An NFO from this fund house after 5 long years
Head of Equities - HSBC Global Asset Management
WF: What is the asset allocation strategy for this fund and how will asset allocation be dynamically managed?
Neelotpal: This fund is being launched after about 5 years pause from the fund house on NFOs. Asset allocation is the soul of the product and hence, is important to understand and have a proper asset allocation strategy. The fund proposes to invest in equity and debt. The equity proportion is 65% - 80% and the balance will be into debt. The provision to invest in REIT to the extent of 10% will be included under debt. The investment in equity will provide capital appreciation and investment in debt will provide the stability for the fund. The optimal asset allocation would be achieved when equity proportion is around 70% and debt is 30%, this would help achieve best risk adjusted returns. Hence, equity would be restricted between 65% - 75% to optimize on returns.
WF: When you initially cast your portfolio, for the equity portion what is the likely market cap mix that you propose within the overall flexicap strategy? How will market cap allocations be dynamically managed?
Neelotpal: There is a reason for using the flexicap strategy, while the objective is to optimize returns on the asset class (equity as a whole), the individual sub-classes within this asset class – largecap, midcap, smallcap are all reverting to the mean. Over the last 13 calendar year returns, in 5 of those years, largecaps have outperformed, in other 5 years smallcaps have outperformed the most and in the remaining 3 years midcaps have outperformed the most. The flexicap strategy will enable the fund to invest across the market cap curve depending on the prevailing dynamics. In the current scenario, largecap represented by Nifty Index is up by about 4% on a YTD basis, however, there are only about 8-10 stocks within this universe who have contributed to these returns. This essentially conveys that the rest of the 40+ stocks have performed below par. When it comes to Corporate earnings for the largecap, bulk of the stocks have started to perform reasonably well over the last couple of quarters. This indicates that there is a gap between stock returns and corporate earnings revival. This provides an opportunity for us to buy into largecaps at this point. The story with midcap and smallcap space is slightly different. Both midcap and smallcap have underperformed largecaps by 21% and 28% respectively. The premium valuations have normalized a lot in the midcap and smallcap space. This has led to normalization of P/E multiple difference between large caps and mid & small caps, which were trading at a significantly higher P/E during the early part of this year. The correction in individual stocks have been more severe as compared to the overall index. Some of the stocks where the fundamentals were attractive but we were not comfortable with the valuations earlier are now at levels which are more comfortable. Given these aspects, we are of the view that flexicap strategy would suit the fund best. There is a process of identifying stocks based on valuations and profitability, these stocks will be tracked regularly. There will be some shift between market caps, but there is no intentional dynamic management across market caps. Within the equity proportion, initially, there will be exposure to the extent of 65% - 75% in largecaps and the rest will be distributed between midcaps and smallcaps.
WF: Given the current economic scenario, for your equity portion, which sectors are you likely to invest in?
Neelotpal: Under any economic scenario there are bound to be challenges and opportunities in in the markets. There are opportunities in the current scenario as well. At this juncture, we believe, the equity portfolio should be overweight on domestic consumption stocks, sectors which will benefit from the current rupee depreciation (energy and metal companies apart from exporting sectors), and financials within which those stocks which have access to better and cheaper funding.
Within the consumption space, we are interested in discretionary space. We are at a per capita income of about $1900 and in the future, we are likely to move towards $2400 in about 4 years as per broader estimates. With this shift in per capita income, there is likely to be some significant shift in the aspirational and discretionary consumption as well. Hence, the sectors which deal with aspirational and discretionary goods are likely to grow faster than the rest of the economy.
The sectors which derive benefit from rupee depreciation are export companies and global cyclicals. Metal prices are rising and India stands to benefit from rising prices and currency fluctuations as well.
WF: The fund intends to pick midcap and smallcap stocks which are mis-appraised and mis-priced, while they may have the potential to create wealth over a 3-5 year time-frame, the alpha generation over the shorter time frame may be compromised. How do you propose to generate alpha over the short to medium term?
Neelotpal: The stock picking strategy should primarily focus on medium - long term which will provide ample time for the mis-appraised to be set right. Not all the midcap and smallcap will be in the same situation of being misappraised or mispriced. Not all the stocks picked will have a 3 - 5 year time frame, we intend to pick few stocks which are slightly more evolved, they would be over a different time frame (shorter time). The midcap and smallcap may be around 1/3rd to 1/4th of the equity portion. There will be more focus on the largecap for the time being, since we see some definite opportunity in largecap with only selective stocks having outperformed, and corporate earnings having revived. Hence, in the short – medium term, the alpha would be generated from largecap stocks and over the long term, the midcap and smallcap stocks would provide the alpha to the fund.
WF: What will be the strategy for the debt portion – in terms of duration and credit risk?
Neelotpal: Debt portion is primarily to provide stability for the portfolio. We have an optimal duration strategy, although there is scope for investing across the interest rate spectrum given that at various phases in the market, different instruments would perform well. However, given the current scenario, we believe that the lower end of the interest rate spectrum is likely to do well. We are looking at accrual as the source of income for this portion . Similarly, while we have the option to invest across various credit risk instruments, we will focus on investing in high quality instruments which have lower capital risk. This would provide the much needed stability for the portfolio.
WF: The fund is being positioned as a wealth building opportunity across all time-frames. Can you elucidate this positioning and the strategy that will deliver to this positioning?
Neelotpal: Two points to this answer. First point is subject to comparison of pure equity product (data is available for ~45 years) with that of absolute returns from a hybrid product. The back tested data indicates that the returns generated from hybrid product is very close to the returns generated from pure equity products. On a rolling tenure basis across various timeframes including 3 / 5 / 7 / 10, the average returns generated by pure equity product is around 14% - 16%, however, the dispersion is quite high. On a 1 year rolling return basis, about 2/3rd of the returns would be positive and 1/3rd of the returns would be negative. But, over a 5 year rolling period, the returns dispersion is fairly smooth. Investor is likely to have a smoother ride if one were to stay invested for minimum of 5 years or longer.
The second part indicates why the fund would be suitable across all time-frames. The fund will be investing using the flexicap strategy for equity portion and optimal duration strategy for the debt portion. The equity strategy will help us benefit from the mis-pricing that will happen across market caps. The debt strategy will help us benefit from the mis-pricing which will happen across the interest rates spectrum and credit risk spectrum. Both the markets are on a mean reversion trajectory, if we were restricted by market caps or duration / risk spectrum, then the fund would not have delivered across all time-frames. Given that the fund does not have any such restrictions, it is positioned as a fund which is likely to perform across all time-frames.
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