The Mutual Fund Show: What RBI’s Rate Hike Means For Investors

Vishal Dhawan: It is a continuation of what came out in April. The focus away from growth to inflation, especially on the back of a RBI report last week which said that growth impacts of Covid-19 have been so severe that the shock will probably take many years to recover from.

Clearly, it means that inflation is now centrestage from a domestic perspective as well. All of this while, a lot of the conversation around inflation was a sort of global conversation, and inflation in India was still talked about as maybe being under control and driven by supply-side issues.

But the RBI coming in and doing a surprise announcement has brought inflation centrestage. It brought home the point that the war’s impact is not just sitting in Europe, somewhere far away, It's very evident for us as well.

One of the messages that I would take away is that probably the inflation prints going forward are still going to be a reasonable cause for concern, which is why that needs to be sort of seen as at least in line with what's happening globally.

From a debt investor perspective, (there are) at least two or three takeaways that I would focus on. One is to avoid knee-jerk reactions to news like this. While it's tempting to act immediately saying that this is a realisation that inflation is a problem, we need to keep in mind that a lot of investors, in the last few months and quarters, have bought Maturity Targeted Index Debt funds.

Effectively, even though there's a mark-to-market impact that takes place for them, as long as they hold to maturity their impact is not going to be there, because on maturity they will get back what they had expected to get back when they invested.

There is a tendency to move towards equity at these times because debt looks less attractive. But we need to remember that when interest rates move up, equities are also impacted.

That's why you saw both debt market sell-off today as well as equities, and therefore changing asset allocation just because of this may not be the greatest idea.

It will continue to mean that investors may want to be at the shorter end of their debt strategies–liquid, overnight, short-term funds–so that they are able to reinvest back as interest rates keep going higher, and take advantage of the fact that there is an interest rate cycle that has turned and may well continue to be this way for the next few quarters.

Nikhil Kothari: The volatility is likely to continue as the RBI wants to bring rates back to pre-Covid levels. So, we may see another 50-60 basis point overall rate hike over the next two or three quarters.

It is a good time to match your horizon with the funds which actually hold a security maturity. For example, if someone wants to invest for three years, there are Passive Debt Funds which basically invest for three years.

If you're holding the debt funds with maturity, interim volatility is not going to impact you. The good part is that if the interest rate goes up, the coupons which come from the securities will be invested at higher rates, so the effective return after the holding period will be higher. I would rather recommend that people who want to invest in debt funds try to match their horizon with the fund maturity. That's going to be a good strategy right now.

If you want to play the long-term interest rate cycle, wait for some time to invest in funds which are high maturity, because as the interest rate is likely to go up another couple of quarters, you can invest in long-term debt, not now but later.

So, for those with a mature horizon there is the Target Maturity Fund. If you don't have a clear horizon, then be on the shorter end of the curve which will help mitigate volatility.

But there is no point in redeeming money right now. It might show negative returns but if you hold the fund till maturity, you would be able to cover your losses.

Nikhil Kothari: If you look at Target Maturity Funds, they are homogeneous in nature because they are all (invested) more or less in securities. Otherwise, low duration funds or ultra short term funds which have low expense ratio–you should look at those funds as potential investment options currently.

If someone has a one-year horizon, there are funds which basically mature in 2023, so they can invest in those funds. For someone having a three-year horizon, there are funds maturing in 2025-26, so they can look at those funds.

Vishal Dhawan: At the longer end, with the tenor being close to 740 (days), and durations beyond that being even higher, a lot of these fears are probably priced in fairly well. One of the things that investors have learned over the years to do with equity is buy when there is fear.

The same thing needs to get transferred onto debt investors as well. They don't need to start saying that, ‘My bank deposit is more stable at this particular point’. But they should really be saying that, ‘Maybe there's an opportunity that these sort of surprise events are creating for me, and without trying to necessarily time it to perfection, maybe there is an opportunity for me to add to my fixed income exposure because yields are now quite attractive’.

Equity investors have learned over the years to do SIPs. Debt funds are good options from an asset class perspective to also run an SIP, especially when you see yields move up so much.

