The Indian equity market wrapped August on a positive note, advancing for the third consecutive month. Continuing this optimistic trend, it has begun September by scaling new highs. The Sensex breached 82,500, while the Nifty 50 closed near 25,300, as of September 02, 2024. The Midcap and Smallcap indices too are trading near their all-time high levels.

The recent rally can be attributed to the latest US personal consumption expenditures price index, which rose only marginally by 0.2% in July. This favourable data eased concerns about global growth and also signalled potential rate cuts by the US Federal Reserve in this month. Moreover, the reports of a drop in crude oil prices due to slow Chinese demand and higher OPEC+ production from October is a positive news for India. Besides, with expectations of a rate cut in the USA, FIIs have begun steadily buying in the emerging markets such as India, over the last couple of months.

Meanwhile, retail investors continued to participate actively in the market via direct stocks as well as equity mutual funds, including participation in initial share offerings of high risk small and mid-sized companies. This segment was conventionally only dominated by high-net-worth individuals (HNIs).

Mid caps and Small caps Outperformed Large caps

Mid caps and Small caps Outperformed Large caps

Base taken as 10,000
Past performance is not an indicator for future returns
Data as of September 02, 2024
(Source: ACE MF, data collated by PersonalFN) 

Amid the sustained rally in the Indian equity market, equity mutual funds across sub-categories have rewarded investors with remarkable gains. Small Cap Funds and Mid Cap Funds were the top-performing schemes as the segment outperformed their large-cap peers. Certain schemes belonging to the very high risk categories, such as Sector & Thematic Funds, were also the top performers, while Multi Cap Funds, Flexi Cap Funds, Large & Midcap Funds, and Large Cap Funds, etc., fared decently.

[Read:  Small Cap Index Near an All-time High: Should You Rejoice or Worry?]

Now the question arises: Will the equity market continue to soar high and reward investors in equity mutual funds? And what investment strategy should one follow at this juncture?

Well, in my opinion before understanding the investment strategy to follow now, investors need to watch out for the following risks before they get swayed by the optimism in the market:

1) Lofty Valuations

Market experts are of the opinion that the Sensex is on the path to hit the milestone of 1,00,000 mark. However, the journey towards the summit may not be a smooth one. One must remember that just as the Sensex went from 65,000 to 80,000 level within a span of about one year, gaining about 25%, it can also correct by 30% or more. Considering that the valuations in the market have moved up significantly, particularly in the mid-cap and small-cap segments, any negative trigger can result in a huge downside.

India’s Current Market Cap-to-GDP Ratio

India's Current Market Cap-to-GDP Ratio

Based on historical values, divided into five zones.
Data as of September 02, 2024.
(Source: gurufocus.com

At present, India’s market capitalisation-to-GDP ratio, also known as the Buffett indicator (named after legendary investor Warren Buffett), is in the ‘modestly overvalued’ zone at 109.48%, but lower than the 10-year high of 119%. It is noteworthy that large caps appear to be better placed in terms of valuations compared to mid and small-cap stocks, indicating a better margin of safety.

[Read: Do Large Cap Funds Make More Sense in An Overheated Equity Market?]

2) Speed Bump in Corporate Earnings Growth

According to a report by Business Standard, the corporate earnings growth of India Inc. hit a speed bump in the June 2024 quarter. The combined net profit of about 2,900 companies considered grew by 4.4% y-o-y, growing at the slowest pace in the past six quarters. In comparison, the combined net profit of these firms was up 40.9% y-o-y in the same quarter last year (Q1FY24), and by 10.7% y-o-y in the previous quarter (Q4FY24).

If the slowdown in growth continues in the remaining quarters of the financial year it could negatively impact stock prices, and in turn, returns on equity mutual funds.

As per the report, the earnings slowdown was largely led by oil & gas companies, non-bank lenders, fast-moving consumer goods, cement, and iron & steel firms. On the other hand, banks, automotive companies, non-ferrous metal producers, pharma, and capital goods companies reported strong double-digit growth in earnings for the quarter.

3) Slowdown in GDP

The Indian economy hit a 5-quarter low of 6.7% in Q1FY2025 compared to 8.2% in the year-ago quarter and 7.8% in the previous quarter. The lower growth can be attributed to muted government spending due to the Lok Sabha elections, lower corporate profitability, and lower core output.

The GDP was also dragged by a slowdown in agriculture sector, which registered a 2% increase in the June quarter, as against 3.7% in the year-ago quarter. The growth of eight core industries too slowed down marginally to 6.1% in July, compared to 8.5% in July 2023.

India’s GDP growth hit a 5-quarter low in Q1FY2025

India's GDP growth hit a 5-quarter low in Q1FY2025

(Source: mospi.gov.in

Notably, Goldman Sachs Group Inc. has lowered India’s growth forecast by 20 basis points each for this year and the next, citing a contraction in central government expenditure as it looks to bring down the fiscal deficit to below 4.5% of the GDP.

