The reason you must hold on to equity funds despite turbulence in 2023

If investors exit the market now, they could be left on the sidelines when a sustained recovery begins

After two years of blockbuster returns in 2020 and 2021, most categories of equity mutual funds have given single-digit or negative returns in 2022. Equity markets’ lacklustre performance may continue for some time in 2023 as well.

Investors may, however, draw solace from the fact that equity funds in India were spared the carnage witnessed globally. “Global challenges like higher inflation and interest rates, higher energy costs due to the Russia-Ukraine war, and growth concerns across US, Europe and China impacted equity sentiment. Global investors reduced equity allocations leading to sharp correction across key markets globally. The Indian market, however, displayed remarkable resilience amid this global correction and was among the year’s better-performing ones,” says Sailesh Raj Bhan, deputy chief investment officer (CIO)–equity investments, Nippon India Mutual Fund.

Large-cap funds: Better suited for turbulent times

Large-cap funds (regular) have given a category average return of 2 per cent year-to-date (YTD) in 2022.

The global environment remains challenging. The longer these headwinds continue, the greater could be the impact on India’s growth possibilities.

“In such an environment, investors would be better off having a higher exposure to large-cap funds, which tend to be more resilient. Large-cap funds focus on market leaders and established businesses that have successfully navigated different market cycles. Hence, these businesses appear well placed in the current context of robust domestic growth possibilities and a weakening global macro-economic environment,” says Bhan.

One trend that has been predominant in the large-cap category is the inability of a large number of active funds to beat their benchmarks. “On an average, we have seen that 60 per cent of the average large-cap fund’s portfolio is similar to the index. With a differentiated portfolio of only 40 per cent, these funds find it difficult to cover the expense ratio of these funds and also provide outperformance,” says Arun Kumar, head of research, Fundsindia.com.

In future, these funds will either have to reduce their expense ratios, or build more differentiated portfolios. “A differentiated portfolio, however, will lead to periods of both high out- and underperformance vis-a-vis the benchmark. The smoothness in returns, a hallmark of the category, could be lost,” says Kumar.

In view of these factors, he says, there is a compelling case for going with an index fund or an exchange-traded fund in this category.

Mid-cap funds: Earning downgrade, valuation hurdles

After two blockbuster years—23.6 per cent category average return in 2020 and 43.8 per cent in 2021—mid-cap funds turned in a lukewarm performance of 2 per cent YTD in 2022.

The Nifty Midcap 150 Total Return Index (TRI) has given a return of 4.1 per cent YTD. Fund managers say even a small positive return is an achievement in the current environment.

“One reason is that the mid-cap index is focused more on sectors focused on the domestic economy, like consumer durables, capital goods, banking, etc. These have gained from the ongoing recovery in the domestic economy,” says Niket Shah, senior vice president and fund manager, Motilal Oswal Asset Management Company.

Shah expects the mid-cap index to correct over the next six months. “The primary reason for this would be earnings downgrade. In the previous quarter, 65-70 per cent of the companies in the mid-cap index reported earnings downgrade. This will continue even in the current quarter. Inflation will take a toll on the growth of many companies,” says Shah.

Premium valuations could also act as an impediment. “The mid-cap index is trading at 24x one-year forward earnings, according to our calculations, is much higher than the five-year average of 21x and the 10-year average of 18.5x,” says Shah.

In the second half of 2023, if inflation cools and central banks across the globe, including the RBI, begin to cut rates, mid-cap funds may revive.

 Small-cap funds

After earning category average returns of 30.4 per cent in 2020 and 62.6 per cent in 2021, the small-cap category has been able to eke out a return of only 0.02 per cent YTD in 2022. “The overall market is undergoing a period of consolidation with single-digit return, and the small cap segment is no different,” says Chandraprakash Padiyar, senior fund manager, Tata Mutual Fund.

The category could continue to face headwinds in 2023. “Global growth is likely to slow down in 2023. This will surely have some impact on the Indian business environment. The outlook for the overall equity market in the near term is range bound with a negative bias. Though the valuations within the small-cap category are reasonable, its performance is likely to be similar to that of the overall market,” says Padiyar.

One silver lining is that the segment’s earnings growth outlook remains decent. “If the market corrects sharply, it will provide opportunities for long-term investors like us to deploy additional capital,” adds Padiyar.

Stay invested despite volatility

Many investors believe 2022 was a very volatile year. “If you look at the Sensex from its inception, an intra-year fall of 10-20 per cent happens almost every year. Only in three or four years of its existence has the Sensex fallen by less than 10 per cent,” says Kumar. Investors entering the equity markets should be prepared for volatility.

Similarly, wars, high inflation, etc have also happened in several years in the past.

Many investors want to exit the market when it is volatile and re-enter it when it begins to move up. Such timing is extremely difficult to pull off. After a bad patch, there are many false rallies prior to one that sustains. The market also tends to move up while the news flow is still negative. Investors who exit the market in volatile times risk being left behind when it recovers, so it is best to stay invested.

In 2022, funds having a value/contra style performed better than those following the quality or growth style. In 2020, it was the opposite. “Don’t move from quality funds to value funds now. It is very difficult to figure out which style will do well at what point. If you pick a style which has been known to do well across the world, stick to it for 7-10 years,” says Kumar. Also, diversify across styles.

Maintain a 15-20 per cent exposure to international funds and a 20-30 per cent exposure to mid- and small-cap funds despite their poor performance this year (if risk appetite permits).

Finally, rebalance your portfolio if the asset allocation of various categories has deviated from your target asset allocation by more than five percentage points.

How funds did in 2022: Managers explain

Large-cap category

“Nippon India Large Cap Fund follows the sustainable growth at reasonable price style of investing. The fund is benchmark aware but not benchmark constrained. It adopts an active stock selection approach. There was a meaningful overweight allocation to themes which could potentially benefit from past policy reforms and normalisation of the economy, like large banks, manufacturing/capex and discretionary consumption. All these themes contributed to the fund’s performance.”

Sailesh Raj Bhan, Deputy CIO–Equity Investments, Nippon India Mutual Fund

Nippon India Large cap Fund YTD return: 10.9 per cent

Category average YTD return: 2 per cent

Mid-cap

"Last year, we were overweight on information technology, cement and pharma. These sectors were trading at premium valuations, so we moved out of them and went overweight on banking, consumer goods and capital goods. This benefited the fund significantly. Moreover, many of the stocks that we picked in our portfolio over the past couple of years have turned out to be multi-baggers."

Niket Shah, Senior Vice President and Fund Manager, Motilal Oswal Asset Management Company.

Motilal Midcap 30 Fund YTD return: 10.5 per cent

Category average YTD return: 2 per cent  

Small-cap

"Good stock selection helped the fund deliver better performance. We are focused on identifying smart managers who can deliver high cash flow growth on a consistent basis. We also focus on reasonably valued stocks." Chandraprakash Padiyar, Senior Fund Manager, Tata Mutual Fund.

Tata Small Cap Fund: 6.2 per cent YTD return

Category average YTD return: 0.02 per cent