The Five Lessons of 2018

Markets closed out 2018 in a burst of volatility, capping a year of several yo-yos. Equity and debt markets had a tumultuous 2018, which served to drive home certain basics. Here they are.

 

1. Midcaps and smallcaps are risky

2018 showcased a fact that had been brushed under the carpet for years – that midcap and smallcaps are risky and are not meant for those who cannot handle steep falls. The year reinforced the norm that when markets are in a correction mode smaller stocks tend fall more than their larger counterparts.

In the 2014-2017 period, midcap and smallcap stocks seemed infallible. Consider 2016 – markets across the globe corrected from the second half of 2015. Within the first two months of 2016, the Nifty Midcap 100 lost 15% and the Nifty Smallcap 100 dropped 24%. Midcap and smallcap funds lost 17% on an average. But while sharp, the fall was short-lived. March to October 2016 saw the two indices gain 35% and 44% respectively. Funds in this space rose 35% on an average. This behaviour repeated in 2017. The real pain of a correction was not felt.

But in 2018, the midcap and smallcap segment fell and stayed down. January was the peak and the two representative indices corrected steadily right through the year. There was no bounce back, even as the Nifty 50 and Sensex alternately rallied and corrected throughout 2018. The Nifty Midcap 100 is down 18% from its January peak while the Nifty Smallcap 100 lost 33%. On a weekly rolling basis, both indices have clocked more weekly losses than they have weekly gains in 2018. This has not been the case in the 2013-2017 period. The fall saw the high 2017 returns completely wiped out.

                               

But here’s the good news: while midcap and smallcap funds fell, most have managed better than the indices. On an average, midcap and smallcap funds lost about 3 and 10 percentage points less than the benchmark in 2018. Funds such as Franklin India Prima, Invesco India Midcap, HDFC Midcap Opportunities, Axis Midcap, HDFC Smallcap, Reliance Smallcap, and Franklin India Smaller Companies all showed good ability to limit downsides in the correction.

2. Equity is not for the short term

Volatility made a comeback in 2018; deviation in 1-month rolling returns of the Nifty 50 this year are over 1.5 times more than in 2017. Measured by this metric, volatility in 2018 was higher than years such as 2014 and 2016 as well. The Nifty 50 and the Sensex were strong in January, corrected for the next two months, rose until September, crashed spectacularly over the next two months and were volatile for the rest of the year.

Equity market behaviour was also unpredictable. A recent example is the market reaction to the December resignation of the RBI governor, which coincided with shock state election results. Markets spent one day correcting and bounced back almost immediately, contrary to all expectations. Similarly, factors such as oil prices and the rupee fluctuated right through the year, influencing equity markets in their wake. Finally, global markets were also unpredictable and volatile.

Volatility apart, 2018 showed that short-term is not good for equity especially after a year like 2017. Of the BSE 500 index, 75% of the stocks have ended the year on a loss. Equity funds faltered in 2018 in consequence across all categories. A 1-year or even a 2-year period is not enough for equity investing. Investors who got into the market in 2017 would have seen their gains reversed by the end of 2018. Getting into short-term predictions on where markets will be headed, whether markets are at a low or a high, whether this is a good time to invest or not, would all have been an exercise in futility.

Keeping a 5-year and above horizon for equity is always preferable, and tagging important near-term goals to equity is a strict no.

3. Hybrid aggressive funds are not infallible

Not just pure equity – 2018 reminded markets that hybrid aggressive funds can also fall. These funds are still equity oriented and a steep market wide correction will pull down returns in the short term. Remember that these funds do move across market capitalisations on the equity side and a midcap fall would hurt returns even as these funds shifted to the largecap segment.

While the debt component provides a balance, it would not have been enough to compensate entirely for an equity fall. Funds also tend towards longer-term accrual on their debt side and yield fluctuations hurt too. Therefore, while hybrid aggressive funds are far less volatile than equity and contain downsides much better, they are still liable to fall in a 1-year period if there is a sustained equity market correction. These funds require a 3-year holding period to deliver.

                                   

Those depending on regular dividends from these funds would also have learnt a lesson in 2018. In correcting markets, surpluses are hard to come by. Funds may have also been using the dips to accumulate stocks at cheaper prices. Some funds which were paying monthly dividends skipped a couple of months. Other funds may have kept up their quarterly/monthly dividend payments, but the amount was much reduced.

Should markets continue to correct, dividends could further be affected. Therefore, depending on equity-oriented funds for regular cashflows would not be wise.

