The downside protection myth!

In behavioural finance, it has been proven that people experience the loss of investment more sharply than gains. Therefore, it is obvious that we tend to seek downside protection. However, we also cannot deny the fact that we believe active funds are best in protecting the downside risk than passive funds. Again, this belief is for obvious reasons that active funds can take investment calls depending upon their investment philosophy and so, passive funds need to follow the benchmark index it is tracking.

This leads to the myth that active funds can provide downside protection. This does not mean that none of them provide downside protection. But, finding such fund is difficult. Many a time fund managers do take cash calls. And, taking cash calls is a tough decision as taking a wrong decision can drag your performance. Even we do not know the intent of cash holding. The cash can be held by the fund to tackle redemptions when there is a high inflow and lack of opportunity, etc. This further makes it difficult to choose the right fund with downside protection.

To understand things better, let us put forth some analysis. As we know due to Coronavirus, February 28 was termed as ‘Black Friday’ that witnessed a gap-down open by 250 points and Nifty 50 closed at 11,201.75. On March 5, it closed at 11,269, which is still around 200 points away from covering the gap-down. Therefore, the period from February 01, 2020 to March 04, 2020 would be ideal for our analysis. So, first, we would find out the best performing large-cap fund in the past one year and then compare its performance with its benchmark index for further study. With this, Axis Bluechip Fund was the best performer in the past one year and its benchmark is Nifty 50. It is to be noted that we have rebased the values to one.

Now, if we look at the above graph, then we can see that Axis Bluechip fund underperformed its benchmark in rising time and outperformed in falling times. The reason for the same is cash. As on January 31, 2020 the fund holds 9.8 per cent in cash and its equivalents. This cash position is helping them to outperform its benchmark during the fall. However, it will not work in its favour in the rising market. Hence, here, the key is asset allocation. Now, let us see how dynamic asset allocation fund performs in the same period.

The above graph clearly shows that IDFC Dynamic Equity Fund underperformed when the market was rising and outperformed when the markets are falling. However, its outperformance is not due to cash but it’s due to dynamically allocating between stocks and bonds.

So, from the above graph, we can see that overall dynamic asset allocation fund gives you a pleasant ride during the volatile times and also, truly protects the downside risk by way of asset allocation and not by way of cash calls. Therefore, if you are looking for downside protection, then choose funds that have diversified its assets among different asset classes. Also, you can invest in different funds and diversify your portfolio.