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Should I invest in mutual funds or stocks?


August 4, 2020

From questions on whether to invest in mutual funds or stocks to how to use hybrid funds, we had a wonderful time answering your thought-provoking queries in our first, premium webinar on portfolio design. But the 40-minute QA could still not do justice to the questions we received. We have therefore answered more here.

On fund categories and allocation

Why should we not have a simple portfolio with just balanced funds and with 10% in midcaps?

While it is true that hybrid aggressive funds are suitable for those who do not have enough sums to diversify, there are limitations to holding just these funds. One, you may not get any distinct style diversification – say between growth and value and focused as most funds in this category don’t follow any clear strategy.

Two, while some have a large-cap tilt or are diversified, others have a midcap tilt and are more aggressive. So, unless you can spot the market cap bias, you may be taking on more risk than you can. Hybrid aggressive funds fared worse than large-cap funds in periods such as 2018, many of which were laggards because of their aggressive equity portfolios.

Also be aware that in recent years, this category has been struggling to contain declines, falling more than large caps in short periods. This is a development we are watching with concern.

Three, the debt portfolio of many hybrid funds is not too well-managed nor does it stay steady. While earlier, the debt part had mostly long duration instruments, now there is some credit risk as well. Funds are also switching between accrual and duration strategies based on rate cycles. So, you need to carefully pick one that does not have excess volatility (due to long-only duration) or credit risk.

Additionally, there are very few consistent hybrid funds. This and the lack of distinctive strategies means that you will be hard-pressed to mix different styles to avoid them all failing together if they followed similar strategies. Also be aware that in recent years, this category has been struggling to contain declines, falling more than large caps in short periods. This is a development we are watching with concern.

Equity savings and dynamic allocation funds have seen poor quality debt papers even before this crisis. Hence how is that safe for short term goals?

We have been looking at the debt part of hybrid funds. Barring sporadic cases in the balanced advantage category we haven’t seen any cause for concern. In instances where holdings are below AAA, what is important is the exposure (proportion) of their holding and the time frame of such papers. We have seen some funds hold small exposure to quite a few high-risk papers. While this is not very desirable, it is important to assess the quantum of hit if those small exposures go wrong.  Also, remember, liquidity issues (which is the bigger threat to owning such papers) is unlikely given the equity exposure.

What’s the difference between dynamic asset allocation and balanced advantage funds? As per SEBI they are one category, but you have funds categorized separately in your presentation.

Yes, SEBI categorises funds that dynamically manage their exposure to equity and debt as Balance advantage/dynamic asset allocation. So, there is no distinction between the two. However, many funds within these categories behave differently. For example, we see several balanced advantage funds having higher open equity exposure and managed lot more aggressively.

Their downside containment is also not as effective as dynamic asset allocation. Dynamic asset allocation funds, on the other hand, have not delivered too well in rallies, as their exposure to equity is often lower than balanced advantage. However, there is no clear definition here and these fund categories seem to be arrowing their differences in approach. At PrimeInvestor we study the style of each fund in this category and decide whether it is useful for any given time frame and risk profile.

Webinar

Can a do-it-yourself 60:40 equity: debt portfolio do better than ICICI Pru Balanced Advantage?

Yes, you can. It will depend on the kind of equity funds you are exposed to. ICICI Pru Balanced Advantage can deliver marginally higher returns than pure debt and closer to hybrid conservative in its return profile. If your equity portfolio has smart exposure to different styles and has sufficient diversification it can beat the balanced advantage fund. However, it may be hard for you to contain the downsides since a balanced advantage fund can more deftly handle the asset allocation calls than you can. If your time frame is longer, then a separate equity and debt mixed portfolio works better.

Within an equity portfolio, what would be the percentage split between multicap and midcap funds. Assuming I don’t have any other category (large, small etc). What is the number of funds under each category?

In general, any exposure over 15% can meaningfully make an impact in your portfolio – positive or negative. If you have high risk appetite you may go up to even 30% in midcaps but remember that your multicaps too would have some exposure to midcap stocks. Keeping it to 20-25% would ensure you don’t go overboard. This is not a rule. It is simply based on the assumption that you are talking of a long-term portfolio and can take risks.

