Fortify your equity portfolio by diversifying into value-oriented funds

Both value and dividend yield funds benefit from market downturns by investing more aggressively on such occasions

With the markets scaling new highs over the past few days, valuations have also moved up. The Nifty trailing 12-month price to earnings (P/E) ratio is now at 34.18, about 34 per cent higher than its five-year average of 25.45. If you are worried that a correction in the near future could dent the value of your portfolio, book some profits and bring your equity allocation back in line with your long-term asset allocation. Another step you could take to make your portfolio more resilient is to bring some style diversity into it by including value-oriented funds.

Value funds: They invest in stocks that offer a margin of safety, that is, those whose intrinsic value is less than their current market price. It is a more conservative investment approach that tends to do well across market cycles. “These funds tend to lag during phases of high momentum in the markets. But they make up when there is a drawdown in the market. By investing aggressively at lower levels, they can potentially deliver better long-term returns,” says Mrinal Singh, deputy chief investment officer-equity, ICICI Prudential AMC, who manages the Rs 15,422 crore Value Discovery Fund. The fund manager invests in stocks at low valuations. Singh says that when value gets unlocked in these stocks, investors make exponential gains from such investments.

 

Dividend yield funds: Another category that has a value-orientation is dividend yield funds. A key filter these funds use to select stocks is high dividend yield. This gives them a value tilt. On her approach to selecting stocks, Swati Kulkarni, executive vice president and fund manager, UTI AMC, who manages the largest fund in this category, says: “First, the stock’s current dividend yield must be high. But it is also important that it should have earnings growth, so that dividend growth remains high in future also. Even if the dividend pay-out ratio remains the same, if there is earnings growth the amount distributed will be high. The company’s free cash flow yield must also be higher than the dividend yield. This gives predictability to dividends in the future also.”

Both value funds and dividend yield funds tend to provide sound downside protection during downturns. “The margin of safety approach ensures that the fund does better during a fall,” says Singh. In dividend yield funds, the dividend yield of the portfolio provides a cushion on the downside.  

Lag the markets in bullish phases: Investors entering these value-oriented categories must remember that when the markets are in a phase of high momentum, these funds tend to lag behind. One reason is that their investment universe shrinks. Says Singh: “These funds do not participate in the markets when the margin of safety is lower.” Adds Kulkarni: “When the markets are extremely bullish, the universe of stocks in which dividend yield funds can invest shrinks. Therefore, there is a possibility of underperformance in the short-term.”

Another risk in value funds is that if the fund manager does not get his stock selection right, some of those that he picks could turn out to be value traps. “Their valuations could remain low for a prolonged period for a variety of reasons – governance-, performance-related, and so on,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

 

The dividend yield strategy is not for investors seeking rapid capital appreciation from their investments. If a company has a high dividend yield, it often signals that it does not have many investment opportunities within its own business, so it is returning surplus capital to its investors. Also, investors should not invest in a dividend yield fund in the belief that it will make high dividend pay-outs. That may or may not happen.  

What should you do? Investors who wish to include value-oriented funds should remember that value investing is a style that requires patience and a long-term investment horizon. Enter them only if you have a horizon of at least seven years.

Dhawan suggests that you may allocate about 20 per cent of your equity portfolio to value-oriented funds, and around 5 per cent of this portion can go to dividend yield funds.

When selecting a value fund, make sure the fund manager follows a consistent approach and has managed to perform across investment cycles. When choosing a dividend yield fund, ensure that the portfolio dividend yield is at least two times that of the index to ensure there is no style dilution.