Deciding On Funds To Buy And Hold
The funds that you buy and hold serve as anchors providing a sense of stability and direction for portfolios. Therefore, the choice of funds should be such that they require minimum maintenance and yield good returns over a specified period of time
The recent fall in the equity market has highlighted a different character of retail investors. Contrary to the earlier perception that retail investors are the last to join and the first to leave, this time they were clearly the first to join the party when their institutional counterparts were still sceptical. There were instances when retail investors were nimble enough to spot opportunities in the equity market, investing in a staggered manner. This behaviour reflects that a lot has changed in the last few years and that now retail investors are acting in a more mature manner, displaying discipline while taking investment decisions.
Once again when the market has taken off on an upward spiral and has risen by more than 40 per cent from its recent lows, investors have started to book profit. This has been reflected in the June 2020 mutual fund inflow numbers where redemptions have increased considerably from equity -
dedicated funds. Making these tactical investment moves should be part of your entire investment strategy but this should not be your only investment strategy or rather a trading strategy. Nobody has ever consistently timed the market and benefited out of it. To fulfil your long-term investment needs you need to have a more disciplined approach.
Investment Process
The investment decision process for retail investors is well cut out and has been documented by professionals and academia. There is a five-step process that needs to be followed in a sequence.
1. Setting the long-term asset allocations, as for example, how much of your investment should go into bonds and how much should go into stock.
2. Establishing the investment policy and rebalancing the parameters.
3. Determining the active and passive allocations of your investment.
4. Selecting the funds based on the above decisions.
5. Continuous monitoring and rebalancing of your portfolio.
The activities listed above should be followed as per the given sequence and the decision on the first two points forms the core of your investment process. There are many research papers that indicate how the first two activities will account for most of your portfolio’s long-term returns. One of such prominent studies is that by Gary P, Brinson L, Randolph Hood and Gilbert Beebower, published in 1986, which reported that an investment policy – measured as the average quarterly exposure to stocks, bonds and cash – explained 93.6 per cent of the variation of quarterly portfolio returns, whereas on an average, the market timing explained only 1.7 per cent of the variation in portfolio returns and reduced portfolio performance by 0.66 per cent per annum.
Despite this, many individual investors guided by their advisors blindly follow the traditional multi–asset class, multi-style model to construct their portfolio. They will invest in different sub-category of equity and debt to diversify the portfolio. This is a process that is being mostly followed by institutional investors. However, this may not suit retail investors. So, what is it that retail investors should follow? They should follow a core and satellite strategy to design their portfolio. This means a portfolio with a core of long-term holdings orbited by riskier equities such as sectoral funds. This approach reduces the risk of underperforming against adopting an approach where you try to time the market or fill your portfolio with sectoral calls. Besides, it also helps explores more potential to beat the market versus an all-core approach.
Funds to Buy and Hold
Equity : When we speak of core, it does not limit itself to equity-dedicated fund but also includes debt funds. First, we will consider equity. The idea behind a core fund is that it should be a fund that is able to deliver returns in both good and bad times without being too volatile. While almost any fund can deliver returns when the markets are rising, as is obvious nowadays, it takes a special skill to keep a fund relatively stable during volatile or bad times. The funds that you need to buy and hold should be that part which captures the three market factor returns i.e. beta, size and book to market or value. In other words, the funds should be such that they have lower beta while the size should be small and of good value.
Funds with Lower Beta : There are many empirical studies that convincingly show how high beta assets often deliver lower expected returns than predicted by one of the most used asset pricing model, namely, CAPM (Capital Asset Pricing Model). Not only that, it has also been proved that lower beta assets deliver returns higher than expected according to the CAPM. Therefore, when you are investing in a fund, which you will continue to hold for a longer duration, go for a fund with lower beta.
To know whether lower beta impacts the long-term performance of the fund, we studied 218 equity-dedicated funds that have been in existence for more than 10 years. We divided these funds into five equal segments based on descending order of returns. The result clearly shows that there is an inverse relation between the beta of a fund and its long-term returns. We can see that funds with lower beta have outperformed the funds with higher beta.
In the table above we see that the average return of funds with average beta of 0.74 is higher than funds with average beta of higher than 0.8. The last entry in the table shows that funds with lower beta have lower returns in comparison to the earlier entries. The reason is that many funds in this category are from the infrastructure sector and the performance of this sector in the last 10 years has not been good. Since the return of the overall category has been lower, funds with lower beta in this category failed to outperform. However, even in this category, funds with lower beta have outperformed the category.
The reason for such anomaly is simple mathematics: the effect of compounding. Consider two stocks with an average arithmetic return of zero: the more volatile one goes down 50 per cent and then up 50 per cent, generating a compound return of – 25 per cent over the two periods; the other that goes down 10 per cent and then up 10 per cent compounds a loss of just – 1 per cent. Therefore, one characteristic of the fund that you decide to hold for a longer duration is that it should have lower beta in its category and overall also.
