While soaring stock markets led the party at equity mutual funds last year, especially at diversified funds, the times have indeed changed.

The market crash and the resultant volatility post-elections and the announcement of the Common Minimum Programme have meant that the equity investors who laughed all the way to the bank early this year are now fretting.

Although market analysts are still optimistic about the future direction of Indian markets, they advise caution in terms of your portfolio exposure. If you are unsure which equity fund category is best to look at, don't worry.

Fund managers advise that on the long-term diversified funds are likely to do well, given that India's fundamental growth story remains intact.

However, given the current volatility, they advise that it is better to put your eggs in defensive sectoral baskets like IT or pharma funds, which have a better chance of withstanding market volatility.

Still outperforming the indices

The performance of funds in the last six months tells its own story. Most of the equity funds, including diversified and leading sectoral funds, have given negative returns during the period.

That is no surprise given the fact that Sensex itself declined by 21.73 per cent during the last six months.

In fact, funds have performed better than the index during the past half-year, though positive returns eluded them in the face of the big crash in the aftermath of the elections.

For the one-year period, the Sensex return amounted to 30.30 per cent while the average returns of diversified funds were at 47.37 per cent.

Leading diversified schemes like HSBC Equity Fund (83.77 per cent), Reliance Growth Fund (76.96 per cent), HDFC Capital Builder Fund (73.55 per cent) and Templeton Mutual Fund's Franklin India Opportunity Fund (59.68 per cent) and Bluechip Fund (59.48 per cent) have managed to beat the index by some distance.

While these funds have been in the negative territory vis-à-vis six-month returns, the fact that they still managed to outperform the index has compelled investors to stay put. Returns have also started looking up in the past month, edging back into the positive territory.

A look at the assets under management of leading diversified funds reveals that despite minor changes, investors continue to believe in the diversified story.

While HSBC Equity Fund's corpus has grown from Rs 814.73 crore (Rs 8.14 billion) in December 2003 to Rs 1,124.65 crore (Rs 11.25 billion) in June, that of HDFC Capital Builder Fund has increased from Rs 60.54 crore (Rs 605 million) in December to Rs 101.53 crore (Rs 1.01 billion) last month.

But there were some exceptions. Funds like Reliance Growth Fund and Franklin India Opportunity Fund did see an erosion in their assets.

While the AUM of the former declined from Rs 479.96 crore (Rs 4.80 billion) in December to Rs 460.62 crore (Rs 4.61 billion) in June, that of the latter slipped from Rs 271.13 crore (Rs 2.71 billion) in December to Rs 204.60 crore (Rs 2.05 billion) last month.

Sectoral funds were not lagging far behind in terms of performance either. Technology funds led the way, generating returns of 55.37 per cent on an average as compared to the 55.04 per cent managed by the BSE IT Index.

Pharma funds (50.85 per cent), too, performed well, beating the BSE Healthcare Index (35.53 per cent) by some margin. The six-month returns in these funds are also in the red, but like the broad market in the past month, they have started moving up to the positive territory.

CASE FOR... ...diversified funds

Given strong fundamentals, diversified funds are likely to do well over the long-term. A broader portfolio reduces risk. Diversified funds offer better selection and variety of stocks. ...sectoral funds In volatile markets, exposure to insulated sectors will be a good defensive bet. Sectoral funds will be able to piggybank on sectors which are witnessing good sentiments. They offer more exposure to undervalued sectoral picks.

Focus on tech, pharma provides the succour

The underlying theme of the recent good performance of diversified schemes has been their focus on sectors like IT and pharma, the least effected by the market volatility. And that strategy is likely to continue in future, too, given the results.

"The markets appear to be direction-less at the moment. In this scenario, I think sectors like technology, auto and pharma will outperform," says Nandkumar Surti, senior vice president (investments) at JM Capital Management.

According to Surti, the secular story is building up in these sectors, which are also good defensive bets in choppy markets.

However, funds which have been holding on to oil, banking and other PSU scrips have felt the heat. "Sectors like oil and banking, which have been favourites in the earlier part of the year, have been negatively impacted in the aftermath of elections," adds Surti.

Funds with a mid-cap focus also have done well in the past three months, compared to those with a large-cap focus as evidenced by the good showings of Birla Mid-cap, Franklin Prima Fund and Sundaram Select Mid-cap.

Several tax-saving schemes, including Prudential ICICI Tax Plan, Birla Tax Plan 98 and HDFC Tax Plan 2000, have also managed to outdo their peers on the basis of their exposure to mid-caps.

Among sectoral funds, those with an exposure to IT and pharma eclipsed others, thanks to the fact that the two sectors withstood the market crash to an extent.

"We are bullish on technology, pharma and auto sectors and believe they are good defensive bets," says Nilesh Shah, chief investment officer of Prudential ICICI Mutual Fund.

Good fourth-quarter corporate results and positive future guidance by tech companies were the main reasons behind the fund manager's confidence in technology sector, while the focus on pharma was mainly because of the perception that the sector is a good defensive bet in volatile times.

