Quarterly MF review – trends and changes

In the first of our quarterly MF review updates in this review cycle, we explained the changes we have made to Prime Funds, our recommended fund list. In this second update, we thought to cover two different aspects: one, changes we made to our MF Review Tool, in the way we call out our recommendations. Two, trends we have observed unfolding over the past couple of quarters that we’re keeping a watch on.

Let’s take the changes to our MF Review Tool first.

Quarterly MF review: Changes

Change #1: High-risk buys – a new ‘callout’

Our MF Review Tool, broadly, gives Buy/ Sell/ Hold calls on funds. But given that the nature of funds and their performance can’t always be neatly boxed into one of these three calls, we have a few more nuanced calls when the fund calls for it. For example, in floater funds that have longer maturity periods, we’ve mentioned the minimum timeframe you need to hold them for, so that you don’t use them for very short-term goals for which floater funds are normally good fits. Then there’s the ‘Buy through direct’ calls that we give for those funds where the expense ratio of the regular plan is far higher than that of the direct plan.

From this review cycle onwards, we are introducing the following call – ‘High-risk Buy’. You will primarily find these calls in debt and debt-oriented funds. The reason is this. 

Debt funds, even outside the credit risk category, take calls on low-rated debt. You would have become familiar with this post the Franklin episode when even their shorter tenure funds held significant credit risks. And we’ve often talked about credit risks being masked in other categories. Many funds that take such risks also falter on other performance metrics we see. But there are a handful of funds that deliver across parameters and where the credit risk is within reason for that category. We cannot ignore these funds because of their marginal credit risk nor can we simply tell you it’s a ‘Buy’ because their performance is top notch.  We’ve therefore marked these funds as a ‘High-risk Buy’. 

If you’re investing in these funds, make sure that they do not form the entirety of your debt allocation and that you blend them with low-risk funds. Also note that we have marked only credit risk in these calls and not duration risk.

Change #2 Calls on credit risk funds

Since the launch of PrimeInvestor in mid-January 2020, we have avoided taking any calls on credit risk funds. While the large hits to mutual funds came from the risk in IL&FS and DHFL papers in 2018-19, we knew it was not the end and stayed away. There were many more. But regulatory needs as well as AMCs’ own learnings have driven some change. 

We now see that many credit risk funds have rejigged their portfolios. While there is risk, it is evident that they are striving to provide some liquidity and take more calculated risks. This comes also at a time when the yield scenario has been unfavourable for investors. 

The pandemic has prevented the Central Bank thus far from lifting rates at a time when inflation is steep. Even as the market took note of inflation, the RBI’s operations of pumping more money has kept rates from climbing at a pace at which it should have. As a result, most fund categories have struggled to deliver 4-5% returns over the past year. 

Hence, given the improvement in credit scenario together with the low returns prevailing in other categories, we took a call of selectively providing ‘buys’ in credit risk funds as well. Up until this time, we’ve refrained from giving Buy calls in credit risk funds. Funds with lower instrument-level concentration, lower group concentration, high AUM, low volatility, yields that are rewarding for the risk taken and their worst return periods are better than most (and not negative) have made it to our buys. 
You can check our MF ratings or our MF review tool for those. As mentioned in our earlier review, this class of funds is not for low risk takers, those looking for regular income  and those with less than 5-year time frame.

Quarterly MF review: Trends observed

The changes above are the ones we’d like to highlight in this review cycle. Individual funds, of course, have seen changes in their buy/sell/hold calls, so do use the Review Tool if you wish to know if our view on the funds have changed.

Now, let’s move on to some key trends we have observed. Some trends are worth watching to know if they develop further into investment opportunities.

Trend #1 Top ratings in floater funds

When fund returns come up, so do your questions! As many of you noticed, returns of floater funds were stepping up over other funds. In our ratings, floater funds are combined along with ultra-short, low duration and money market funds. This is because these categories serve similar timeframes and, by and large, invest in similar instruments. 

