How to Choose Mutual Funds at a Market High

September 24, 2024 Mutual Fund

Indian equity markets have been hitting record highs recently, drawing both seasoned investors and new entrants to the market. With major indices such as the Nifty 50 and S&P BSE Sensex scaling new peaks, investors may feel tempted to jump into the rally to maximize gains. However, buying mutual funds at market highs could be risky. The market’s high valuations bring the potential for correction, making it critical to employ a balanced strategy that mitigates downside risks while still offering upside potential.

In the first half of 2024, Indian equity markets have witnessed strong momentum. As of September 2024, the Nifty 50 index has crossed 25,000, and the S&P BSE Sensex breached the 80,000 mark, driven by positive earnings reports, increased domestic consumption, and strong GDP growth.

Data as of September 23, 2024
(Source: ACE MF, data collated by PersonalFN Research) 

Currently, Indian equities are trading at historically high valuations, with key indices such as the Nifty 50 and the S&P BSE Sensex hovering around record levels. Compared to global markets, Indian equities stand out as relatively expensive.

[Read: Investing in High-Risk Mutual Funds: A Bold Approach]

The Nifty 50 is trading at a trailing price-to-earnings (P/E) ratio of approximately 23.98, while the S&P BSE Sensex has a P/E ratio of around 24.22. Both are above their long-term historical averages of around 19 and 20, respectively. These elevated valuation levels indicate that Indian markets are being priced for strong future growth, driven by robust corporate earnings and continued economic expansion.

Key sectors such as information technology, financials, and consumer goods have led the rally in Indian markets, contributing to the elevated valuations. However, the premium valuations of Indian equities mean that investors must remain cautious, as any global macroeconomic shock, policy change, or earnings miss could lead to a market correction.

When equity markets are at record levels, the prices of underlying assets within mutual funds-especially equity-based funds-tend to be overvalued. This increases the chances of a decline in net asset values (NAV) if markets corrects or if corporate earnings do not meet the optimistic growth expectations already priced in.

As a result, investors who enter the market at such elevated levels could experience short-term losses and increased volatility, especially if economic conditions shift or external factors such as interest rate hikes, inflation, or global geopolitical tensions come into play.

[Read: Navigating the 2024 Market Volatility: Key Investment Strategies for Your MF Portfolio]

Timing the market could be challenging, and even professional investors find it difficult to predict when the peak has occurred, adding to the risk of investing during these periods.

How to Choose Mutual Funds at Market High

Choosing mutual funds during a market high requires a strategic approach to mitigate risks while capitalizing on potential returns.

Analyse current market trends and economic indicators. High valuations might suggest a market correction is possible, so be cautious. Consider a diversified approach by investing across different categories such as equity, debt, and hybrid funds. This helps spread risk.

[Read: What Is STP in Mutual Funds and Why It Makes Sense at a Market High?]

In the prevailing market scenario, the Core & Satellite Strategy emerges as an effective approach. This strategy focuses on building a solid ‘core’ portfolio consisting of stable and reliable mutual funds, while the ‘satellite’ portion includes more aggressive funds that offer higher growth potential. By giving a higher weightage to the core, you could protect your portfolio during market corrections and still benefit from long-term growth.

Why Investors May Consider the Core & Satellite Strategy at Market High

Core Portion: This portion forms the foundation of your portfolio and is composed of stable, well-established mutual funds that provide consistent returns over the long term. These funds are generally less volatile and offer a safer investment during market highs. The focus here is on capital preservation and stable growth.

At a market high, the core portfolio should take precedence to protect the bulk of your investment from market corrections, while the satellite portion could be tactically adjusted to capitalize on short-term opportunities.

When the market is at a high, there is an increased risk of corrections due to stretched valuations. In such situations, your core portfolio should be designed to weather potential volatility while still providing room for growth. Let’s explore the types of funds that best fit the core portion:

The core portion of the portfolio consists of relatively stable and less volatile mutual funds, such as large-cap or flexi-cap funds, which are better equipped to handle market fluctuations. Large-cap funds, in particular, focus on well-established companies with a track record of consistent earnings, making them a prudent bet during periods of market turbulence. On the other hand, Flexi-cap funds provide diversification across market capitalizations, giving fund managers the flexibility to shift between large, mid, and small-cap stocks based on market conditions, thereby balancing risk.

