The Mutual Fund Show: How To Build A Defensive Portfolio

Nisreen Mamaji: Typically, in the current situation, RBI has just increased the repo rate by 50 basis points, currently it is about 5.9%. What happens is that the RBI is trying to control inflation and the target is about 4% for the next two-year period. Currently, it is about 6.7% to the year end. This is a period when you know, the interest rates are very volatile. In this situation, debt mutual funds will typically face interest rate volatility and there is an inverse relationship between interest rates going up and the yields going down.

Debt mutual funds have two types of risks, either they have a default risk where the principal or the interest is not payable, or they will have an interest rate risk, which is what the current situation is, and therefore, they are not in favour, you know, investors will feel a little uncertain in this period.

So, good alternative would be the target maturity funds, which are passive funds, and they will just recreate the index or the ETF to which they are benchmarked, which would normally be a sovereign bond, or it could be a Nifty SDL- State Development Loan or a Nifty PSU. So, in this situation, whatever the maturity of the issuer, will be the maturity of the target fund.

The target maturity fund is a passive fund, it will be an open-ended fund, but these interest rate risks will be contained in this situation. So, typically, it is a passive fund, the maturity will be linked to the underlying you know, index or the ETF and it will replicate that. So, the bonds in the portfolio are held to maturity and all interest payments which are received during the holding period are reinvested into the fund.

So, it's a good alternative to the debt mutual fund for an investor whose risk appetite does not permit him to invest in any other asset class and he wants to be in a debt mutual fund and understand the yield that he will get without having any volatility.

Juzer Gabajiwala: As Nisreen rightly put it, there is an inverse relationship of, you know, debt funds vis-a-vis the interest rate movements currently. So, currently we are seeing interest rates going up and because of the mark-to-market, all the debt funds return will be showing negative.

So, an ideal time actually for a person to enter a debt fund is when we know that interest rates have peaked out. But at every point of time, there is always an appetite for investors who want to be conservative, and they are always looking at, you know, parking funds for fixed tenure and typically when you want to do a fixed income instrument, you don't like to see any changes in the returns, even though it is also only on paper.

In that sense, target maturity funds are a good option. They are something like an open-ended fixed maturity plan is what I put it for a layman understanding, we know that the instrument is fixed. So, when you have an option to keep on exiting at any point of time, right, but you know that if you hold this to maturity, this is the return you entered today, so, net of that is what you will get in return.

If you hold it for a four-year, ten-years of the instrument, you know, you have to hold it for that time period, but it gives you a liquidity option which was not available in fixed maturity plans. You had to hold those close ended. So, here if you exit out, obviously, you are exposed to the interest rate movement. So, one thing is that you do have a duration risk, but as the duration keeps on approaching towards maturity, then your duration risk also keeps on going down.

Juzer Gabajiwala: We have now suddenly seen in the last one year there is a huge traction of target maturity funds. So, what was the AUM (assets under management) somewhere around Rs. 5000 crores and now suddenly shot up to around Rs. 55,000 crores. We are seeing a lot of different types of things as you know, where some of them have only preference towards government securities.

So again, it all depends upon the investors’ appetite because investors don't like to take credit risk. In fact, nobody would like to take a credit risk. The interest rate risk is inherited, means you cannot avoid it, it's more of a global scenario. But if somebody is extremely conservative, then you would look at only G- Sec type of a portfolio, otherwise as Nisreen was mentioning, you have an SDL- State Development Loans, PSU bonds are also there.

Depending upon what is happening and how much the return keeps on increasing because the PSU bond will yield a better return than typically a G-Sec. So, the return will be most likely better of those funds.

So, you can have target maturity fund could have a return of nearly up to, net of expense I am talking, around 7.3-7.4% is what they can go up to, net of taxation, like if a person typically holds for three-years plus with the benefit of indexation and it will knock out 10% of the return. So, 7.3% minus 0.7% will be 6.5% is his post tax return and that will end up comparing with what investor is getting in the current market scenario. You know, which other instrument is giving him 6.5% post tax! So, the only downside here is that if somebody wants cash flow, as income from like a fixed deposit, you get regular cash flow. The regular cash flows don’t work out here.

Nisreen Mamaji: I am sorry to interrupt. The expense ratio is also quite low in the target maturity plans for a direct option that will be 10 to 20 bps, for a regular option it will be 20 to 40 bps. So adding to what Juzer said, besides the taxation you also look at net YTM (Yield to Maturity) which is less of expenses. There also, you know, it would have a USP to the alternatives

Nisreen Mamaji: So typically, you know, you would just go with an asset management company that you are comfortably investing your funds with. So right now, ICICI Prudential had a few launches of target maturity funds and I think they have managed to garner a good amount of AUM also, and, you know, because their fund manager is typically doing a great job on some of the other options we expect as far as the process is concerned. The product and the AMC will deliver.

Juzer Gabajiwala: When people see a lot of volatility in the equity market, and we have a lot of negative news and I always say in the markets, fear is always sold. Every time you will have news which is negative and negative things sell much more than the positive unfortunately.