Given their very short maturities, changes in interest rates reflect fairly quickly in their ratings and returns. But the small differences in where they invest, sometimes, elevate certain funds. Floater funds, as we said, have seen their performance hold up even as other very short-term funds slipped. The top 4 funds by score, in our rating set, are all floater funds. Nippon India Floating Rate, for example, moved up from 4 to 5 stars over the past two quarters. Money market funds and low duration funds, on the other hand, dropped a notch or two in ratings. Because they use interest rate swaps and derivatives, they have been better able to keep their returns up as yields dropped in CDs and CPs, pulling down other fund categories.

This is very different from the scenario a few quarters ago. In the December 2020 quarter, for instance, low duration funds such as Axis Treasury Advantage and ABSL Low Duration scored at the top. Go a little further back to the March or June 2020 quarters and the top-rated funds were dominated by money market funds such as ABSL Money Manager, UTI Money Market and Nippon Money Market. 

What’s the takeaway here? 

• One, don’t go by ratings alone to decide which fund to buy. An ultra-short duration fund or a money market fund can still be good portfolio fits even if their rating has dropped. Always use our MF Review Tool to know whether a fund is a buy, sell, or hold. 
• Two, don’t try to aim for specific categories to invest in – for example, don’t look specifically for low duration funds, or ultra-short duration funds for your portfolio. Know that there are multiple categories that will work for your short-term goal. 
• Three, don’t ask us why ratings for specific fund categories are low or why there are no 4-star or 5-star funds in the category. The short-term nature of these categories mean that trends show up more quickly and the fact that we combine a few categories means some have an upper hand than others in some scenarios (like we explained for floater funds). In our Prime Funds, we look for trends like these to decide what funds to add to pick up those opportunities. For example, we added more floater funds two quarters ago.

Trend #2 Hybrid aggressive funds picking up

We have been fairly vocal about hybrid funds and their performance. As we observed, hybrid aggressive funds were faltering in returns and getting less consistent. This was limiting their usefulness for portfolios where pure equity and debt funds could be blended. While the latter point still holds, the performance of these funds has improved as the market rally has lifted stocks across the board. This apart, some of these funds have taken aggressive bets in the mid-cap or small-cap space. 

ICICI Pru Equity & Debt, for example, which was earlier part of Prime Funds, has made a tremendous recovery in line with other funds from the AMC. The same trend plays out in HDFC Hybrid Equity. 

As with pure equity funds that we noted in the Prime Funds review, several bottom-rung funds have rallied. ABSL Equity Hybrid, which dropped sharply as high-risk bets in the mid-cap space hit returns from 2018, is now among the top returning funds in the 1-year period. Mid-cap allocation in this fund is still among the highest in the category. Returns hold above top-rated funds such as Canara Robeco Hybrid Equity. 
However, we’re still wary of changing calls on these funds or reviewing our stance. Aggressive calls by funds can come back to hurt returns should markets turn volatile. Many funds still lack consistency against the Nifty 50 Hybrid index, as well as the category average. The caution we adopted in equity funds given the nature of the market rally holds in these funds as well. The funds currently in the Prime Funds list, while not the best in recent returns, are the ones that have held up relatively better across market cycles.

Trend #3 Divergence in equity holding by balanced advantage funds

We have discussed divergence in equity holdings of funds in the balanced advantage category before. But the divergence cannot be starker than it is now. While some funds are sticking to what their ‘quant model’ tells them about asset allocation to equity and debt, others seem keen to simply ride the equity wave, irrespective of what their valuation meter may be showing. The data below will show you the divergence in net equity holding (post derivative hedging) of some of the popular funds.

You will see that funds that have a clear model driven largely by fundamentals, like those from the DSP and ICICI fund houses have a much lower net equity position compared with say a more momentum-driven model (they call it pro-cyclical) like that of Edelweiss. Then there are others like HDFC Balanced Advantage that do not hedge at all! 

Needless to say, funds that had higher net equity managed far superior returns in the past year. Such returns may mislead you, especially when you pick this category for 1-2 year time frames. Hence, without knowing the ability of this category of funds to contain downsides, going merely by their returns could be risky at this juncture.