Additionally, value funds and contra funds are an attractive option for your portfolio during a market high. Value funds focus on companies that are undervalued relative to their intrinsic worth, offering the potential for capital appreciation when markets correct and valuations normalize. Contra funds take a contrarian approach by investing in underperforming sectors or stocks that are expected to bounce back over the long term. These funds provide an opportunity to benefit from market corrections, as their holdings tend to recover faster once the overall market reverts from its highs.

[Read: Adding New Mutual Funds for Better Gains? Here’s Why It Could Be a Risky Move]

Satellite Portion: The satellite portion includes riskier and more aggressive funds that aim to generate alpha (excess returns) during favourable market conditions. These funds could be added or removed based on market cycles and individual risk appetite.

These funds are more tactical and could help boost overall returns when markets perform well or during sector-specific rallies. The satellite portion includes mid-cap and small-cap funds, which target companies with high growth potential but more volatility. While these funds could outperform during market upswings, they are more susceptible to downturns, making them suitable for tactical growth in a portfolio.

Additionally, sectoral and thematic funds allow investors to capitalize on trends in specific industries, such as technology or healthcare. Although these funds could deliver substantial returns if their chosen sector thrives, they carry higher concentration risk. International funds or emerging market funds provide geographic diversification, helping to mitigate the risks of a downturn in Indian markets by investing in global or high-growth emerging economies.

Together, these satellite funds enhance the overall portfolio’s growth prospects while balancing the core’s stability with tactical, high-potential investments.

Key Factors to Evaluate When Choosing Mutual Funds at Market Highs

Choosing the best mutual funds requires careful consideration of multiple factors, especially when markets are at a peak. Here are some key aspects to evaluate:

1. Fund’s Historical Performance

While past performance is not a guaranteed indicator of future success, a fund’s historical performance across different market cycles could give you an insight into how it may perform during market highs or corrections.

2. Expense Ratio

The expense ratio indicates how much of your investment goes toward managing the fund. Lower expense ratios are preferable as they minimize costs and maximize returns.

3. Fund Manager’s Expertise

The experience and track record of the fund manager play a crucial role in navigating volatile markets. Look for managers with a history of sound decision-making, especially during market highs.

4. Portfolio Composition

Analyze the underlying portfolio of the fund to ensure it aligns with your risk tolerance. A diversified portfolio with a mix of large-cap, flexi-cap, value, and contra stocks could offer more stability during volatile times.

[Read: How You Can Use a Mutual Fund Screener to Choose Mutual Funds]

5. Volatility (Standard Deviation)

Evaluate the fund’s volatility through its standard deviation. Funds with lower volatility tend to offer more stable returns, making them suitable for the core portion of your portfolio during a market high.

6. Risk-Adjusted Returns (Sharpe Ratio)

The Sharpe Ratio measures the fund’s return per unit of risk. Funds with a higher Sharpe ratio are preferable, as they provide better risk-adjusted returns.

7. Market Valuations

At market highs, it’s crucial to consider broader market valuations, such as the Price-to-Earnings (P/E) ratio. If valuations are stretched, consider funds that focus on value or contra strategies.

8. Consistency of Returns

Look for funds that provide consistent returns across market cycles rather than those that outperform only during bull runs. Consistency is key for the core portfolio.

To conclude…

At a market high, it’s tempting to chase short-term gains, but a disciplined approach to mutual fund selection could help safeguard your investments from potential market corrections. The Core & Satellite Strategy offers a balanced way to approach investing during market highs, with the core portion providing stability and the satellite portion offering growth potential.

Ensure to evaluate factors such as the fund’s historical performance, expense ratio, and risk-adjusted returns to make the best investment choices. Prioritizing funds that offer consistency and diversification could help protect your investments from sharp downturns while positioning you for future growth.

By combining these strategies and careful fund selection, you could build a resilient portfolio that stands the test of time, even in high market conditions.

This article first appeared on PersonalFN here