4. Higher debt returns don’t come without risk

In other words, do not chase higher debt fund returns without understanding the risk. The failure of an institution such as IL&FS and a credit downgrade from the top rating to default in a matter of days is a one-off event. Downgrades do not always result in default. What the episode did show is the effect of credit risk and rating downgrades on debt fund returns. A drop in a paper’s credit rating results in a revaluation of the market value of the paper, consequently influencing fund returns.

Two, it shows that higher portfolio yields and returns can come about only in the face of higher risk. Where fund yields or fund returns seem higher than peers or the average, this is usually because some level of credit risk has been taken in the portfolio. For example, consider Indiabulls Short Term, which has among the best 1-year returns of 7.4% and a November portfolio yield of 11.7%. About 56% of its November portfolio is in papers rated below AA+, which defines higher credit risk. In contrast, Kotak Short Term Bond, whose 1-year returns are 6.3% and YTM is at 8.7% holds no paper below AA+. Therefore, while one fund may look like it is lagging on returns, it could be because it is less risky. This holds for hybrid conservative funds too.

Three, it spotlighted concentration risks in debt funds. Adverse rating actions have a bigger impact on concentrated portfolios than more diffused ones. Invesco India Credit Risk, for example, suffered a good deal more from the IL&FS fallout than a fund like Aditya Birla Sun Life Credit Risk fund. The Invesco fund had a much higher exposure to the IL&FS group papers than the ABSL fund, and therefore saw a steeper NAV fall post the downgrades. The 1-day fall in NAV after the first downgrade was 0.03% for the ABSL fund and 0.39% for the Invesco fund. NAV drops after the second downgrade were similarly much higher.

A larger fund size also helps, especially in the liquid and ultra short duration categories. A pull out by institutional investors can leave the fund vulnerable while additionally making it harder to meet redemption requirements.

Therefore, where there is no ability to see a drop no matter what the holding period, it is always best to stick to funds that do not take risks.

5. Debt can be volatile too

Debt funds follow either an accrual strategy or combine it with a duration strategy (like dynamic bond funds) when the interest rate cycle throws up opportunities. However, 2018 (in conjunction with 2017) showed that the interest rate cycle can get unpredictable and yield movements can be volatile.

Going into 2018, markets had been building in rate hikes. The Reserve Bank followed through with two hikes. Gilt yields were falling, dropping to 7.12% by around April. Then crude oil prices spiralled, rate hikes in the US continued, the rupee depreciated, and inflation remained. Gilt yields were rising. Then there was a liquidity crunch in the wake of IL&FS. Gilt yields hit the 8% mark and moved lower later on. The end of 2018 was a reversal of the start, with rate cut expectations now being built in with inflation staying low. The graph below shows the movement of the Nifty 10-year Gilt index over 2018, which is influenced by gilt yield changes.

Volatility in debt cannot be ruled out. Betting on rate cycle directions and a duration strategy can backfire. Sticking to an accrual strategy is a better option, especially for the risk averse.

What should you do?

The lessons are not new. 2018 just reinforced them. The steps you need to take are not new, either:

1. Stick to an asset-allocated and category-allocated strategy. This will ensure that you are in line with the level of risk you can and you need to take, based on your goals. It will also ensure that you haven’t gone overboard on some funds – like midcaps, for example.
2. Maintain a long-term view when it comes to equity. Each year, markets find different reasons to move. There will always be bad news and good news. Over time, though, short-term moves get ironed out. Keep return expectations realistic. A 12% CAGR over a 20-year period in equity is the same as buying a piece of land for Rs 20 lakh and selling it for Rs 2 crore.
3. Stick to your SIPs. Don’t lose faith. SIPs cannot give you high returns if the market corrects. What SIPs do is to ensure you are not influenced by short-term movements and invest across market cycles. This will allow you to catch market downs as well as ups and keeps your savings on track.
4. Don’t be afraid of debt funds. credit events like the ones in 2018 are extremely unlikely to repeat. Debt funds always hold the potential to beat FDs and are more tax-efficient. Be aware of the risks in the fund you hold, and stick to the safer options. If you cannot handle volatility of long-term debt funds, stay with short-term high-quality accrual funds.
5. Keep a mix of funds in your portfolio. Not just in terms of different asset classes or categories, but in fund strategies too. This will ensure that if one strategy takes time to deliver, another will prop up returns in the meantime.

It is rare that equity and debt markets both do poorly at the same time. 2018 was a good year to bring markets back to earth and help understand the risks in investing. So, don’t get discouraged by the 2018 market and think long term. Cut out the noise and stay invested!

MORE WILL UPDATE SOON!!