Price corrections: Immediate impact of market drops on mutual funds decoded

Equity markets have long been subject to cycles of growth and contraction, often triggered by global events that lead to sharp declines in asset values. From the Great Depression of 1929 to the COVID-19 pandemic in 2020, these downturns have left investors grappling with the question of how to navigate these financial storms. A recent analysis by Ventura Securities sheds light on a critical aspect of this challenge: drawdowns and the performance of mutual funds during market downturns.

 

 Drawdowns: Price and Time Corrections

 

A drawdown is a key metric that measures the difference between the highest value of an investment and its lowest point after a decline. Essentially, it indicates how much an investment has lost before it begins its recovery and how long it takes to return to its peak value. Drawdowns consist of two components: price corrections, which reflect the fall in value, and time corrections, which describe the time taken for the investment to recover.

 

 

Price Correction: The Immediate Impact of Market Drops

Price corrections occur when the value of a mutual fund or stock falls from its peak. These declines can be unsettling, but for mutual funds, they are often temporary, especially compared to individual stocks. For instance, during the COVID-19 pandemic, the Indian equity market witnessed some of its steepest falls.  Ventura’s study highlights mutual funds that experienced significant drawdowns between January and March 2020, particularly those in large-cap, mid-cap, and small-cap categories:

 

Large Cap: Nippon India Large Cap saw a 32.3% drop

• Mid Cap: ICICI Pru Midcap dropped by 32.0%
• Small Cap: Aditya Birla SL Small Cap fell by 34.3%

On the other hand, some funds saw more moderate declines:

 

• Large Cap: JM Large Cap Fund saw a 11.9% drop
• Mid Cap: Axis Midcap dropped by 18.0%
• Small Cap: Bank of India Small Cap fell by 16.1%

 

The difference in drawdown percentages reflects the varying degrees of market volatility and the resilience of different mutual fund categories.

 

Time Correction: Recovery After the Fall

 

While price corrections are jarring, mutual funds tend to recover from them over time. Ventura’s analysis  delves into the recovery period—the time it takes for funds to regain their previous peak values.  The study shows that funds with smaller declines generally had faster recoveries:

• Large Cap: JM Large Cap Fund recovered in 4 months
• Mid Cap: Axis Midcap bounced back in 4 months
• Small Cap: Bank of India Small Cap saw recovery in 3 months

On the other hand, funds that experienced steeper declines took longer to recover:

 

• Large Cap: Nippon India Large Cap took 9 months
• Mid Cap: ICICI Pru Midcap recovered in 6 months
• Small Cap: Aditya Birla SL Small Cap bounced back in 7 months

These recovery periods highlight the varying resilience of mutual funds and underscore the value of staying invested during market corrections, especially when recovery follows a predictable pattern.

 

 

There have been 4 times in the past 30+ years that the Indian equity market had a steep fall

• The global financial crisis in 2008 was the one with the steepest fall and it took 2 years for the equity markets to recover. This recovery period is an example of time correction, where the market eventually returns to the level before the fall.
• Harshad Mehta Scam (1992),
• Dotcom bubble (2000) 
• Covid Pandemic (2020). 

 

One of the great advantages of a mutual fund is that it is always flush with funds as new investors put in money, which allows them to buy stocks when markets are down. Also, they do not have the hangover of impact costs, as being a pass-through vehicle, it does not have to pay any capital gains tax; in contrast, in the case of a direct stock this tax is applicable. Essentially, mutual funds do not pay capital gains tax on their buying and selling.

 

For example, an investor holds a stock, Alpha, which is initially worth Rs 1000. Let’s say its price drops to Rs 500. She also has another stock, Beta, initially valued at Rs 100, but now valued at Rs 200. If the investor wants to buy more of Alpha after the price correction, she has two options; either invest additional money or, in the event of a lack of funds, sell Beta. However, selling Beta could potentially attract an impact cost in the form of capital gains taxes.

 

Another distinction is that a mutual fund never experiences a permanent drawdown and it does eventually recover but at times if you have invested in a bad stock, you can incur a permanent drawdown, i.e., the stock may never recover (examples being Kingfisher Airlines, Jet Airways, etc.).

 

Ironically, a fall in prices will typically be swift and sudden, while recoveries are likely to be slow and painful, much like the experience of going down the stairs, which is easier than climbing up. When a stock price falls from Rs. 100 to Rs. 50, it is a 50% fall; the same stock to recover now has to go up by 100% to reach the same level.

 

"We have seen that both price and time corrections play a crucial role in market cycles. All you have to do is remain patient. Although market corrections can be unsettling, history shows that markets do tend to recover over time," noted the study.