February 09, 2015

An Idea Whose Time Is Overdue

Thirteen years ago, a revolutionary idea was presented to Indian mutual fund investors: that of a scheme which would automatically adjust its exposure to equity based on the state of the markets. In a bull phase, it would gradually reduce its allocation to equity, while in a bear phase, it would gradually increase its allocation to equity.   As path-breaking as the idea was, it never got to see the mass adoption that it should have.  In this post, I propose to revisit this idea and its origins, suggest some tweaks, and make the case for its place in the future of the mutual fund industry.

This idea came out of the heartburn that investors experienced in the bear phase of 2000-01.  Leave aside the technology funds, from the market peak of 11 Feb 2000 to the bottom of 21 Sep 2001, most diversified equity funds lost over 50% of their value (some lost over 80%).  Questions were being raised about the competence of fund managers- why hadn’t they exited their holdings and stayed in cash?  A commonly heard response from fund houses was that it was not the mandate of the fund manager to do so.  In a way, that was true.  But a couple of questions remained unasked and unanswered.  Could a fund manager have accurately timed the market, if he/she were to have had the mandate? Would investors have been more forgiving if a fund manager did try to time the market, but erred on the side of caution?

In the process of searching for answers, the erstwhile Pioneer ITI Mutual Fund decided to present the investors with a choice.  In Jan-Feb 2002, it launched the Pioneer ITI PE Ratio Fund (PERF) - an equity-debt, tactical asset allocation scheme that would automatically change its allocation based upon the P/E Ratio of the NSE-50.  To further eliminate the scope of bias, the equity portfolio was to replicate the NSE-50 index.  Only the debt portion was to be actively managed.  For a fund house that prided itself on its equity fund management as well as its focus on investor interests, this was a bold move.  It was quite like telling investors: if you truly doubt our competence as fund managers, then it is in your best interest to go for this scheme.  As things turned out, very few investors showed any interest.

A few months after the launch, Pioneer ITI was acquired by Franklin Templeton, and shortly afterwards, work began to morph PERF into something that might be more appealing to investors.  The index investing strategy made way for active management, and SEBI’s allowing of the launch of funds-of-funds, presented an opportunity to capitalize on schemes with a proven, stellar track record.  Thus was born the Franklin India Dynamic PE Ratio Fund of Funds (FIDPERF).  This scheme has gone on to inspire a handful of other schemes across the industry, some of which manage more money.  But the longer vintage of FIDPERF combined with its consistent adherence to its stated asset allocation make it the best scheme to analyze to understand what such a strategy can accomplish.

So, what does FIDPERF have to show for itself?

The fairest comparison of this scheme’s performance would be with its underlying equity fund, Franklin India Bluechip Fund (FIBF).  What emerges is the extent to which FIDPERF has been able to protect downside risk.  The best example of this is its performance in the bear phase of 2008-09.  While FIBF fell by nearly 55% from the peak, FIDPERF lost only 35% of its value.  To anyone who understands the maths of downside risk, this is a significant difference.  Again, in 2010-11, while FIBF fell by nearly 21% from the peak, FIDPERF fell by less than 7%. 

The effect of this downside risk protection can also be seen in the range of returns over longer periods.  The table below gives the maximum and minimum returns of both these schemes (excluding loads) over investment periods of 3, 4 and 5 years.

Annualized Returns



3 years: Max



3 years: Min



4 years: Max



4 years: Min



5 years: Max



5 years: Min



While it would have been only natural for FIDPERF to protect the downside risk, one may be tempted to argue that so would any well-managed balanced fund.  I am not aware of any balanced fund that has consistently focussed on large-cap stocks.  Even so, as far as I can make out, no balanced fund in existence over this period has protected the downside risk this well.  That FIDPERF has done so is because of its ability to reduce its equity allocation below the level of any balanced fund.  What is also noteworthy is that this performance is despite the very questionable performance of the predominant underlying debt fund.  In 7 out of the 10 calendar years from 2004 to 2013, this debt fund gave less returns than a 1 year SBI bank deposit.  In those 7 years, the returns of this debt fund trailed the returns from a 1 year bank deposit by an average of 2.90% p.a..  This includes one year where the returns lagged behind by as much as 5.29% p.a..  (PS: that fund was finally replaced last year).

But more than the comparison, it is the implications of these numbers for investors that make the case for FIDPERF.  These numbers suggest that FIDPERF is a scheme that has the potential to give the kind of long-term returns that one would associate with an equity fund, yet without the need to time one’s entry or exit. In other words, it offers the rare combination of the potential for equity-like returns with peace of mind.  As research in Behavioral Finance suggests, such a combination significantly enhances the chances of an investor staying the course, a trait that experts regard as a key to long-term wealth creation.  That, in my opinion, is the biggest triumph of its strategy.

Of course, given that most investors rely on financial advisors to guide them on buy/sell decisions, it is equally important that advisors regard FIDPERF in that light.  Unfortunately, there has been limited conviction amongst most advisors and even those tasked with promoting the scheme.  The media, which could have directly provided insights on this scheme to investors hasn’t helped either- it has rarely given this scheme the prominence it deserved.  

Usually, if a deserving scheme does not attract  the investments it deserves, I feel a bit of sadness for advisors who couldn’t see the opportunity, and for the investors who rely on such advisors.  This scheme draws stronger emotions from me: it makes me pity those clients whose advisors couldn’t see this scheme for what it truly is.  It also makes me wonder why the powers that be, at SEBI, AMFI and the industry at large haven’t thought of using the scheme’s strategy to create a commoditized product.  Such a scheme would be easier to sell.  It could be sold by many more advisors.  It could be sold in a much more constructive manner, across the industry.  Here are some suggestions as to what this product should look like:

Just like FIDPERF, there should be a pre-defined asset allocation strategy linked to the P/E ratio of the NSE-50.  Let the equity portion replicate an index.  Let the debt portion be invested in money market instruments and high credit quality, short duration instruments. Give it tax benefits under Section 80 C.  Let the dividends and gains also be tax free.  Let it replace index funds and diversified equity funds in SEBI’s definition of ‘simple and performing’ schemes.

To build a culture of equity investing, I cannot think of a better stepping stone than such a product.  It is an idea that has worked well for anyone who has reposed faith in it. It is an idea that can give the industry much-needed, long-term stability.  It is an idea that the industry needs to work together on.

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