Defensive funds: Focus on consistency across cycles, not just performance

During the downturn, some funds managed to limit losses better than their peers and the benchmark. Investors are now debating whether to shift to these funds.

 

How they limited losses

 

Certain strategies contributed to these funds’ resilience. “Some fund managers went heavily into cash, allowing them to protect the downside when markets corrected,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Research India. Only a few fund managers took this approach, holding over 20 per cent in cash. Most maintained cash levels below 10 per cent.

 

Sector allocation also played a role. “Some sectors like financial services, healthcare, and information technology (IT) fell less during the correction. Funds overweight on them declined less,” says Belapurkar.

 

Sub-asset allocation was another factor. “Flexicap funds with a tilt towards largecaps declined less than the benchmark,” says Alekh Yadav, head of investment products, Sanctum Wealth.

 

Will they lead the recovery?

 

Funds that curbed their losses may not necessarily lead the rebound. “Funds that turned defensive heading into the correction tend to underperform when the market rebounds, especially if the recovery is sharp,” says Yadav.

 

Outperformance will depend on the fund manager’s agility. “If a manager held high cash levels, performance will depend on how quickly they redeploy it. For those who did well due to sectoral bets, performance will depend on which sectors recover first,” says Belapurkar.

 

Market recoveries are unpredictable. Managers who held excessive cash risk being left on the sidelines if the recovery is sudden and sharp. 

 

Maths favours defensive funds

 

A fund whose net asset value (NAV) drops from ₹100 to ₹50, a 50 per cent decline, must rise 100 per cent to regain the ₹100 mark. “The maths favours funds that fall less. The steeper the fall, the harder the recovery,” says Deepesh Raghaw, a Securities and Exchange Board of India (Sebi)-registered investment adviser.

 

Defensive funds are also easier to hold amid volatility. “Investors are willing to accept slightly lower returns in bull markets but dislike a steep fall, a tendency known as loss aversion,” says Yadav.

 

Funds with beta below one (lower volatility than the market) offer stability. “A fund that declines less in downturns and rises moderately in rallies offers stable returns. Such funds help build resilient portfolios,” says Belapurkar.

 

What should investors do?

 

Investors should assess their asset allocation (equities, fixed income, and gold mix) and sub-asset allocation (largecap, midcap, and smallcap mix). This downturn would have given them a better picture of their risk appetite. Those who took on more risk than they can handle should reduce exposure to equities, and within equities, to mid- and smallcap funds. 

 

“Try to control risk first through your asset allocation and sub-asset allocation,” says Raghaw.

 

Largecap funds provide stability. Mid- and smallcap funds tend to fall more, but also have the potential to offer higher returns over the long term. “Choose a suitable mix of these sub-asset classes based on your risk appetite,” says Raghaw.

 

When selecting individual funds, look beyond recent performance. “Instead of going by recent performance only—how funds have performed in the downturn—look at performance across market cycles. Go with funds that have displayed consistency across cycles,” says Yadav.

 

Only investors comfortable with volatility may opt for funds that are more volatile than their category peers, but have historically delivered superior long-term returns.