It is not very often that we hear of extraordinary returns in mutual fund schemes; such returns are generally associated with investments in direct equities.

As you know 2020 was a highly volatile year for the equity market due to the impact of COVID-19 outbreak on the economy. Despite this, the market witnessed a broad-based rally; the Nifty 500 – TRI is up by around 75% on a 1-year return basis (as on March 26). The following factors led to the swift rally in the market:

Amid the sharp recovery in the equity market from the March 2020 market crash, many mutual fund schemes witnessed a massive improvement in performance in the last one year. Various equity mutual fund schemes across categories have generated returns in the range of 60-80% or more on the back of the bull run and rewarded those who had stayed invested with immense gains.

Graph: Indian equity market in a bull run

Data as on March 26, 2021
(Source: ACE MF)  

Some funds such as, SBI Contra Fund, PGIM India Mid-cap Opportunities Fund, Quant Active Fund, Quant Small Cap Fund, and IDFC Sterling Value Fund, among others took it to the next level by delivering over 100% in the last one year. Consequently, these funds doubled investors’ wealth within this short period.

Let us find out what led to the stellar returns of these equity funds…

A quick look at the table below tells us that almost every fund that doubled investors’ wealth in the last one year (excluding Thematic/Sectoral funds) has a predominantly mid-cap or small-cap biased portfolio.

Small and mid-cap stocks were expected to be hit hard by the pandemic, since their fate is closely linked to economic progress, but they turned out to be among the biggest wealth creators. The segment benefitted from the RBI’s liquidity boost that provided easy access to capital, while the government’s push to boost manufacturing and other stimulus measures likely worked in its favour.

In addition, most Small-cap fund and Mid-cap fund have higher allocation to the stocks in the Pharma and Infotech sector, which outperformed most other sectors amid the economic downturn.

Table: Equity funds that doubled investors’ wealth in the last one year

Scheme Name Absolute (%) CAGR (%) Std. Dev. Sharpe
1 Year 2 Years 3 Years 5 Years
SBI Contra Fund 104.37 18.54 11.18 13.45 24.56 0.095
Category Average – Contra Fund 84.30 16.82 13.05 16.39 23.13 0.126
PGIM India Midcap Opp Fund 118.68 32.89 19.27 18.57 25.34 0.174
Quant Mid Cap Fund 101.65 23.21 16.15 14.11 23.51 0.147
SBI Magnum Midcap Fund 103.32 21.38 11.38 14.01 26.12 0.099
Category Average – Mid Cap Fund 85.09 19.49 12.17 15.99 23.66 0.110
Quant Active Fund 123.92 29.39 20.36 20.01 24.60 0.184
Category Average – Multi Cap Fund 75.10 16.42 12.12 14.91 22.94 0.112
Aditya Birla SL Small Cap Fund 109.42 10.86 3.08 13.12 29.42 0.025
DSP Small Cap Fund 104.37 20.25 8.70 14.65 27.64 0.068
HDFC Small Cap Fund 103.64 10.08 6.92 16.95 27.14 0.061
HSBC Small Cap Equity Fund 103.31 14.37 4.15 12.50 28.95 0.027
ICICI Pru Smallcap Fund 108.33 23.37 10.68 15.09 28.83 0.096
Kotak Small Cap Fund 127.98 30.92 16.66 19.70 27.87 0.149
L&T Emerging Businesses Fund 102.00 11.21 4.64 17.32 26.90 0.032
Nippon India Small Cap Fund 118.04 22.06 11.55 20.16 28.68 0.093
Quant Small Cap Fund 178.75 27.87 18.12 13.09 31.04 0.164
Category Average – Small Cap Fund 105.36 20.89 9.52 15.85 27.55 0.081
IDFC Sterling Value Fund 114.40 12.87 6.70 15.70 29.36 0.063
Templeton India Value Fund 100.02 11.81 7.67 13.09 26.68 0.068
Category Average – Value Fund 80.78 12.46 8.35 13.72 23.80 0.068

Data as on March 26, 2021
Funds with track record of at least 3 years considered
Returns are point to point and in %, calculated using Direct Plan – Growth option. Those depicted over 1-Yr are compounded annualised.
(Source: ACE MF)  

Should you invest in these funds in an endeavour to double your wealth as quickly as possible?

Investors often tend to select a scheme solely based on the recent attractive returns, which in my view is not a prudent approach. It is important to remember that past performance is in no way an indicator of future returns.

A top performer of a particular year/market phase/cycle rarely appears as the top performer in the ensuing year/market phase/cycle. Besides, certain funds have the ability to generate alpha only during positive market trends and may be unable to generate consistent returns across timeframes.

Further, it is possible that the scheme has generated superior returns by undertaking higher risk and therefore may prove to be unsuitable to your risk profile, especially if you are a moderate-conservative investor.

Typically, certain categories such as Mid-cap fund, Small-cap fund, and Focused fund have the ability to generate higher alpha as compared to categories such as Large-cap fund, but they are also highly risky. Thus, chasing returns can cost you dearly and affect your financial goals.

As you can see in the table, among the top performers of the last one year (in terms of returns), very few fare well on risk-reward parameter as compared to the category average and may witness significant drawdown if the market corrects.

Notably, the Indian equity market may be at risk in the near term due to various factors ranging from expensive valuations across market capitalisation, to concerns about the second wave of COVID-19, rising US bond yield, potential surge in non-performing assets, among others.

So instead of chasing returns, a better approach will be to invest in schemes with steady performance regardless of market conditions.

Though there is no harm in analysing a fund’s past performance, it should not be the only deciding factor for investment. The fund must be able to reward investors by undertaking reasonable level of risk consistent with its investment style and strategy. Remember that the true essence of alpha is to generate ‘extra return without taking extra risk’.

Furthermore, you should be looking at the portfolio characteristics of the scheme to assess its ability to generate reliable returns by analysing the following:

  • Whether the scheme is well-diversified across stocks and sectors
  • The quality of securities held
  • Portfolio churning rate

Invest in schemes of fund houses that have a reliable performance record and follow robust investment processes with adequate risk management systems in place. The ability of a fund to generate alpha depends on the expertise and ability of the fund manager in taking the right call at the right time and reward investors, irrespective of the market movement. Therefore, it makes sense to check the experience and qualification of the fund manager as well as the track record of schemes they manage.

Once you have identified a worthy fund to invest in based on the above-mentioned parameters, opt for the SIP route to mitigate the impact of volatility on your portfolio. Finally, since equity investments take time to grow and generate meaningful returns, ensure that you have a long term invest horizon of at least 5-7 years.

This article first appeared on PersonalFN here

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