The emerging boom in global generic markets, higher domestic spending on healthcare and 'compulsory licensing' of patented products post-2005 also tilted funds' preferences to the pharma sector.

"Investors who have been looking at diversified funds can now look at these sectoral funds as better options. This is not to say that diversified funds will not do well, but they are likely to do so in the longer term. For the short-to-medium term, sectoral funds appear a much better bet," notes Surti.

Go forth and diversify

While short-term strategy is one thing, if one looks at the longer term the game will play out differently, warn fund managers.

Rajat Jain, chief investment officer of Principal Asset Management Company, says: "I don't think sectoral funds are going to be the flavour going forward. The markets have become more stock specific rather than following any general trend."

Jain's concerns arise from the fact that in an uncertain market, it is difficult to pin point the winners. "The problem with a sectoral strategy is that there is no way of knowing which is the better sector to choose from," says Jain.

Which means that the party at diversified funds may still continue, though the allure might have dimmed considerably. "Given the scenario, diversified funds stand a better chance than sector funds. The only thing is that diversification needs to be broader," says Jain.

"We follow a bottom-up approach. There are any number of good companies which are available cheap. So to tap the potential of these companies, one needs to diversify," explains Jain.

Ved Prakash Chaturvedi, chief executive officer of Tata Mutual Fund, is also a votary of diversified funds, though he does agree that given the current volatility, defensive sectors like IT and pharma are likely to outperform.

Expect short-term volatility

Given the current sensibilities, fund managers are cautious about the future direction of the markets, at least in the immediate term.

le all of them continue to believe in Indian markets' long-term story, only a few are willing to stick their necks out and predict the prospects in the short term.

Reason: market dynamics have undergone a subtle change in the course of the last few months, and more dramatically since the election surprise.

Question mark over index funds

Index funds have also performed admirably in the past year, especially during the market boom. However, lower market returns have led to lower returns from index funds, too. But the question to ask is whether markets have bottomed out or is there more downsides yet to come? If you go by recent estimates of research houses it may seem so, or at best it may not move up much from current levels. Given the scenario, it can be argued that investing in index funds may not be such a great idea after all. "One should look at index funds when the economy is in a bearish phase and the index has bottomed out. However, despite the market volatility, India's economy is strong and the outlook is very positive. Given the scenario, it may not be the right time to look at index funds. Rather, one should look at actively managed diversified funds for long-term returns," avers Chaturvedi. But actively managed funds carry their own risk. "Most of the active fund managers do not outperform the indices," says Rajan Mehta, executive director of Benchmark Asset Management Company. There are other worries, too. Consistency of returns, for one. "Most of these active funds have a core-portfolio horizon of 15-20 years. If you go by the US example, a fund may have four-five managers during that time. So you have no way of knowing how they will perform. That way index funds are much safer since they are passively managed," stresses Mehta.

Importantly, fund managers are still optimistic about the future. "Our outlook still remains bullish and we could see the index moving up to 5,700 levels by end of 2004," says Surti.

Jain is also of the view that the fundamental story still holds good. "Our equity funds haven't lost any money despite the market crash. This means that markets are pretty mature and are positive about the future."

According to Chaturvedi, investors should make use of this down-turn as an entry point into the markets and invest carefully. "This year is going to be difficult for equities, though it does provide long-term investment opportunities."

According to Shah, expecting too much returns from equity funds in FY05 is not fair. "Markets are unlikely to give returns in excess of 50-80 per cent, but a 12-15 per cent return for FY05 is definitely possible. Investors should follow a systematic investment plan and understand that equities are a long-term game," he adds.

In short, the consensus is that clarity is yet to emerge on the market direction, at least in the short-term. While recent performance history points out that diversified funds may be coming off the high horse of big returns, sectoral funds may be on their way up the ladder, say analysts.

An overall decline in market sentiments may affect a broader sector strategy, diluting the return potential of diversified funds, while the so-called 'insulated' sectors like technology and pharma look like having a better chance to outdo the general market.

But the key to unlocking the equity fund mystery may lie in this: if you are after robust long-term returns, go for diversified funds.

However, for the short-term and till clarity emerges on a plethora of factors such as interest rates, government policies and monsoon etc., adopting a 'defensive sector' strategy may not be such a bad thing.

Last year, the markets were able to generate great gains based on the valuation expansion story. However, this is not the case now. "There is a lot of uncertainty this year, mainly about the government's policy directions and the fate of monsoons," notes Surti.

Jain agrees: "Currently the markets lack clarity. The short-term outlook is turbulent. I think the markets are going to be volatile till the new government settles down," he says.

According to Chaturvedi, external factors like rising global interest rates, oil prices and inflation are impacting the short-term outlook. The progress of monsoon is also a worrying factor.

"Current market sentiments may be fragile. But they can change overnight. However, fundamentals do not change overnight. We believe that despite the short-term bearishness, the long-term story is reasonably sound," says Shah.