How to Generate Alpha By Investing in Equity Mutual Funds in 2022

January 28, 2022 Mutual Fund

The S&P BSE Sensex has lost over 4,000 points or 6.6% over the last seven trading sessions (as of January 27, 2022). Equity mutual funds saw a decline in their NAV in the range of 3-10% during this period.

In the coming months, the COVID-19 pandemic induced restrictions, escalating geopolitical tensions, rising inflation, the US Federal Reserve tapering its bond-buying programme, and a possibility of a rate hike, the impact of the Union Budget on various sectors, etc. are likely to make equity markets nervous.

Therefore, unlike the last two years, i.e., 2020 and 2021, the Indian equity market may not generate stellar returns in 2022. Given the high equity valuations, markets can even consolidate further.

Graph: Sensex stumbled over 4,000 points over the last few days

Data as on January 27, 2022
(Source: ACE MF)  

However, don’t be dismayed by the expectation of higher volatility in the equity market. Here are the investment strategies you can follow to generate alpha from equity mutual funds in 2022:

1) Avoid chasing top-performers of 2021

Certain equity mutual fund categories like Small-cap Funds and Technology Funds were the top performers of 2021. Many of you may be tempted to invest in such top-performing schemes/categories expecting similar returns in 2021. But it is unlikely that a particular mutual fund category or scheme will continue to generate stellar returns year after year. Instead of basing your decision on recent performance, a better approach will be to select a scheme with a consistent track record compared to its category peers and the benchmark. This way, you will not have to churn your portfolio frequently. Though there is no harm in analysing a fund’s past performance to judge its return potential, it should not be the only deciding factor for investment because past performance is not an indicator for future returns.

2) Choose schemes carefully

A spree of new fund offers by the mutual fund industry over the past couple of years has made it difficult for investors to select schemes with high growth potential. However, it is imprudent to assume that new funds have higher growth potential than old funds. Instead of adding too many NFOs to your portfolio, follow a goal-based investment approach. Select worthy schemes within each mutual fund category after defining your financial goals, risk profile, and investment horizon. Ideally, if you have a long term investment horizon of at least 5 years, your Core portfolio should consist of actively-managed equity schemes such as Large-cap Fund, Flexi-cap Fund, and Mid-cap Fund. Choose schemes that have a long term track record of generating reasonable risk-adjusted returns and also fares well on qualitative parameters.

3) Stagger your investment

Investing a lump sum amount during an uncertain and volatile market environment can be risky. Investing through SIP will help you mitigate the market risk by staggering your investment/s over a period. When you invest in SIP, you accumulate more mutual fund units when prices are low, so when the market bounces back, it results in higher returns. Similarly, you buy fewer mutual units when prices are high. This enables you to lower your average investment cost over a period. Therefore, do not stop your SIP if you see your mutual fund returns declining in the short term. Over the long term, the rupee-cost averaging feature of SIP helps in compounding of wealth, thus rewarding investors for their patience. Remember, there is no ‘bad time’ to start investing via SIP if your goals are more than 5 years away.

4) Keep emotions at bay

The equity market can often test your patience, and you may feel tempted to take some portfolio action. However, reacting every time market fluctuates can impact your returns and make it difficult for you to achieve your financial goals. It is important to note that equity mutual funds may underperform in the short run due to unfavourable market/macro-economic conditions, though they can suitably reward investors who choose to stay invested for a longer period. If you have invested according to your asset allocation plan, there is no need to make changes to your portfolio based on market conditions. So instead of reacting to market movement, one must focus on their goals by building a suitable portfolio, based on your asset allocation, that can stay strong on both upside and downside market conditions.

5) Embrace market volatility

Equity market and volatility often go hand in hand. However, for long-term investors, volatility is an opportunity rather than a cause of concern. If the volatility drives market lower, it will provide a chance to boost your mutual fund investment, via SIP or lump sum, at a lower cost. And when the market recovers again, you will be rewarded with healthy gains. The equity market witnesses various events throughout the year. Most of these events do not have any long-term impact on the indices. Therefore, equity mutual funds can always deliver positive returns in the long run despite market volatility.

To conclude

Equity mutual funds can help you generate market-beating returns over the long term and maximize your wealth. However, not all mutual funds have the potential to generate significant alpha for their investors. Therefore, it is important to choose mutual funds for your portfolio carefully. The fund must reward investors by undertaking a reasonable level of risk consistent with its investment style and strategy. Remember that the true essence of alpha is to generate ‘extra return without taking extra risk’.

When you select a scheme, apart from assessing the scheme on risk-reward parameters, you should be looking at the portfolio characteristics of the scheme to assess its ability to generate reliable returns by analysing the following:

• Whether the scheme is well-diversified across stocks and sectors
• The quality of securities held
• Portfolio churning rate

Invest in schemes of fund houses that have a reliable performance record and follow robust investment processes with adequate risk management systems in place. The ability of a fund to generate alpha depends on the expertise and ability of the fund manager in taking the right call at the right time and reward investors, irrespective of the market movement. Therefore, it makes sense to check the experience and qualification of the fund manager as well as the track record of schemes they manage.

Once you have identified a worthy fund to invest in based on the above-mentioned parameters, opt for the SIP route to mitigate the impact of volatility on your portfolio. Finally, since equity investments take time to grow and generate meaningful returns, ensure that you have a long term investment horizon of at least 5-7 years.

This article first appeared on PersonalFN here