Avoid sector, thematic funds; stick to diversified equity offerings

Many retail investors, who are experiencing their first bear market, are shocked at the erosion in the value of their mutual fund (MF) portfolios.

The pain is especially acute for those who had taken excessive exposure to sector/thematic and small-cap funds.

Even international diversification has failed to stanch the bleed in this downturn.

Steep fall in sector/thematic funds

Among sector/thematic funds, technology (tech) funds are on average down 23.4 per cent year-to-date (YTD), while health care funds are down 15.7 per cent.

Each sector/theme follows its own cycle. Periods of outstanding performance are followed by deep slumps.

To make money, an investor must be able to time his/her entry and exit well.

“Most retail investors lack the knowledge, research capability, and temperament to pull this off,” says Arun Kumar, head of research, FundsIndia.

An investor who enters these funds when past returns are looking good is setting himself/herself up for disappointment as the sector/theme would already have experienced its good run and may be headed for a downturn.

“Most investors should avoid sector/thematic funds altogether and instead stick to diversified equity funds, where the fund manager takes the call on when to enter and exit various sectors,” says Kumar.

Little protection from foreign funds

International funds have also failed to provide downside protection in this downturn as the US market has fared worse than the Indian market.

Investors, too, have made a crucial mistake.

“Most of the investment in the US market went into a tech-heavy index like the Nasdaq-100 instead of a more diversified index like the S&P 500.

“Investors could also have invested in funds diversified across geographies,” says Vaibhav Porwal, co-founder, Dezerv — a wealth-tech firm.

Investors should continue with their exposure to international funds nonetheless.

They had entered these funds for geographic diversification.

The expectation wasn’t that the US market would outperform the Indian market each year.

“There will be certain years in which the Indian market outperforms, and vice versa.

“By taking exposure to both geographies, you are trying to make sure you don’t have to time your entry and exit from each of these markets.

“Instead, you take exposure to both and enjoy a smoother journey over the long term,” says Kumar.

Small-cap funds are less resilient

Small-cap funds have declined 12.3 per cent YTD on average.

When small-cap funds are outperforming and their past returns are looking good, many retail investors tend to buy several of them.

During a bull run, they fail to book profits and rebalance their exposure to this category.

They become overexposed to what is inherently a volatile category.

“After experiencing this correction in small-cap funds, investors should decide whether they have the risk appetite for investing in it.

“Then, they should see if they have an investment horizon of 10 years or more.

“If both these conditions are fulfilled, they should continue with an exposure of up to 10-15 per cent of their equity portfolio (5-10 per cent in the case of investors with low-risk appetite),” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

If your fund has underperformed

In each category, some funds have managed to provide better downside protection than others.

YTD, for instance, ICICI Smallcap Fund has declined 4.9 per cent, while the HSBC Small Cap Fund has declined 22.7 per cent.

Experts say this doesn’t necessarily mean you should jump from the underperformer to the outperformer.

“Different funds follow different styles. Hence, they outperform in certain market cycles and underperform in others.

“Over the past year, value-oriented funds have done better than growth funds,” says Porwal.

Kumar suggests investors should assess performance over a longer horizon of seven to 10 years before deciding to exit a fund.

Finally, according to Dhawan, investors should stick to their asset allocation and do periodic rebalancing.

This could mean investing more in equity categories where they have become underweight.

They should also continue with their systematic investment plan/systematic transfer plan.

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