For a defensive portfolio, what I would recommend is either look at kind of balance advantage fund. It is a good category, is something where it can help them look at the fund houses which have got a typically good size. However, in this particular model, you need to also study a bit more, because you need to understand what models are there.

For example, you had ‘Edelweiss Balanced Advantage Fund’, it typically follows a pure trend base. So, they have a trend base what they follow, and they have defined a strategy of doing it, as compared to what we used to have previously ‘HDFC Prudence Fund’, which has now become 'HDFC Balanced Advantage Fund', which was managed by Prashant Jain who has done a wonderful job.

They have changed the fund manager, but they follow more of a static model in terms of the fund manager will decide. So, the asset allocation is decided by one of the fund managers, equity is managed by one person and the debt is managed by somebody else. So, as you know, you are coming down to the percentage of the equity which is dynamically being allocated. So, I think this is a good product specifically for investors who want to be aggressive but have suddenly wanted to be defensive in the current market scenario.

Typical return expectation over here in terms of expectation should be around 10-11%, is the expectation what individuals should have. If you get more than that it's a bonus, and off late these have been you know, if you see typically see these funds move their equity exposure from 30% to 80% and they manage it to the arbitrage so that they retain the equity taxation, so you have the benefit of an equity taxation. So, you would pay 10% for being long-term, that is just 10% tax, like any other equity fund, and I am sure we will also be able to manage inflation, if it is around maybe even 5-6% then you are at least getting slightly better inflation-adjusted return. You will not see that much volatility as much as you will see in equity funds.

But I personally like this category for investors and if they want to get more defensive then you keep on reducing the equity exposure. Ultimately, what asset allocation and what volatility an investor is able to manage, is a call they have to take.

Juzer Gabajiwala: This is what we have picked up as these are the top five which are popular in the market in terms of AUM. So, that's what we have taken into account and ultimately, what becomes popular- where the returns are good and when they are managing it well, It tends to become popular, that's why the size is there.

We have to see how ‘HDFC Balanced Advantage Fund’ will get managed now because there's a change in the fund manager. I mean, you had a fund manager managing it for more than 25 years and he has given alpha even above the Nifty in that time. Okay, so the fund has outperformed Nifty with 65%-odd equity, that really talks very good for the fund. But obviously now we need to see going forward what happens with the new fund manager.

Investors nowadays are also reading a lot, hearing a lot, a lot of advice comes from the internet, so when they keep on asking us questions, then we need to tell them, so you need to give them that this is the model they are following, something which they should be ultimately comfortable with.

Nisreen Mamaji: So, see typically right now, because of the geopolitical unrest and the spiralling inflation in developed countries, this has had an adverse effect on our equity markets. Having said that, you can be in equities if your period is longer and as I just said, this lady is interested in investing for about five years. So, we have a couple of strategies that we suggest.

One is the dynamic asset allocation category, which I think that Juzer has already aptly explained. So, besides HDFC, which has an equity component of about 68% right now. We are also recommending the ‘Nippon Balanced Advantage Fund’, which has an equity of 41%, debt of 30% and arbitrage of about 29%. A one-year returns of the entire BAF (balanced advantage fund) category hasn't been good. But if you look at about the three-year category, this is delivered about 11.13% and a five-year CAGR is about 8.5% for Nippon, but in the last one year because of the lack of opportunities in the arbitrage segment as well, the entire BAF category hasn't performed well.

So, another also a good option for the dynamic asset allocation category would be like an asset allocator fund of funds. So, we are recommending the ‘ICICI Pru Asset Allocator’ which is invested 30% in equity and 58% in debt. So that also gives us a very good, you know, option because it has gold of about 12% as well. So, these three investment category options would ensure that the return expectations are met.

In the last one year again, the CAGR in six-months has been about 2.6%, one-year is 4.3%, three-years is 12.8% and the five-year category is about nearly averaging 11%. But this asset allocator would have a debt taxation because it belongs to the fund of funds category, so you know automatically you will be invested for three years, and you will have the benefits of indexation.

Another interesting category is a multi-asset category, which will include perhaps international equities, it could include gold, it could include rights, there you know, we are recommending the ‘HDFC Multi Asset Fund’, currently the position is about 55% in equities, 12.5% in debt, arbitrage is 12.5% and 11% gold.  So, this will give you exposure to various asset classes and therefore for the defensive strategy you are not dependent entirely on one asset class, which you know would be risky at this point of time.

Now, as you said her tenure is little longer, then there we can also recommend certain defensive strategies and equities itself. A value strategy is very much in favour right now because in this kind of a situation the value categories, you know, in the next couple of years we expect it to perform well, also, we can get defensive category like an FMCG or a dividend deal category.

So, in dividend deal, we recommend ‘ICICI Pru Dividend Deal’ and in FMCG also we are recommending the ‘ICICI Pru’ where returns have been in the top five. So, if your tenure is longer, you can look at 100% equities and the defensive sectors would be what I mentioned earlier.

Nisreen Mamaji: Those are typically defensive strategies. So, if you are looking at a longer tenure, you are open to some amount of volatility. If your risk tolerance would allow it then yes, of course, you can be looking at the value category which is expected to do well in the coming three to five years.