Is It Time To Book Profit From Equity Mutual Funds?

If your allocation to equities has increased recently and is higher than what you had planned for, it may be time to rebalance the portfolio by redeeming some units of equity funds and move that fund either to short-term debt funds or gold.



The strong rebound of the equity market in the last seven months is probably one of the best recoveries we have ever seen in the equity market. It will be recorded as one of the biggest financial stories in the annals of stock market history. After losing 40 per cent of its value in the first quarter of the year, bellwether equity indices are at a kissing distance of their lifetime high while some sectoral indices are already trading at their lifetime high. Even the broader markets have moved in tandem with frontline indices and are up by more than 50 per cent from their recent lows.

The small-cap index is actually up by more than 70 per cent. This spectacular rise in the equity market might, however, not be a reflection of the economic reality, which is yet to recover from the ongoing corona virus pandemic. This current rise in the equity market is primarily driven by liquidity in the market. The graph below shows the performance of the indices year-till-date.

The graph shows that we almost have a V-shaped recovery in the equity market without a corresponding rise in the performance of India Inc. Corporate earnings for the second quarter of FY21 have witnessed a remarkable improvement on a sequential basis; however, it will take some time for companies to fully recover from the output lost in the first quarter of this fiscal. The rise in equity market along with loss in economic activity has led to stretched valuation of the equity market in India. The valuation of the equity bellwether indices are trading above 2 SD (standard deviation) of their long-term average. Besides, what is also disturbing is that return on equities (ROE) is also lower than the long-term average.

Historically, the equity market has not generated positive returns over three to 12 months from such higher valuation. The returns generated by Nifty, once it reaches PE of 29 or greater than 29 are very poor for next three, six, nine and 12 months. The graph below shows the average returns. Therefore, it is the right time to book some profit from your equity funds and rebalance your portfolio.

Rebalancing your Portfolio

Rebalancing is the process of putting back your portfolio’s weightages back in line with your targets. For many investors it may look counter-intuitive as rebalancing forces you to sell something that has been performing and divert it to the ones that are lagging and may be losing money. This may be psychologically challenging. But rebalancing does not require you to exit from the asset. It is just lightening up on the funds that have done well. So you should consider it as booking profits and protecting your gains.

At the same time, if you put this money into funds that have not done well recently, it means that you are getting them cheap and that may enhance your returns going forward. The common rule is to rebalance your portfolio once a year, maybe at the start of the year. Nonetheless, you can also rebalance your portfolio once your asset allocation deviates from your target by a certain percentage, say, 5 per cent or more. You should not react to every single market swing and only do a periodic rebalancing if your portfolio is seriously out of alignment.

This can be better understood with an example of the incessant fall in the equity market in the first quarter of 2020. Suppose your target asset allocation is 60 per cent into equity and 40 per cent into debt. You start your year with this allocation. By the end of March 2020, your asset allocation would have been 46 per cent in equity (equity market fell by 39 per cent) and 54 per cent in debt (long duration funds gave return of 6 per cent). Now to restore to your original target allocation you will have to sell 11 per cent of your debt fund and invest into equity funds. If you would have rebalanced, your portfolio value would have been 107.3 while if you would have failed to rebalance, your portfolio value would have been 103.4.

After this rise in equity value, your portfolio needs to be rebalanced again as the value of equity is near 70 per cent of your portfolio and any fall in equity will adversely impact your portfolio returns. Now you can realise the benefit of rebalancing and how it works to improve your portfolio returns. Nonetheless, while doing such rebalancing you should pay attention to the tax implications and exit loads. In the above example, considering you are in the highest tax bracket, your tax burden will not increase beyond 1 per cent.

Moreover, if you want to minimise the tax burden you should sell those funds that have completed three years in case of debt funds and one year in case of equity funds. It’s a rare event when a losing asset becomes a winning asset in such a short span of time that you are forced to sell in order to rebalance. Nevertheless, you should be disciplined in your approach towards your portfolio management and rebalancing your portfolio allows you to maintain your desired level of risk, even after major market fluctuations.

Time to Book Profit from Equities

Just as one size does not fit all, one asset allocation will not serve everyone. Therefore, if your allocation to equities has increased recently and is higher than what you had planned for, it may be time to rebalance the portfolio by redeeming some units of equity funds and move that fund either to short-term debt funds or gold, if it is below 5 per cent of your total portfolio. Besides, what also favours booking profit from equity is high volatility that we are witnessing in the equity market globally.

The reason for such heightened volatility is the US’ presidential election and the second wave of corona virus in Europe and US. Though you cannot control volatility, you can always control the risk in your portfolio through prudent asset allocation. Just rebalance your portfolios to restore the asset allocation mix you decided for your investments. Mutual fund investors who are investing through systematic investment plan should continue with their investment and only the accumulated amount should be considered for rebalancing your portfolio to restore to target asset allocation.