We have discussed in detail about number of funds in this article here. https://primeinvestor.in/how-many-funds-should-i-invest-in/

On sector funds and international funds

What is your view on international funds? What should be the allocation to these funds? What is the minimum holding period for these kinds of funds? How to select them?

International funds are best used as diversifiers; it is difficult to time them unless you’re tracking every global market development there is. Instead of trying to identify top international funds, we think it is better to go with ones that invest in indices of foreign markets. Right now, we have that for the US. Also, it makes sense to choose a market that has lower correlation with the Indian market. Anywhere between 10-20% allocation is fine but temper your return expectations as you may not have the kind of returns you are seeing now in US funds.

Can we choose sector funds with higher market capitalisation to avoid further risk?

Whether a sector fund will have high or low market cap will depend on the kind of sector rather than the fund’s ability to choose large or small stocks. For example, by its very nature, banking and IT funds may have higher market cap while infrastructure may have lower market cap. It does not mean banking is less volatile or risky.

On investing, investment styles and returns

Sometimes high YTM might simply mean higher risks or even suggest that the fund has seen downgrades in papers that pushed the yields up. Hence, getting enamoured by YTM is a risky affair.

For regular monthly income /SWP do you have any list of funds for senior citizens?

Yes, we do have them. Based on your tax bracket, you can pick from the ‘income generation portfolio’ The 20-30% tax bracket will have funds as well. https://primeinvestor.in/portfolio-life-situation-retiree/

Is YTM a good indicator of returns?

Yield to maturity is a better indicator of your returns (before expense) in shorter duration categories like liquid money market or low duration. However, with medium to higher duration categories, you have a capital gain/capital loss component arising from interest rate movements, besides the income from accrual (interest). This won’t be factored in when merely looking at YTM. Also, sometimes high YTM might simply mean higher risks or even suggest that the fund has seen downgrades in papers that pushed the yields up. Hence, getting enamoured by YTM is a risky affair.

What is the expectation on returns from debt funds? Is it like FD return before tax?

It would entirely depend on the category of funds and your time frame. We have covered this in detail here: https://primeinvestor.in/what-returns-should-you-expect-from-your-debt-funds/

From what you are saying, fund investing styles changes. if so, as a retail investor how do I keep track of it?

Not really. Funds don’t change styles frequently – what we mean is that you should invest in funds where the strategy is understandable and mix styles. Some funds have clearly stated styles, which can be found in the fund literature that AMCs publish. Others have distinct styles but are not stated so. And a few others are a mix and do not particularly follow a style consistently. Identifying funds with distinct styles is important as that will allow you to truly diversify your portfolio. We do that in our Prime Funds list. You should consider skipping funds if their style is not clear even if they perform well.

How much importance should be given to fund manager churn?

We have covered this in detail here: https://primeinvestor.in/prime-qa-what-to-do-when-your-fund-manager-changes-or-amc-merges/

If one can pick stocks based on fundamental and/or technical analysis, does it still make sense to still invest in MFs or invest directly in diversified basket of stocks?

It requires a fair amount of experience, time, and dedication to do what a fund manager does 😊 If you are confident you can, yes, you can embark on such a journey. Second, maintaining a basket of stocks is more expensive since it involves demat charges, brokerage and more importantly taxes every time you churn stocks.

Fund managers can effortlessly buy and sell stocks and not incur taxes because mutual funds are pass-through vehicles where you are taxed only when you sell a fund (not when the underlying stocks are sold). Hence, if you do decide to maintain your own portfolio, you need to keep it compact and ensure you do not sub-optimally churn and incur high costs.

Is it better to split the SIP each month fortnightly or do single SIPs?

If you have multiple funds you can have your SIPs at multiple dates if your cash flow planning (bank balance) is not an issue. You are basically widening the net to average. That is all. It may or may not work based on which years you are investing in.

Out of subject – when are you coming with stock recommendations?

Good things take time 😊 It is work in progress and we hope to come up with a product that is useful and not just another ‘stock alert’. 😊

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