Value funds have staged a comeback after a deep lull between 2018 and early 2020. The category has clocked superior performance in the last one and a half years and has outpaced the Large-cap Funds, Large & Midcap Funds, and Flexi-cap Funds category. In 2021, the top performing Value Fund generated absolute returns of 66.2% compared to the 31.6% returns generated by the Nifty 500 – TRI index. On an average, Value Funds offered returns of 37.2% in 2021.
What are Value Funds?
As per SEBI norms, Value funds are equity-oriented mutual funds that follow the value-investment strategy, investing minimum 65% of its assets in equity and equity-related instruments with the flexibility to invest across market capitalisation. Value funds look to discover undervalued stocks, i.e. stocks that are trading below their intrinsic/fair value, but with strong fundamentals, and hold them till their value is realised.
As the fund managers of Value Funds invest in undervalued stocks, some of their bets may not pay off immediately. Thus, Value Funds can underperform over the short to medium term. Over the long term, value funds can generate returns in line with growth funds or even outperform them.
Reasons why Value Funds turned attractive in 2021
Until a couple of years ago, the market was driven only by a few index heavyweight stocks that led to polarisation of market. The equity market witnessed various events such as Demonetization, GST, liquidity crisis in NBFCs, economic slowdown etc. which adversely impacted the growth in the broader market.
Besides, SEBI’s recategorization norms for mutual funds did not appeal mutual funds much, especially those that carried significant allocation to mid-cap and small-cap stocks. Consequently, value as an investment style turned out of favour and the performance of Value Funds suffered.
However, as the market rally became broad-based since the latter half of 2020, returns on Value Funds turned attractive. Many mid-cap and small-cap stocks were available at fair valuations after underperformance between 2018 and early 2020. Fund managers that took exposure to such stocks benefitted immensely.
Moreover, several PSU stocks (where value funds have significant allocation) soared in the past couple of years after a long hiatus. Some beaten-down sectors and companies also surprised investors by reporting strong earnings growth. A combination of these factors led to improvement in the performance of Value Funds.
Table 1: Top Performing Value Funds During Bull Market Phases
(Source: ACE MF, PersonalFN Research)
Table 2: Top Performing Value Funds During Bear Market Phases
(Source: ACE MF, PersonalFN Research)
The above table represents the top performing value funds during bear and bull market phases. By nature, value style funds tend to underperform their growth-oriented peers in bullish market phases whereas outperform in a bearish market condition.
Looking at performance of Value Funds in the current bull phase (2020-2021), it is clear that most of the value funds that are heavyweight on mid-caps and small-caps and those following a blend of Value and Growth have done exceedingly well, whereas some of the true to style value funds have ended up in the bottom performing funds. As an investor you need to understand the true style followed by value funds, and not get carried away by its performance.
Value as an investment style is meant for defensive purpose. Therefore, give higher preference to Value funds that have the potential to do well in bearish market conditions, as against those that shine only in bullish markets.
Will Value Funds continue to shine in 2022?
After a massive rally in the last 18-20 months, the valuations in many stocks across market caps have run ahead of the fundamentals and look expensive. Moreover, the new variant of COVID-19 has emerged as a key risk that could impact consumer sentiments and business activities in the coming months. Rising inflation trend and normalisation of monetary policy by RBI is another factor that could lead to higher volatility in the equity market.
Therefore, it is likely that the bullish momentum in the equity market will slow down in 2022, and we may witness higher volatility and even consolidation. In such market scenario, momentum driven high beta stocks may see correction and as a result, investor focus may shift to fundamentals and values.
Notably, high beta stocks tend to outperform in during market uptrend but the risk-reward ratio for such stocks tend to turn unfavourable during volatile market or downswings. During volatile phases and downswings investors prefer stocks that could generate market-beating returns albeit at lower risk. This could work in favour of Value Funds.
One of the key characteristics of Value Funds is that they can protect the downside risk better than growth-oriented mutual funds. Value funds invest in stocks that are trading below their intrinsic value. Hence, value stocks have limited downside risk because they generally invest in beaten down stocks and sectors that have high growth potential.
While Value Funds may underperform during momentum driven or polarised market, they perform well in settings where the market rally is broad-based and driven by fundamentals and earnings upgrade.
Should you invest in Value Funds in 2022?
Both growth funds and value funds have their pros and cons. Since it is not possible to predict when growth or value funds will do well, it is advisable to invest in a mix of growth and value style funds based on your financial goals and risk profile. This will help you to get favourable returns across market phases and cycles. But remember to avoid investing in either Value fund or growth-oriented fund on recent performance.
Value funds are a good way to gain exposure to quality stocks across market caps. The category acts as a good portfolio diversifier due to the better margin of safety it offers. However, the category can undergo extended bouts of underperformance when growth stocks are in favour. Value funds can form a part of your core portfolio if you can handle an extended period of underperformance and if your investment horizon is at least 5-7 years.
It is often observed that some value funds take high exposure to growth stocks in a bid to boost returns. Such funds should ideally be avoided because the downside risk in such funds can be relatively high. Stick to value funds that focus on the guiding principles of ‘Value Investing’ while constructing the portfolio.
Therefore, to select a true-to-name and the best Value Fund analyse the schemes based on various quantitative and qualitative parameters. And when you invest in Value Funds opt for the SIP mode of investment to mitigate the impact of market volatility.
This article first appeared on PersonalFN here