An interesting Mutual Fund – Part 1

When one invests in the stock market, historically one would agree that equities invested over long periods of time have given good returns over a long period of time (take any period of 5 years, 10 years), and well-managed diversified equity schemes offer an easy and convenient access to this asset class and provide good returns. However, one will always be asking questions given below at the back of the mind (irrespective of the market conditions – when it is bullish or bearish)

• Should I book profits now or atleast partially book profits?
• Should I enter the markets now or atleast enter the markets partially ?
• How much should be in debt and how much should be in equity ?

To ally the above fears, some investors invest in balanced funds that have a mix of debt and equity component (Typically between 60 %and 70 % in equity and between 40% and 30% in debt). Thus at all times the fund tries to balance the amount of equity and debt component to the above percentages.

While, the balanced funds do this well, one must look whether this is the right thing to do for a savvy investor. Let us introspect a bit into this and see if the approach and practice is correct and logical.

Today the sensex is close to 15000 (close to all time highs for the stock market). Let us take a balanced fund that was launched when the sensex was 10000 (say about an year ago). At that time let us say that one invested Rs 100 in a balanced fund (70% in equity and 30% in debt). Simplistically the equity component would have gained 50% (assuming that the equity investment gave market returns) and let us assume that the debt component would have given say 8%. Thus logically the Rs 100 that was invested would be worth (70*1.5 + 30*1.08) = Rs 132.4 (with equity contributing to 79% and contributing to 21% of the value). Thus the MF now to maintain the balance of the equity and debt component (in the ratio of 70:30) will sell equity and invest into debt thus bringing back the ratio between equity and debt (say again to 70:30 ratio). Had the sensex reached 5000 instead of 15000 the MF would have had more debt component and less of equity component and the reverse would have happened.

All is good so far and one can argue that this is a good technique to maintain the balance between equity and debt. But there is a catch here. Is it prudent for the MF to sell some equity when the sensex is 15000 just to balance the portfolio ? or stick to the ratio of the equity and debt component that was mentioned in the prospectus ?.

This is where the valuation (measured by the P/E ratio which is the ratio of the price of the stock by the earnings per share) comes into picture. One should not see the absolute value of a share/index and assume that a stock that is Rs 200/share is cheaper than a stock that is Rs 2000/share. One should look at the value of the share than the price of the share. It is like saying that ½ kg of washing powder at Rs 50 is cheaper than 1 kg of the same washing powder at Rs 90. Obviously the 1 Kg of washing powder is cheaper than the ½ kg when u compare the price per gram. Similarly, because the sensex is at 15000 does it mean that valuation is high and just because the sensex was at 10000 does it mean that the valuation is low. For all you know the valuation of the index at 15000 could be lower than the valuation at 10000 and hence it could be better that one has more equity component when the sensex is 15000 than what it was when the index was 10000.

To put in a simpler language, the amount of equity and debt that one should have must depend on the valuations of equity and debt and not based on a pre-determined ratio between equity and debt.

In the next part, I will share with you an interesting fund that addresses some of the pitfalls that I think exists with the theme of the traditional balanced funds and practices. Talking about this fund is purely my opinion and was interested in the concept of the fund and thought I will share it with you.