Trend #4 – The equal weight success story

There is a sudden interest in quant funds, especially in one category – the equal weight Nifty 50 index. What does equal weight do? It kind of rebalances – since it has to hold equal weight across – by reducing holding in stocks that run up. By keeping weights at bay, theoretically, it also curtails falls, if any, in stocks that have a high weight in the parent index. In the past 1 year, the DSP Equal Nifty 50 fund delivered 66% as opposed to the Nifty 50 TRI’s 50%. This has led to significant interest in the equal weight space. 

But before you jump at equal-weight funds, do note that the equal weight Nifty 50,  as an index, has underperformed the Nifty 50 over 3 and 5 year periods. The reason why this worked now is that some of the Nifty index’s heavyweights (like HDFC Bank, Reliance Industries or TCS) have not performed too well. 

The equal weight index, by design, keeps the weight low to these heavyweight stocks and instead has higher weights to the tailenders – Adani Ports & SEZ or Hindalco Industries or Grasim Industries. These stocks in the long tail buttressed returns of the equal weight index; their insignificant allocation in the market-cap based Nifty 50 did not allow for superior performance in that index. This fortune could well change with market cycles and history suggests that market-cap based investing has scored.

Trend #5 – More indices, higher tracking error and expenses

Apart from equal weight indices, there are more index funds to choose from today (we aren’t yet rating the newer ones for want of track record of tracking error). However, an interesting trend that is emerging is that, barring the traditional Nifty 50 and the Sensex indices, most other indices have a higher expense ratio and a higher tracking error. 

Take the example of the Next 50 index from UTI. It has an expense ratio of 0.32% on an average in the last six months as opposed to just 0.12% for the UTI Nifty 50 fund. Similarly, the UTI Nifty Next 50’s tracking error (1 year) at 0.46% is higher than 0.32% for the Nifty 50. Such a trend is noticeable with broader market index funds, as well as midcap & small cap index funds.  The DSP Equal Nifty 50, for instance, has a 0.39% expense ratio and 0.94% tracking error for the above-mentioned period.

Hence, it is important for you not to compare across indices and instead see, which one scores better within funds that have a common benchmark. Yes, it is a different matter that these newer indices can do better at containing cost and reducing deviation from benchmark.

Trend #6 – Quant AMC’s performance

We’re talking of a different Quant. This is Quant AMC, earlier Escorts AMC. These funds had very small AUMs and insipid performance and therefore never made it to our filters. Post the transformation into Quant Money Managers from Escorts in early 2018, though, things have begun to pick up. We’re now rating 3 of the Quant AMC funds. 

These ratings are also on the higher side. Quant Active, a multicap fund, scores a 4 star rating for instance. The reason for entering at a high rating is that returns on Quant’s funds are phenomenal, especially over the past two years. Quant Small Cap’s 1-year return of 182% leaves both the Nifty Small Cap and other small-cap funds in the dust. The same trend holds for Quant Active. The change in fund management, therefore, has helped these funds rise from the bottom quartile.

Soaring returns notwithstanding, our calls on the funds remain a hold. For one, the strategy the AMC follows appears to be a momentum-driven one, with high portfolio churn. The fund latches on to quick opportunities to drive returns. While such a strategy will work in markets such as the one we’re seeing, the going can get tough if markets start to correct. We do not know how Quant’s funds will adapt to the different market scenarios and for long-term portfolios, we’d prefer to recommend funds that can hold across market cycles.

For another, AUMs have swelled in a very short time. Part of the performance, therefore, can be attributable to the rapid pace of inflows. Quant Small Cap, for example, went from an AUM of Rs 8 crore in July last year to Rs 736 crore now. Quant funds’ strategies of spotting and snapping up short-term opportunities can get harder if AUMs get larger. Deftly deploying larger sums in stocks without affecting impact cost can be tricky to manage. This may, therefore, result in returns moderating. 

Therefore, until we have a better grip on how Quant AMC’s funds can hold up over longer periods, we’d prefer to avoid clear Buy calls and retain them at Holds. If you wish to invest in these funds, be prepared to watch performance closely.