Exit Equity MFs Now?

Heightened volatility has brought a question to the mind of many investors about whether they should book profit from their MF investments and wait for the market to correct and let the dust settle after which they can make a fresh entry. The article highlights the pros and cons

 The equity markets around the world have started to show some signs of fatigues now. The ride for equity investors is not as smooth now as it was in the last quarter of 2020. There are some equity indices such as technology-heavy Nasdaq which has already gone into a correction mode and is down by more than 10 per cent from its recent peak. What is also nagging investors is the rise in daily volatility in the equity market. Year-till-date (March 5, 2020), the daily volatility of key equity indices in India has increased to 1.35 per cent (21 per cent annualised). Compare this with the last five years’ (ending December 2020) median of 0.95 per cent (15 per cent annualised). Historically, higher volatility is a precursor to a fall in the equity market.

Aiding this volatility are the global macroeconomic conditions, which are not shaping in a way that gives confidence in the continuation of the current rally of the equity market in the short term. The most important global factor is rising US bond yields, which if they remain persistent will lead to a rise in interest rate sooner than later.

This will adversely impact the equity market; we saw a glimpse of this recently when the US yield on 10-year treasuries breached 1.6 per cent, highest in a year, and the equity markets globally saw a major sell-off

Returns from MF Schemes
This heightened volatility has brought a question to the mind of many investors about whether they should book profit from their MF investments and wait for the market to correct and let the dust settle after which they can make a fresh entry. There is no easy answer to this and is well-summarised by John Maynard Keynes, “The market can stay irrational longer than you can stay solvent.” Currently the equity market is trading at a valuation which is three sigma above its long-term average. What this means is that in the entire trading history of frontline equity indices such as Nifty and Sensex, only less than 0.5 per cent of the time they have traded at such higher valuation or greater than this.

Assuming that the valuation will finally drift towards its long-term average we may see some correction in the market depending on how the earnings of the India Inc shape up. The other factor that is weighing in the minds of many investors is the better return that their Equity MF investments have generated recently. In the last few years we have seen that returns provided by most of the equity MF schemes have remained quite subdued, especially for funds dedicated to the broader market. Nevertheless, if we look at the recent performance, they are exceptional. In the last one year some of the categories such as IT, energy and pharmaceutical have generated return in excess of 50 per cent.

Even other categories including broader markets such as mid-cap and small-cap have generated returns of more than 40 per cent. Such a good short term performance has helped to lift the past performance of the funds. For example, from the start of year 2018 till the end of 2020, the average return generated by the equity-dedicated funds was only 2.04 per cent and out of 20 categories including different thematic funds, nine generated negative returns. Even the Systematic Investment Plan (SIP) returns were not impressive. According to a study done in the month of July 2020, only six out of 192 equity mutual funds gave double-digit returns in a five-year period. The worst performers were the mid-cap and small-cap-dedicated funds, majority of which generated negative returns. So, once these investors saw a positive return on their investment, they started booking profit.

Hence, we are witnessing a continuous outflow from equity-dedicated funds primarily due to profit booking and portfolio rebalancing amid the markets touching new highs. February 2020 becomes the eighth consecutive month when there was net outflow from the equity dedicated fund.

Timing the Exit from Equity MFs
Should you join other investors and start booking profits from your MF investments? There is no easy answer to this and hence we have to rely on history to know the return from equity after such high valuation. We have used Nifty 500 index as proxy to equity MF returns.

The below graph shows the PE ratio highs reached by Nifty 500 historically. Now let us see the returns generated by Nifty 500 in the next five years if you have invested at peak. We see that the best annualised return was generated at 7.5 per cent between December 2007 and March 2012. Compare this with the average annualised return of Nifty 500 since the start of 2001, which is 15.9 per cent. Hence, it makes sense to exit if you are a lump sum investor.

If you are a SIP investor then let us check what your return is. The table below shows that if you are investing through the SIP route, you can continue with your investment as there is hardly any difference in returns.

Although you should not stop your SIP, the accumulated amount through SIP needs to be acted upon. What should you do with such corpus? There is no one size fits all and hence the question needs to put in the following perspective. First, what is your asset allocation plan and secondly, the purpose for which you are investing. Investing is ideally done with a financial goal in mind and wealth creation may be one of them.

Asset Allocation
Sticking to your asset allocation will always help you to make your investment journey smoother and generate better risk-adjusted returns in the long run. The goal of asset allocation is to reduce risk through diversification by combining exposures to a variety of investments that have historically performed differently during various market conditions. According to a research study by Brinson, Singer, Beetbower published in Financial Analysts Journal which was again updated in 1991, most of the returns generated by your investment in the long run come from asset allocation and other factors such as security selection play insignificant roles. The graph below shows how different factors impact your investment returns.

