Sectoral Funds: Triggered To Perform Post-Pandemic

The recent pandemic engulfing the world is not the only one of its kind. There have been several such critical situations in the past and each one of them has impacted the equity markets in different ways. We take here a historical look at how such events have shaped the markets and draw conclusions about the funds that investors must invest for better returns going forward. 

There are some events that change the course of history. These events are so impactful that they leave an indelible mark in the history of mankind, leave alone the business. A new normal emerges after each such event, which may be quite different from the current norm. The current outbreak of the corona virus will also be recorded as one such event that will have a huge bearing on global economy and human lives. The impact has been visible in the equity market where domestic investors lost around Rs 50 lakh crore in a short span of 48 trading sessions(Jan-20 to Mar 23), which is more than one-third of the total wealth held in the stock market. This is the highest ever wealth destruction in the history of the Indian equity market over such a short span of time. Nevertheless, we believe that there is always light at the end of tunnel. The only thing is that this time it seems that the tunnel may be a bit longer to traverse

Impact of the Pandemic
The initial reaction to the crisis was so severe in the stock market that every sectoral index worth its name technically went into a bear phase and saw a drastic fall in value post the peak it reached on January 2020. The worst impacted indices were Bankex, Auto, Capital Goods and Realty. They all witnessed a fall of more than 40 per cent in their value between January 20 and March 23. Even the best performing sectors, namely, healthcare and FMCG, lost one-fifth of their value in this period. In terms of categories there was no difference between the fall of large-cap, mid-cap and small-cap – all of them sliding down by around 38 per cent.

This fall is reflected in the performance of the equity mutual funds dedicated to such categories. A study of the average returns of the funds in different categories for the same period shows that they have also fallen with the same magnitude. For example, 13 funds dedicated to the banking sector have, on an average, fallen by 42.77 per cent. The pharmaceutical-dedicated funds in the same period, on an average, have fallen by 13.86 per cent. The current downturn has severely impacted the long-term returns of the equity-dedicated mutual fund. This time it has been a hard hit for investors who have opted for the systematic investment plan (SIP) route for investment.

It is saddening to note that on an average the SIP returns for the last three years have been negative. There were 306 ‘direct’ funds whose returns were studied. These funds generated average negative return of 10.57 per cent in the last three years. There are 20 MF schemes that have generated positive returns in the same period; however, most of them are from the ‘international’ category and do not have a significant asset base.

Therefore, if we take the weighted return (weight by AUM of fund), investors have lost around Rs 66,000 crore over the last three years. If we stretch the period of study to five years, the return improves, but only marginally, and fails to impress. For the same set of funds the SIP return is still negative at 1.83 per cent. If we consider the ‘regular’ plan of the fund that makes for a majority of retail investment, the picture gets even worse as they have higher expense ratios.

A Crisis-Driven Opportunity
This is possibly one of the greatest health crises the world is facing in a century and it is likely to percolate to an economic crisis. But for many this threat is a god-send opportunity. Many investors who missed the investment opportunity earlier and were waiting on the sidelines are looking at this fall to enter the market. From a stock perspective and even a fund perspective the fall has brought down the prices to a level that was last visible only in the year 2017. The following graph shows the performance of some of the large equity-dedicated mutual funds by AUM in the last three years. All these funds have AUM greater than Rs 15,000 crore at the end of March 2020 and altogether they hold almost 15 per cent of the total equity MFs’ AUM.

The above graph clearly indicates that barring the Axis Long Term Equity Fund, all funds are now available at an NAV of three years ago. For many investors this is a lucrative opportunity as they can invest at this kind of NAV. This is the reason why investors have poured in (gross inflows) more than Rs 30,000 crore in the equity-dedicated mutual funds in the month of March 2020. The net inflows to the equity MFs were however at around Rs 12,000 crore, highest in the last 11 months. This is despite the market going through one of the worst falls in more than a decade.

We also firmly believe that this is the right time to build your portfolio for a long term. In the short run we may see some more volatility with downward pressure, but for the long run it is going to be a good bet. And so, with investors willing to take the plunge, the focus should be on zeroing in on categories or sectoral funds that are going to generate the best returns going ahead once the current health and economic crisis subsides.

Lessons from History
To absorb the complexities of the current situation better we need to take a leaf out of history and understand how different categories of funds have behaved during and after such crises. We will take equity indices as proxy to categories since we have seen that fund categories mimic the return of the indices with minor variation. Moreover, many mutual fund schemes have seen a change in investment style after the SEBI-mandated re-categorisation exercise in 2017-18, which make analysis of their historical data irrelevant.We need to go through past case-studies wherein global markets were affected by pandemics, some even more dangerous than the current one and others with a mild impact.

For example, Spanish Flu that spread between 1918 and 1920 worldwide killed anywhere between 17-100 million people across the globe. Meanwhile, the death toll due to the outbreak of SARS from 2002-04 was only 774. Below is a partial list of some of the recent pandemics and their timelines.

To understand how different categories of funds performed during and after a crisis we will study three periods, namely, SARS, Swine Flu and the Great Financial Crisis that happened in 2008-09.

SARS
The rapid spread of the Covid-19 since mid-January invariably brings up a comparison with the early 2003 outbreak of Severe Acute Respiratory Syndrome (SARS). It started in South China in late 2002 and was brought under control by measures such as isolation, quarantine and contact tracing. All together, 8,437 people were infected. The first case was recorded on November 16, 2002 while the last was on July 5, 2003. In our research we studied the period between 30 days prior to the first case reported and one year after the last case was recorded.

