What Should Your Investment Strategy be in 2022 to Invest in Equity Mutual Funds

December 28, 2021 Mutual Fund

Now that the holiday season has set in and you might have taken a break from work, it’s perhaps time to sit back and review your equity mutual fund portfolio and tweak the investment strategy if required.

Those amongst you who read our Daily Wealth Letters regularly would know that we, at PersonalFN, do not encourage you to change your investment strategy every so often. Nor do we believe in following the popular investment trends. Nonetheless, it is imperative to revisit your investment portfolio periodically and take the necessary steps if fine-tuning is required.

So what should be your investment strategy for 2022, and how should you approach equity mutual funds in the coming year?

As you would know, the year 2021 has been a spectacular year for equity as an asset class in general and particularly for Indian equities. The Nifty 50 Index has generated around 21% absolute returns in 2021 so far, while the Nifty 500 has fetched around 26% absolute returns. The Mid and Small-caps did remarkably well in a broad-based rally, wherein many sectors viz. Information Technology (IT), healthcare, energy, metal, realty, etc., were among the top performers.

Interestingly, the Nifty 50 Index, which traded at a Price-to-Earnings (P/E) multiples of 38 on a trail-earnings basis at the end of 2020, is now trading at a P/E multiple of 23. Before the COVID-19 pandemic, i.e., at the end of CY2019, the P/E of India’s bellwether index was 28x.

On the other hand, the trail P/E multiples of Nifty Midcap 150 and Nifty SmallCap 250 were 145x and 41x, respectively, at the end of 2020. They too have come off sharply, just as experienced in the case of Nifty 50. At present, Nifty Midcap 150 trades at a multiple of 29X while the Nifty SmallCap Index commands a valuation of 30 times its trail earnings.

Now many of you would be keen to know what might have pushed the earnings multiple downwards, especially when the markets have gone up substantially.

Fall in the P/E multiples during 2021 can be explained by encouraging corporate earnings in the last few quarters (India Inc. net profits hit a record high of Rs 2.39 trillion in September 2021 quarter) due to pent-up demand, improving consumer and business confidence, and of course, the cost rationalization measures taken amidst the pandemic.

However, to assume that the moderation in valuation might offer some cushion against future market corrections might turn out to be a dangerous assumption. Also, it would be incorrect to live under the impression that earnings would improve in a linear manner quarter-on-quarter. That may not be the case. Given the improvement in earnings in 2021, the base for all four quarters of the calendar year 2022 will be fairly high. Unless corporates maintain their earnings run rates, the valuations might still look frothy, although the recent correction of 10%-12% in the broader equity markets may seem to be a comforting factor.

If you observe carefully, the valuations in the small and mid-cap space are still more expensive as compared to those in the large caps. This makes me believe that the ongoing correction in the broader markets isn’t over yet. If markets go further down from the present levels, the mid and small-caps would be more vulnerable than large-caps.

Here are the key headwinds for the markets in 2022…

Omicron cases are rising rapidly across the world and India. This remains a worry, although the initial reports suggest that the Omicron variant produces only mild symptoms resulting in fewer hospitalizations. The government, however, is taking no chances: states government have been asked to take all necessary measures to prevent the rise in infections. This is against the backdrop of the current vaccines not holding up against the virulent Omicron variant, and the inoculation rate for both doses administered is less than 50% in India. If Omicron cases multiply, the government may be left with no option but to reinstate restrictions or localised lockdowns. For now, certain states have imposed night curfews while state election rallies are allowed during the day. It’s still too early to conclude that the spread of Omicron won’t significantly impact India’s and global economy.
Rising inflation is another worry. Unseasonal rains in many parts of the country have posed a risk to food & beverage inflation. Besides, a series of hikes in prices of petrol, diesel, LPG, and CNG, has led to higher readings in the fuel & light inflation category. For certain corporates, rising input or material cost has weighed down on their profit margins. If Omicron causes another round of partial/local lockdowns in India and even in the other parts of the world, the supply disruptions might push inflation up. Core inflation (which excludes food, fuel and light), which had moderated to 5.85% until September 2021, has increased to 6.20% in November 2021, the highest in five months. The Reserve Bank of India (RBI) is of the view that the cost-push pressures from high industrial raw material prices, transportation costs, and global logistics and supply chain bottlenecks continue to impinge on core inflation. The central bank thinks that for a sustained lowering of core inflation, continuing the normalisation of excise duties and VATs alongside measures to address other input cost pressures assumes critical importance, more so as demand improves. The RBI is expected to nurture conducive policy settings (with its accommodative monetary policy stance) till the economy takes firm root and becomes self-sustaining.
Tightening of liquidity can make things worse for equity markets if the growth cools off below expected levels. The U.S. Federal Reserve has already hinted at three rate hikes in 2022 and accelerated the unwinding of its bond-buying program. Ending the bond-buying program amidst the pandemic may pose a risk to global economic activity.
The RBI, the World Bank, International Monetary Fund (IMF), and noted economists have cited that the future pandemic trends still hold the key to global recovery. According to IMF, the global GDP projection for 2021 has been 5.9%, and that for 2022 stands at 4.9% as per its World Economic Outlook, October 2021.

