Major market indices like the Sensex and Nifty have hit new all-time highs in the recent past due to continued inflow from foreign portfolio investors (FPIs). Since the earnings growth of Indian companies is still low, this has pushed up market valuations, thereby increasing risk. The Sensex’s trailing 12-month PE is significantly higher than what it was in 2008. Low Sensex EPS, due to huge losses by a few companies, is the main reason for the high Sensex PE. To negate the impact of these losses, we plotted another Sensex PE considering only companies with positive earnings. Though below the 2008 peak valuations, this new ratio is also close to an all-time high. “Market valuations are not cheap now. Equity investors need to be on the safer side,” says Sankaran Naren, ED & CIO, ICICI Prudential AMC.
Smart investors extract higher returns by investing when the market is down and booking profits when the market is up. However, most retail investors do the reverse. To get out of this trap, investors need to link their equity allocation to hard numbers like market valuations. If they are not equipped to do that, an easy way out would be to invest invest in dynamic equity funds.
Sensex PE is significantly high
Risk is high now due to elevated market valuations.
Since most dynamic funds remain invested in a significant amount of debt when the market is at a peak, they are less risky. “Suitability of products like these depends on the risk profile of the investor. Investors can get equity exposure with reduced risk through dynamic equity funds. Therefore, they are suited for investors who are conservative and risk averse. A product like this is also suitable for people who are getting into the market for the first time,” says Chandan Singh Padiyar, Sebi registered investment adviser. Naren, on the other hand, believes the product is suitable for all. “Market and investor sentiments move in cycles. So a strategy that will get people to buy at the bottom and book profits at the top provides a better investment experience. Risk will be lower and the return per unit of risk will be high. This product is suitable for long-term investors, who want to be invested in bull and bear markets,” says Naren.
The stable long-term returns of dynamic equity funds is another plus. Since these move to debt close to market peaks, these tend to underperform pure equity funds during market peaks. However, this averages out in the long term. Despite the fact that the market is close to its all time high, most top performing dynamic equity funds have beaten the Sensex over the last five years (see table).
These funds have given stable returns
Though they underperform in bull markets; they do well in the long term.
Source: Value Research; Data as on 24 April
If you plan to do your asset allocation using such funds, it could be difficult because each fund house follows its own rules of timing and therefore, the equity exposure will be different. So, pure hybrid funds will be more suitable for investors who want to do asset allocations blindly. “Most retail investors start SIPs in equity mutual funds like an RD and then continue for years without even bothering to check the status of their investments. Ideally, they need to check their asset allocation and rebalance it regularly. Dynamic funds only reduce the problem and not remove them. If you want fully automated asset allocation, go with a pure hybrid fund, where asset allocation happens automatically,” says Padiyar.
Investors of these kinds of funds should be aware of the taxation. This is because some of the funds are fund of funds. Though some tax parity was introduced recently between equity funds and equity funds of funds—where the underlying equity fund holdings are more than 80%, this may not be of much use to dynamic equity funds.
This is because their equity funds holding can go significantly low at market peaks. In such circumstances, they will get clubbed with debt funds for taxation purposes. However, the fund of funds structure gives investors one advantage. Being a mutual fund, it can shuffle investments in other schemes without any tax incidence. If the investor is doing it himself, he has to pay tax for all these re-allocations. Since there won’t be any tax incidence till the fund of fund is redeemed, it will help investors compound their wealth without any interruption. To avoid fund of funds taxation rule, other schemes usually keep the equity exposure above the mandatory 65% or maintain cash holding above 65% and bring down ‘effective equity holding’ using futures. This means they remain pure equity funds for taxation purposes.