Since we did not have many of the sectoral indices at that time, we studied the impact only on BSE Sensex and BSE 500. In the mentioned period, the BSE Sensex saw a drawdown or maximum fall of 14 per cent from its peak while BSE 500 saw a drawdown of 12 per cent, slightly lower than the Sensex. The graph below shows the performance of both the indices 30 days prior the onset of the pandemic and one year after the pandemic was over.

In terms of discrete returns of three different periods, the following bar graph shows the returns generated by the indices .

Great Financial Crisis
At first glance there seems to be no correlation between the pandemic and the great financial crisis (GFC). Nevertheless, the way the situation is progressing, we may soon see a financial crisis not only in India but globally. The nationwide complete lockdown will have its implication in the economy and financial sector. Therefore, we thought of studying this period to understand how different sectors and indices react during and after any such crisis. Luckily we do have data for different sectors for the period that we have used for the analysis.

GFC can be traced back to February 1, 2007 when HSBC announced losses linked to the US subprime mortgages. Just a few days later, the Shanghai Stock Exchange Composite index tumbled 9 per cent from unexpected sell-offs, the largest drop in 10 years, triggering major losses in worldwide stock markets. There were another series of corporate events that finally culminated into bankruptcy of the Lehman Brothers, which was the largest bankruptcy filing in US history, with USD 639 billion in debt. India did not remain immune to these events and witnessed some volatility during September and October 2007, but kept its upward march. Finally, in the month of January 2008 we saw a sharp downturn in the equity indices after touching their highs. From its peak of January till its bottoming out in March 2009, BSE Sensex fell by 61 per cent. Beyond the frontline equity indices, there were sectoral indices that fell by more than 75 per cent in the same duration.

For example, BSE Realty and BSE Consumer Durable indices declined by 90 per cent and 78 per cent respectively in the same duration. The table below shows the performance of different indices during and after the GFC. The maximum drawdown column shows the extent of fall an index suffered from its peak to bottom. For instance, the BSE Utilities index fell by 68.34 per cent between January 2008 when the Sensex touched its peak and March 2009 when the Sensex touched its low point. Similarly, BSE Realty index fell by 90 per cent in the same period. From its peak of around 14,000 it dropped to 1,400 and even today it continues to trade at a similar level.

The other columns denote the returns generated by the indices from the bottom of the market. For example, the Realty index jumped by 61 per cent in the next 22 trading sessions wherein 22 trading sessions is considered one month. In the next three months, including the first month (63 trading days), the index jumped by 176.06 per cent. And after one year it was trading at a gain of 146 per cent. From the above table it is clear that the sector that dropped the largest witnessed a sharp recovery. One of the reasons it is so is because the base becomes significantly lower and any recovery on that looks big.

Hence, if you are interested in investing in beaten down sectoral funds you should know when the bottom has been reached (although we believe it is very difficult to know when the bottom has reached) and your investment should only be for a short period. When we analyse market-cap-wise data, we observe that the large-cap equity index fell the least followed by mid-cap and small-cap. Nevertheless, in terms of recovery, in the first month, there was not much of a difference. All the three categories recovered at the same rate. Therefore, if you are not sure where the fall is going to stop, it is wise to remain invested in large-cap dedicated funds. This will contain your losses and at the same time you can ride the recovery. Once you see that the bottom has been formed, you can switch to mid-cap or small-cap-dedicated funds.

The following is a graphical representation of the movement of the indices from their peak to bottom and one year ahead. The two lines indicated through dashes denotes one month after the peak of the market and the Lehman Brothers’ bankruptcy. The graph below also points out that FMCG remained a safe bet during such times. The grey line in the above graph shows that the FMCG index slipped the least. However, it was also the slowest to recover. Nevertheless, it remained the best performer in the entire period.

Swine Flu
Swine Flu, also known as H1N1 Influenza, was a global pandemic in 2009-10. It resulted between 151,700 and 575,400 deaths in the first year according to the medical journal ‘The Lancet’. Most studies, however, put the death toll at around 2 lakhs. The pandemic had struck 179 countries and territories compared to 210 countries impacted by Covid-19 till now. In India the impact was not as much as we are witnessing currently; nevertheless, the equity market fell after this pandemic. The table below shows the performance of different indices from the date of announcement of the pandemic.

"It wasn't October 1987 but it was an imitation anyway, and the combination of the coronavirus and what happened with oil, that's a big one-two punch"

Warren Buffet
while referring to March 9, and the biggest stock-market decline since the financial crisis

The maximum drawdown column shows the maximum fall in the index from its peak during the period April 15, 2009 till August 11, 2010. Even during the pandemic, Healthcare and FMCG indices continued with their solid defence of the investors’ wealth. Nevertheless, they may not have given superlative return after the pandemic was over and the situation returned to normal. If you have an investment horizon of more than one year, consumer durable and auto sector-dedicated funds are likely to perform better.

The above graph depicts the movement of the different equity indices during and after the pandemic. The two lines in dash formation denote the date when the first case was recorded and finally the date when a pandemic was declared. It clearly shows that consumer durables remained the best performer and realty the worst .

Tips for Investors
Looking at the historical records and analysing three different events, one thing that emerges for sure is that if you are a conservative investor, it’s better to stick to funds with higher investment in FMCG or funds dedicated to such sectors. Besides, healthcare funds are also good at minimising the loss of your capital. Moderate risk-taking investors should remain invested in large-cap funds as they fall the least among funds categorised on the basis of market capitalisation.Moreover, they also give a decent upside when the market recovers. Investors willing to take higher risk can go for mid-cap and small-cap-dedicated funds as they offer better returns in one year following any such event. For sectoral funds they can pitch for consumer durables, which are known to have generated better returns in one year Nonetheless, you should invest in them in a staggered manner.