Business Cycle Funds: Macro-driven funds that can fall prey to timing risk

DSP Mutual Fund has launched the DSP Business Cycle Fund. Its new fund offer (NFO) opened for subscription on November 27, 2024, and will close on December 11, 2024. DSP joins 16 other funds which collectively manage assets worth Rs 33,325.4 crore.

 

Investment strategy 

Business cycle funds employ a two-step approach to invest in opportunities across sectors, themes, and market capitalisations.

 

“In step one, the top-down approach focuses on macroeconomic indicators like inflation, economic growth, and fiscal deficit to determine which sectors are likely to perform well during specific phases of the cycle. In step two, from the identified sectors, individual stocks are chosen based on a detailed analysis of various financial parameters to ensure alignment with the overarching strategy,” says Chintan Haria, principal–investment strategy, ICICI Prudential Mutual Fund.

 

 

These funds change their sector allocation based on the phase within the economic cycle. “During the expansion phase, they invest in cyclical sectors, while during a contractionary period they shift to defensive sectors,” says Rajesh Cheruvu, managing director and chief investment officer, LGT Wealth India.

 

They invest in large, mid, and smallcap stocks belonging to the Nifty or BSE 500 universe.

 

Flexible, dynamic approach 

Business cycle funds aim to optimise returns by aligning their portfolios with different phases of the economic cycle. “By investing in sectors that tend to perform during various phases — such as consumer staples during a recession or financials and real estate during expansion — these funds seek to optimise returns,” says Ashish Naik, fund manager, Axis Mutual Fund. 

 

Their ability to transition between themes and sectors enhances their ability to outperform. “Once one theme plays out, these funds can pivot to another,” says Arihant Bardia, chief investment officer and founder, Valtrust.

 

They also provide protection against inflation by investing in sectors resilient to price increases, such as commodities. Naik informs that they also employ hedging strategies for protection during downturns.

 

Timing risk 

The success of a business cycle fund hinges on accurately predicting economic cycles, a complex and uncertain task. “Incorrect assessment of the phase within a cycle can lead to suboptimal returns,” says Cheruvu.

 

Concentration risk is another concern. “During specific economic phases, these funds may become concentrated in certain sectors, increasing risk if those sectors underperform,” says Naik.

 

High churn rates and deep drawdowns are other potential risks, according to Bardia.

 

While sector rotation increases volatility, higher management fees, a consequence of active management, could eat into overall returns, according to Naik.

 

Different from a flexicap fund

 

While business cycle funds have a top-down approach and focus on macroeconomic trends to shift sectors dynamically, flexicap funds start with a bottom-up approach. "The former focuses on cyclical opportunities. The latter aims to achieve long-term growth by investing across sectors and market caps, without the influence of macroeconomic cycles," says Haria. Bardia informs that business cycle funds may see more sector rotation than flexicap funds.

 

Do they suit you? 

Business cycle funds are suitable for seasoned investors. “They suit those looking to diversify their portfolios with a macro-driven strategy,” says Haria.

 

First-time investors, those who prefer stable sector allocations, and those averse to volatility should steer clear of them.

 

While diversified equity funds (passive and active) should form part of an investor’s core portfolio, Haria suggests that a business cycle fund can form part of the satellite/tactical play for medium-term opportunities. Cheruvu suggests restricting allocation to them to 10-30 per cent of one’s equity portfolio.