Don't raise allocations just yet

This current rally has been completely driven by FII buying. Most domestic institutions have been net sellers or have cautiously sat on the sidelines. As a result, there has been a peculiar effect on mutual-fund returns.

In September, while the Nifty rose 11.5 per cent, other broad market indices also registered similar strong positive performances. But, according to a study by Value Research, 275 funds out of an universe of 303 actively diversified equity funds underperformed respective benchmark indices.

This means retail investors using the active mutual-fund route were ‘badly’ served by fund managers. There were a couple of important reasons for this poor showing. One was abundant caution. Many funds are carrying high cash allocations because they think current valuations are too high for comfort.

Another reason for the underperformance is the unbalanced nature of the rally. Large caps (the top 200 stocks) have outperformed smaller caps. Most actively diversified funds hold significant exposures to mid-caps. As a result, they underperformed benchmark large-cap indices. This is the flip side of active fund investing. Anybody who is invested in an active mutual fund is banking on the fund manager’s discretion. If the manager’s gut feel or investing model suggests the market is too highly valued, he should exit. Similarly, if his instincts suggest carrying a substantial corpus in smaller stocks, he must do so.

When the fund manager is right, he beats the benchmarks. When he’s wrong, he underperforms. Between 2005 and 2008, smaller stocks did outrun large-caps and this happened in 2009, as well. Similarly, as and when the market does peak, fund managers with high cash allocations save capital.

Should you be investing heavily at the current levels? Valuations are very high by historical standards. The domestic institutional attitude is negative. FII money is the sole driver and experience tells us that FII attitudes can change suddenly for reasons unconnected with the Indian economics.

Most Indian retail investors have been very cautious through 2009 and 2010 because most of them were burnt badly in the last (2008-09) bear market. One reason for the bearish DII stance has been the lack of retail inflows. However, there is every chance that surging prices will tempt retail investors to re-enter at 32-month highs.

This is a classic error retail investors are prone to. Retail investors usually buy at peaks, sell at lows, and ignore the market in-between, which is when they should be steadily accumulating. It’s probably related to the fact that media coverage of equity is always at its noisiest at peaks and lows.

My personal opinion: If you haven’t entered earlier, this is not a great time to increase allocations to the stock market. If you are already invested or thinking of investing, set tight stop losses and adhere to them.