Any likely slowdown in global growth can also hit the demand for goods and services in India.

While India has maintained its rank among the fastest growing major economies in the world, to retain the tag, consumption growth must improve considerably, private investment needs to pick up, and inflation must remain within RBI’s target.

4) Global Uncertainty and Climate Risks

The RBI has flagged geopolitical tensions along with tightening global financial conditions as a key risk to the financial stability of the economy. It is noteworthy that if geopolitical tensions escalate, it could have a bearing on FPI flows, global demand, supply chains, commodity prices (resulting in inflation), and the returns of the equity markets.

Potential Risks to Financial Stability

Potential Risks to Financial Stability

(Source: RBI’s systemic risk survey May 2024, as per RBI Financial Stability Report, June 2024

The RBI noted that the episodes of geopolitical tensions have generally been associated with spikes in crude oil prices and disruptions in supply conditions, which could interact with other channels and amplify stress on the real economy and the financial system.

Moreover, the rising instances of climate shocks pose a risk to the inflation outlook, particularly prices of food items such as vegetables, fruits, and pulses, rendering the outlook difficult to ascertain.

5) Behaviour Bias/Recency Bias

It is often cited that, “The market can stay irrational longer than you can stay solvent”. What this essentially means is that in a secular bull market, one may fail to pay heed to cues of risk and mistake the frothiness in stocks for real upside.

Market regulator SEBI has warned of froth build in the mid-cap and small-cap segment of the market. Moreover, corporates in India too have been less enthusiastic about the near-term earnings.

Despite this, an increasing number of investors assuming high risk, as highlighted by the unprecedented inflows in high risk categories such as Small Cap Funds and Sector/Thematic Funds, in anticipation of past instances of high returns continue in the future as well. They believe that since these schemes generated extraordinary returns in recent years, they will continue to do well over the next few years as well.

Investors must remember that selecting schemes based solely on past returns is risky because past performance does not guarantee future results. The performance of a scheme may vary significantly from one year to another. Moreover, no scheme can maintain its top quartile rank year after year.

What mutual fund investment strategy should investors follow now?

For long-term goals, instead of chasing top-performing mutual funds of the past, investors should consider creating a diversified portfolio of various sub-categories of mutual fund that aligns with their investment objectives. Investors may use the ‘Core & Satellite’ approach to diversify their portfolio and earn optimal risk-adjusted returns.

This approach involves including long-term steady compounders such as Large Cap FundsFlexi Cap Funds, and Value Funds in the ‘Core’ part of the portfolio. Meanwhile, the ‘Satellite’ portion can include tactical allocation in opportunistic bets having high returns potential such as Mid Cap FundsSmall Cap Funds, Sector/Thematic Funds, etc.

For short-term goals, that are less than 3-5 years away, investors can consider investing in hybrid mutual funds as well as debt-oriented mutual funds.

Investors can suitably decide the weightage in each of these categories and sub-categories of mutual funds based on their financial goals, risk appetite, and investment horizon. This will allow the portfolio to weather the ups and downs of the market and investors can benefit from steady returns across market phases without attracting undue risks.

[Read: How to Choose Mutual Funds For Your Investment Portfolio]

With the equity market trending at record highs, the margin of safety has narrowed. Therefore, investing a lump sum amount can be risky if the market corrects hereon. Moreover, investing a lump sum amount requires investors to time the market, which can be a challenging task. Thus, opting for the SIP mode can be more effective in the current market scenario. Leveraging SIPs will allow investors to keep emotions at bay and avoid timing the market so that their investments continue to grow and compound wealth over the long run.

Amid the broad-based bull run seen in the last few years, most schemes across sub-categories of equity mutual funds have performed exceptionally well. However, it is important to note that not every scheme is worthy of investment. As an investor, one would be better off avoiding schemes that have displayed one-off superior performance, or schemes that lack a long-term track record. Instead, prefer well-managed mutual fund schemes that have performed consistently well across diverse market phases in the past compared to the benchmark index and the category peers.

Market highs often induce risk-on mode, tempting investors to chase aggressive strategies that may not suit their investment objectives. However, it is vital that investors remember their risk tolerance by sticking to the personalised asset allocation plan, and stay the course till the goal is achieved.

Lastly, a periodic review of the mutual fund portfolio is necessary to ensure that investors are on the right path to achieving their goals.

Watch this video to find out how to approach equity mutual funds now:

Note: This write up is for information purpose and does not constitute any kind of investment advice or a recommendation to Buy / Hold / Sell a fund. Returns mentioned herein are in no way a guarantee or promise of future returns. As an investor, you need to pick the right fund to meet your financial goals. If you are not sure about your risk appetite, do consult your investment consultant/advisor. Mutual Fund Investments are subject to market risks, read all scheme related documents carefully. Registration granted by SEBI, Membership of BASL and certification from NISM no way guarantee performance of the intermediary or provide any assurance of returns to investors.

This article first appeared on PersonalFN here


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