Speaking about India, the RBI currently has decided to wait for growth signals to be solidly entrenched while remaining watchful of the inflation dynamics. So, it appears that policy normalisation in India would not begin anytime soon. This, in a way, is a positive for the Indian equity markets for now. However, the overheated primary market may suck out liquidity from the secondary markets. Nearly 70 companies are expected to raise nearly Rs 2 trillion in 2022, which includes the mega Initial Public Offering (IPO) of LIC.

In my view, markets have already factored in the positives. Going forward, volatility is expected to intensify, due to acceleration in the spread of Omicron cases, which would derail economic growth. That said, volatility is the very nature of the equity market. It is how we use it to our advantage, perceive the situation sensibly, and devise an efficient strategy that decides our investment success.

[Read: Worried About Volatile Markets? Multi-Asset Fund Can Be a Good Bet in Uncertain Times]

If you want to take advantage of the higher margin of safety and stability offered by large caps and at the same time capitalise on the high growth opportunities of small and midcaps, I recommend following the ‘Core & Satellite Investment Strategy’. It’s a time-tested strategy adopted by many successful equity investors across the world.

The Core & Satellite Investment Strategy facilitates optimum allocation across investment styles, with an aim to gradually build wealth in the long run.

The term ‘Core’ applies to the more stable, long-term holdings of the portfolio, whereas the term ‘Satellite’ applies to the strategic portion that would help push up the overall returns of the portfolio across market conditions.

By wisely structuring and timely reviewing the Core and Satellite portions and the holdings therein, you would be able to add stability to the equity mutual fund portfolio while strategically boosting your portfolio returns at the same time.

The ‘Core’ holding should comprise around 65-70% of your equity mutual fund portfolio and consist of a Large-cap Fund, Flexi-cap Fund, and Value Fund/Contra Fund. Whereas the ‘Satellite’ holdings of the portfolio can be around 30-35%, comprising of a Mid-cap Fund and an Aggressive Hybrid Fund. But care should be taken to select the best equity mutual funds for investments in 2022.

Here are a few fundamental rules to follow to build a portfolio of equity mutual fund schemes based on the Core & Satellite strategy:

Consider equity mutual funds that have a strong track record of at least 5 years and have been amongst the top performers in their respective categories.
The schemes should be diversified across investment styles and fund management.
Ensure that each equity mutual fund selected scheme abides with its stated objectives, indicated asset allocation, and investment style.
You should not only invest across investment styles (such as growth and value) but also across fund houses.
The equity mutual fund schemes should be managed by experienced and competent fund managers and belong to fund houses that have well-defined investment systems and processes in place.
Not more than two equity mutual fund schemes managed by the same fund manager should be included in the portfolio.
Not more than two equity mutual fund schemes from the same fund house shall be included in the portfolio.
Each equity mutual fund scheme that is to be included in the portfolio should have seen an outperformance over at least three market cycles.
You should restrict the count of equity mutual schemes in your portfolio to seven.

Since the markets are expected to remain under selling pressure as the liquidity dries up, I suggest opting for the Systematic Investment Plan (SIP) route to build the portfolio of best equity mutual fund schemes following the ‘Core and Satellite’ approach.

[Read: How to Get Rich with the Best Equity Mutual Funds in 2022]

If you correctly follow the ‘Core & Satellite’ approach while investing in equity mutual funds, here are the six key benefits it will adduce: