance gives us pause.

Continue to hold existing investments made in the fund and keep a watch on performance. Should interest rates eventually start to fall, the fund can see higher returns and you can use this opportunity to exit on good gains. Stop SIPs in the fund and divert it instead to the gilt/constant maturity funds in this set or from the Debt – Short Term set.

Prime ETFs

Prime ETFs is our list of recommended ETFs in equity, debt, and gold. We look at multiple factors to draw up this list, ranging from short-term and long-term tracking error, expense ratio, trading volumes and usefulness of the index in a portfolio. In this review, we have made only a few changes.

Strategy & Thematic

In this Prime ETFs set, we have made two additions and removed one ETF. The first addition is Nippon India ETF Nifty India Consumption. This ETF tracks the Nifty Consumption index, which comprises 30 stocks along the consumption theme. The weight of individual stocks is capped at 10%. The consumption theme is one that is taking off now with higher-end consumption seeing a firm pick-up and the subdued rural consumption starting to recover. Overall growth in the economy also feeds into the consumption theme. The theme also covers a vast variety of sectors, ranging from FMCG, entertainment, fashion to auto or financial services. As some of these sectors in the theme are  high-growth sectors while a few others are more defensive,  this theme can deliver upside besides containing falls in a down market.

The second addition is Nippon India ETF Nifty Auto. This ETF replaces ICICI Prudential Nifty Auto ETF in this Prime Funds set, which we have now removed. When we had added the ICICI Pru Auto ETF earlier in March, it was a relatively new ETF. Traded volumes were low, but still better than other ETFs tracking the Nifty Auto index and tracking error was well in check. However, volumes for the Nippon India ETF have since surged; the average daily traded value for this ETF for the past 3 months is Rs 1.16 crore compared to the ICICI ETF’s Rs 30 lakh average. While tracking errors for both ETFs are low, we prefer ETFs with higher trading volumes.

Continue to hold all investments made in the ICICI Pru Auto ETF. You can still make additional investments in this ETF if you wish to avoid increasing the number of ETFs you hold; tracking error is still low. Otherwise, use the Nippon India ETF.

As always, please note that thematic funds and ETFs are suitable only for very high-risk investors and cannot form part of your main portfolio. Keep exposure to themes limited to 10-15% of your portfolio.

Check our past quarterly reviews made in 2023 here:

Changes to Prime Funds and ETFs for the quarter ending June 2023

Changes to Prime Funds and ETFs for the quarter ending March 2023

Changes to Prime Funds and ETFs for the quarter ending December 2022

Disclosures & Disclaimers