Did mutual funds anticipate sideways market?

The objective of BAFs, which gained prominence in India from 2020, is to protect the downside risk in times of market volatility and to participate reasonably in the market upside. In India, there are about 28 BAFs with collective AUM (assets under management) of ₹1.87 trillion.

From October 2021, when Indian markets peaked, till date, BAF schemes on an average delivered 3% absolute return. This is impressive, compared to the -1.5% and -3% returns generated by broader market index Nifty 50 and category average of flexi-cap funds, respectively.

Most BAFs in India use counter-cyclical dynamic asset allocation models. In this model, the focus is on the valuations of the market measured by either price to earnings ratio, price to book (P/B) ratio or other similar metrics. If the market valuations are low, the model allocates higher portion to equity and lower to fixed income, and vice versa. ICICI Pru BAF follows this model to determine allocation between equity and debt.

Some BAFs, including Edelweiss BAF, use pro-cyclical allocation models or a momentum-based model. These invest more in equity during the bull market and bring down the allocation during a bear market.

There are also a few funds which use a hybrid model. Most BAFs maintain more than 65% gross exposure to equity to get the benefit of concessional equity taxation compared to debt funds.

This story looks at the performance of some of the largest BAFs (with a long track record) during recent key market events such as the March 2020 correction and the period between October 2021 till now.

HDFC BAF: Higher equity exposure

HDFC BAF has been the top performer in this category both on trailing returns and rolling returns basis (See graphic). This could be partly attributed to a higher equity allocation compared to other funds in the category across time frames. As a result, the HDFC BAF had also fallen the most, almost equivalent to the extent of market’s fall during the March 2020 correction.

Experts in the industry suggest that the ‘value’ style followed by the fund house has worked well in the current market favouring value stocks. With an AUM of ₹52,079 crore, it has been the largest scheme in terms of size in the category.

The fund takes in to account valuations and macros to decide on the asset allocation. Within valuations, which is the core metric for the fund, the team focuses more on two variables—trading price to earnings (P/E) and earnings yield to bond yield ratio.

ICICI BAF: Better downside protection

ICICI Pru BAF is the second largest scheme in the category after that of HDFC. The fund determines the equity allocation based on what the P/B metric indicates. “P/B is not very cyclical and has been a good leading indicator based on our experience of 13-14 years of running the model," said Chintan Haria, head-investment strategy, ICICI Prudential AMC.

The fund has maintained a reasonable allocation to equity across time frames. It comes in the top quartile of funds in terms of performance in the category. While it hasn’t been the top performer in the category, it has protected the downside better than HDFC’s. Between January 2020 and April 2023, the fund has a downside capture ratio of 44, which means the value of the fund has fallen by just ₹44 compared to its benchmark’s fall in value of ₹100. ICICI BAF has been placed better in terms of downside risk among some of the large funds in this category with long track record.

Edelweiss: pro-cyclical

Edelweiss BAF is among the few funds that follow a momentum-based model to decide asset allocation. One drawback of the model is that it doesn’t perform well in the sideways market.

On asking why the fund has chosen this model, fund manager Bhavesh Jain said the model has a higher probability of getting the markets right. “In a trending market (bullish or bearish), the momentum-based model works well. In a sideways market, the valuations model outperforms," Jain added.

All this has reflected in the stark difference in the performance of the fund in two consecutive calendar years—2021 and 2022. In 2021, when there is buoyance in the markets, the Edelweiss BAF delivered about 19% compared to category average of 13.5%. But, in 2022, when markets witnessed a dull year, the BAF delivered just a 2.1% return and underperformed the category average of 3.5%.

The fund scores well based on the downside capture ratio metric as mentioned above. Note that, while asset allocation is based on momentum model, the fund house sticks to ‘growth’ style for stock-picking.

Nippon India BAF: hybrid model

Nippon India BAF follows a multi-disciplinary approach for dividing the portfolio between equity and debt asset classes. The fund house follows a hybrid model, combining both the valuation and the momentum models.

“The reason we added the momentum model is because, at the end of the day, we believe that the wisdom of crowd or the market is supreme," said Ashutosh Bhargava, fund manager of Nippon BAF.

On a rolling-return basis—between April 2016 and April 2023—Nippon’s BAF managed to be in the first quartile of the category in terms of five-year returns. But in the short-term, the fund has had a mixed performance. The fund is positioned well in terms of downside capture ratio during the period mentioned above.

What do experts say?

“Those who want lower volatility with reasonable growth of the portfolio, investors with medium term investment horizon of 3-5 years and willing to have exposure to equity and those in the post-retirement phase with 15-20 years runway ahead with requirement of periodical income—these are the investors BAFs are most suitable for," said Harshad Chetanwala, a registered investment advisor.

Vishal Dhawan, another investment advisor, said that a “combined portfolio with different models could help in navigating the market volatility better."

(For an extended version of this story, go to livemint.com)