It's going to be hard for investors to time their entry into debt when you have so much news coming in on inflation, and a lot of this inflation is important. The RBI Governor spoke about the edible oil impact, for example, coming in both from Ukraine and also from Indonesia. As an investor, there are so many variables that you can't control. Why don't you control it through your SIP strategy instead?

Nikhil Kothari: With the interest rate hike, obviously small cap and BFSI funds will get impacted because there will be treasury loss for the banking and financial services industry, and it may translate to lower earnings this quarter. For the small cap, interest cost becomes a larger component of the outflow and then it really gets impacted.

But this volatility is bound to stay for some more time. The idea is that it is a great time to keep on with SIPs, and then over a period of time, the final result, the equity comes from the growth of the company. If you believe that the segment over a long period of time should do good, it's good to hold on to those equity funds.

Nikhil Kothari: It’s not wise to get out because most of the things are already priced in. We have already seen the huge uptick today, and at 7.4%, it is not a bad level from a long term yield perspective. So, you may have some volatility but it's better to stay invested. And if you are doing an SIP, continue with it.

Vishal Dhawan: There are three-four areas. Banking and financial services have already been hit quite hard on the back of FII selling that has happened in the last few months, because the ownership in that sector is so large from the FII segment.

Therefore, we are from a camp which believes that when interest rates move up, banks may not be in a bad place.

While they lose money on the Treasury, they also gain margins because they don't reset the deposit rates immediately, but the loan rates get reset very quickly. Therefore, we think this may actually be good for the PNLs (profits and losses) over a slightly longer period of time.

Having said that, the way the index–especially the Nifty and the BSE Sensex–are built is that because financial services have such a large exposure there already, it's a good idea that investors don't try to do sectoral calls at this particular point. They stay with indexing strategies at the broader level because they will get exposure to banking and financial services by default, coming there from the better players.

As far as market caps are concerned, India's balance sheets have become quite resilient because things have changed. Therefore, we would say you have to take a very company-specific call on interest rate increase impact, rather than try to just do it on the basis of large caps, mid caps or small caps.

The only area of concern for us is that valuations have been premium. Therefore, by default, investors should not run in again saying, ‘Markets have corrected, let me take all my liquidity and put it in there’, because even today, from a valuation perspective, Indian equities are not cheap. Therefore, you would have to stagger your money gradually.

And this interest rate hike is another indicator that gradually things will normalise. Therefore, returns for equity fund investors will also normalise over a period of time.

Raghav Iyengar: We've had a very interesting journey over the last almost nine months. We talked about asset allocation and said that you need to have money in different asset classes–equity, fixed income, gold, etc.

We did a small study on returns in 2021, and within equities, we found that style is one of the biggest parameters of outperformance or underperformance.

Style happens in three different ways: You can break it into, and this is specific to equity–large, mid, small cap–and then sector concentration, diversification, and lastly, the big $100 billion or $1 trillion question of value vs growth. Within growth, you have got another sub-segment called growth investing with a quality bias.

We did a quant study last year and found that 2021 was a brilliant year for value. Surprisingly, growth picked up and caught up literally at the end of the year, especially in the last quarter–October to December. Quality underperformed practically through most of the year, except in May and June where it briefly hit the market and then went back down.

We realised that growth investing does really well when interest rates are benign, when growth is pretty visible. Value does very well when the reverse happens–markets get very volatile and interest rates are going up. Obviously, quality within that segment also tends to do badly. But this was 2021.

So, if you break that up and give it a 10-year kind of cycle, which is typically a good period to see returns, you will find that each of these three asset classes or styles have had their ups and downs.

We keep talking about investors having to have money in different pools of assets to basically get a good investor experience. The same logic applies in style.

Coming to Axis, we are clearly focused that quality is the way we do our investments. The first thing that happens in quality is we like to look at the management team, the track record–not only the financial track record but how they behave with minority shareholders. Then, we like to see the trades of the business, and we do the usual ratios, balance sheet numbers, and all the other things. Typically, we believe that we are owners of the business. So, we are not a trading-based fund, we rather like to buy and hold it.

Most of my partners and customers ask me now that quality has done so badly in 2021, are you looking to turn? I don't think we will, because if you look at the last 10 years, quality actually outperformed seven out of 10. We will stick to what we know best. Obviously, we have added a lot more companies thanks to our filters.