Small-Cap and Mid-Cap : Contrary to the perception that large-cap holdings should form part of your core holdings, we believe that if you are going to hold a fund for more than 10 years, exposure to broader market-dedicated funds makes more sense. The reason is that small-cap and mid-cap-dedicated funds tend to perform better than large-cap funds in the longer period. Yes, they tend to be more volatile in over a shorter period and may seriously underperform in the shorter run; however, in the long run they tend to generate better returns than large-cap.
For example, since the start of FY04, BSE Small-Cap index has moved up by 1,434.14 per cent as compared to Sensex that has moved up by 1,087.76 per cent in the same period. The table below highlights the comparative statistics of BSE Sensex representing large-cap and BSE Small-Cap index representing small-cap. It clearly shows that although the BSE Small-Cap index is more volatile as represented by yearly volatility, it has generated better returns than the Sensex.
When it comes to equity funds, we see that small-cap funds and mid-cap-dedicated funds perform better than their large-cap counterparts in the longer period. In the last ten years we have seen that a majority of the top performers in terms of returns are from the broader category. Barring few sectoral funds such as pharmaceutical and IT or thematic funds like MNCs or consumption, the top performing funds are from the mid-cap or small-cap category .
The above table clearly shows that the top two positions are occupied by funds having substantial exposure to a broader market. This performance has come after the broader market has been in pain for the past 30 months. In our study of 218 funds we find that in terms of performance, the top 20 percentile is dominated by funds dedicated to the broader market. The table below shows the distribution of funds in the top 20 percentile based on the performance of the last ten years.
Value Funds : Another important category of funds that you can buy and hold is value funds although the last decade has not been good for value funds since they lagged their growth counterparts. This is probably the first decade when growth funds have outperformed value funds. Critics have attributed the shortfall in value performance to everything from unprecedented changes in global monetary policy to overcrowding from the popularity of systematic strategies used to invest in stocks with value characteristics. One of the reasons for such underperformance is that the traditional metrics such as price to earnings and price to book value are insufficient to assess ‘value’ due to changing dynamics of the business.
Given the continued evolution of business towards being service-oriented, it is important to take into consideration intangibles such as brand value, human capital and so on to determine the value. Purely from a performance perspective, value has maintained its historical returns; it is growth that has performed extraordinarily over the last decade. Nevertheless, there are a couple of funds such as ICICI Prudential Value Discovery Fund and Tata Equity PE Fund from this category that have generated respectable returns in double-digits in a 10-year period.
History suggests that some of the weakest periods for value funds when compared to growth funds have been followed by some of the strongest. Hence, value should be something that you should not ignore. Another simple and easy approach, especially for an investor who does not believe in factor returns, would be to allocate 100 per cent of the core to a broad-based market index like BSE 500. However, if you believe that certain specific factors play an important role in generating returns, you can have allocations to small-cap, lower beta and value equity funds.
Debt Funds : The world of debt funds is not as complicated as equity funds even though there are 16 categories of debt funds compared to 10 categories of equity funds. They are carefully arranged in terms of the time horizon of the securities they invest in. So the funds investing in very short-term money must go into ultra-short term funds, short-term into short-term, and so on. The longer the period, the more volatile funds tend to be when interest rates change.
This makes it dangerous to invest in long-term funds for short periods of time. Therefore, if you want to buy and hold funds, you should opt for gilt funds or dynamic bonds. Gilt funds invest primarily in government-issued securities which carry a very low level of risk and are generally rated quite high whiledynamic bond funds seek to maximise the returns to investors by switching the investment portfolio depending on market conditions and fluctuations.
❝Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.❞
- Warren Buffett
There are arguments built in favour of hybrid funds with more exposure to equity. These funds invest in both equity and debt and should serve your purpose. Let the fund manager decide when and how to increase or decrease the exposure to equity or debt. However, we believe that by adopting such a move you lose your flexibility to decide on your own equity-debt mix.
Equity Debt Mix : The funds that you should buy and hold should provide stability to your overall portfolio. They are the anchors that provide a sense of stability and direction for portfolios. Therefore, the choice of funds should be such that they require minimum maintenance. More recently, exchange traded funds (ETFs) have become increasingly popular core holdings because they are low-cost, passive investments with broad exposure. They can be a good alternative; however, one should wait as they are still evolving. In our view, three to four equity funds and one or two debt funds are quite enough for you to buy and hold.
However, the percentage allocation to equity and debt should depend upon one’s risk appetite. This segment of the portfolio is usually directed towards achievement of one’s financial goals, especially those that can be identified as ‘needs’.