Asset allocation is done at two levels. Strategic allocation is long-term asset allocation which is in line with the investor’s risk profile and financial goals while tactical asset allocation is a deviation from this long-term allocation. And it is more in sync with the external factors including market timing.

Strategic Asset Allocation
This is suited for someone who does not believe in active management of his portfolio and has a pre-determined asset allocation or a static asset allocation. In the last one year equity indices have moved up significantly and this might have increased the total weightage of equity part in your overall portfolio. So this may be an appropriate time to book partial profit from equity and align your portfolio to restore original weightage.

For example, your portfolio has only two asset classes, equity and debt, which have strategic asset allocation of 60:40 in equity and debt, respectively. In the last one year the equity part of your investment has generated return of 30 per cent and debt has generated return of 8 per cent. Now your weightage is 64:36 in equity and debt, respectively. In such a case you need to sell roughly 4 per cent of your equity portion and invest in debt to restore the original weightage of 60:40.

Tactical Asset Allocation
Tactical asset allocation is for someone who believes in active management of asset allocation, which changes dynamically. Hence, this strategy is also termed as dynamic asset allocation. Here, the asset allocation changes with changes in market dynamics and economic situations. The goal is to reduce exposure to risky assets when conditions are unfavourable, and increase exposure when conditions improve. There are several approaches to this allocation but value-based strategy is easy to use and can be done by retail investors without much use of any professional service. Under this one can use value metrics to allocate capital to markets that are undervalued.

Typically, the price to earnings ratio of headline index is compared to historical levels. In the current scenario we see that Nifty PE is trading at around 40, which is very expensive compared to its history and depending upon investor’s perception about the risk at this level he can completely get out of equity or book partial profit. Remember that such profit booking may attract capital gain tax and also exit load. Later in this article we will articulate the efficient way to exit from your investments.

Financial Goals
The purpose of investing is not only about the returns but to have enough money to fulfil your financial goals. There will be occasional highs about picking the best fund or beating the market returns in a year. But always analyse your investments with a perspective if they are on the course to achieve the intended goals. And when it comes to goals, all targets are not alike. Different goals require different approaches and have a different time horizon Your different financial goals may fall in the following table.

Once you have decided on your goal the next step is to decide the criticality of the goal. Your upgrading of car does not have the same importance as your child’s education and therefore the latter goal is of higher importance as compared to the former. There are some goals that lie in between. The following table gives an idea about what should be your asset allocation depending upon the importance of the goal and how far is that goal from now.

Equity investment by nature is risky and volatile. In short-term it is very difficult to predict their returns with high degree of precision. Therefore if you have some unavoidable goal such as your child’s education and it is less than five years, you should go for lower equity exposure or even zero and more of debt as returns from a debt fund is less volatile. Nonetheless, in case of some goals that fall under ‘good to have’ or that can be postponed, you can take risk and continue with more equity exposure.

The below table (Criticality of financial goals ) will help you to take right decision on if you should book profit from your equity MFs. For example, you were investing for foreign vacation and you are fortunate enough that current rise in equity market has helped you to accumulate 90 per cent of your planned amount, you can book 100 per cent profit and park your fund in short duration or liquid fund.

Exit Wise
In the equity market, although history will not repeat itself, it may rhyme. Therefore, the current high valuation of the equity market clearly suggests that we should tread cautiously. For investors investing for a long-term goal, they may not be perturbed by such high valuation. However, investors with short-term or near-term goal should start to exit from equity investment. Even those who do tactical asset allocation should exit from equity investment now. The million dollar question is how to exit from equity investment?

No one can time the peak and the valuation can become even more stretched before it comes down. In such circumstances it is better to follow the age old advice to exit through a systematic withdrawal plan (SWP). For planned exits, where one knows beforehand roughly when one needs the money, the thing to do is to start an SWP sometime before your financial goal is about to come. SWPs mean periodic redemption from a fund. There are a number of variations. Investors can either redeem a fixed amount, a fixed number of units or all returns above a certain base level.

They can be used judiciously to withdraw funds from long-running investments. The funds withdrawn can be either invested in short duration funds as they tend to be less volatile and sensitive to interest rate changes or liquid funds. The number of SWPs or time duration to completely withdraw from the investment will again depend upon your financial goal and valuation of the market. According to a study, it has been seen that one year or 12 SWPs gives better returns and lower volatility. Nonetheless, in the current market situation we suggest three to six months an ideal duration.