Markets have been very dynamic. Companies have completely transformed themselves, especially post-Covid. A lot of financial ratios have dramatically improved.

Indian companies have a brilliant track record of overcoming adversity, unlike some of our neighbours or counterparts in other parts of the world. Indian companies tend to do well when things get tough. When the going gets tough, Indian companies get going. In that sense, a lot more companies have got added to our investment universe and obviously, we are doing our best there.

But no, there's no plan to shift that and that's the big risk for an Indian investor today because if you try to keep choosing between styles based on recent performance, you may actually miss out on giving your portfolio an edge over the long term.

Most of us tend to just differentiate on value versus growth, or large cap versus mid cap or just asset allocation. Now, people will possibly have to understand that within equities also, you have to have adequate exposure to each style of investing because if you are too overexposed to one style, that could lead to massive periods of under or outperformance. You have to have a mix of assets. You also have to have a mix of styles within your equity space. And Axis, in that sense, will continue to be growth with quality. That’s where we would stand.

Raghav Iyengar: There is value investment and, of course if you have been following Twitter, the biggest value investor is Warren Buffet of Berkshire Hathaway. He is a pundit. Obviously, he's done very well over a long period of time.

But if you go back and look at some of his portfolios over a period of time, they have also had underperformance. So, what investors tend to do sometimes is to get very overly exposed to one particular style of investing. That sometimes can lead to serious underperformance in their overall portfolio.

You may have the right equity allocation. Let's say, I have 50% in equity, I have got that macro right. But if I take the entire 50% and throw it into one particular style, without style diversification, you could have periods of serious underperformance.

It's very important to try and figure out within your equity portfolio what are the various styles of funds that you have. It’s a little difficult to do because you will have to do a little more reading.

If you were to come to Axis, we are upfront telling you that we are a growth with quality style. That's a fundamental pillar of ours.

Get into each scheme and try and figure out with the scheme documents the fund management style. It’s a regulatory requirement. You need to be more educated. So, watching shows, doing some reading or having a good partner who will hopefully take this and be able to distill it and give it to you will help.

Raghav Iyengar: Some part of that has already happened last year. Among the three styles, if you did a small data crunch, value and then growth and then quality–that's been the performance. In fact, quality’s performed even below the index last year. So, that part of life has already happened.

The important thing is what will happen going forward. Typically, quality tends to try and sort of smoothen out periods of volatility. That's what a good quality base does for you. That's one reason why we like quality because you are trying to marry two different objectives.

We need to invest in equity, which is by its very nature extremely volatile. A lot of our investors, especially the retail population, want to curtail the volatility. They want the equity investment, but they don't want this ‘1,000 going to 10’ and then ‘10 going back to 1,000’ very quickly. That frightens or worries a lot of people. I won’t say you can run away from volatility, that's an inherent feature of equity investing, but one way to curtail it is that you focus on quality. Quality stocks tend to be much more stable. I mean, obviously, they make the headlines for 5-7%.

But when you look at it vis-a-vis all other styles of investing, you will find that the drawdowns are much lower.

We're in uncharted territory today. We have a war, an interest rate upcycle, and a lot of uncertainty.

But what tends to stand out, or rather the quality bias, is the companies that we invest in are fundamentally strong companies. These are the companies that normally go through such cycles much more comfortably as compared to say other types of companies. So, we are sticking to that and our investors and partners are sticking with that, and that's the way we will continue.

Raghav Iyengar: On the debt side, we have always maintained something called a ‘barbell approach’. The majority of our portfolio has been invested in low duration assets. A little bit has been slightly on the longer end of the curve–the five, seven-year curve because that's where the yields are quite attractive.

We will continue to be there. In some sense, we have been a bit conservative for some time. I think equity is very bottom-up for us. We will possibly keep analysing what a hike in the interest rates will do, whether companies can pass on some part of it to consumers, and how an interest upcycle will affect demand. Those are the things that the team is looking at right now.

On the fixed income side, we pretty much were expecting something like this. When you look at the macro data, we were thinking that something like this was bound to happen. The external and internal environments were doing that. But I guess that's the way financial markets are today; uncertainty is the name of the game, and expect the unexpected.