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P/E Ratio based funds: Which one is right for you?
Wed, Jan 30, 2013
Source : Jeni Shukla, Citrus Interactive

Price-to-earnings (P/E) ratio is a widely-used financial ratio that reflects how expensive a particular stock or market index is. It compares the market price of the stock or index with its earnings and reflects how expensive its valuation is. Currently three mutual funds have a clear mandate of using this ratio to determine their portfolios. These are:

Franklin Templeton Dynamic P/E Ratio Fund of Funds. This fund invests its equity component into the flagship Franklin India Bluechip Fund and the debt portion into Templeton India Income Fund. The fund can go up to 100 per cent in either of these funds. It is benchmarked against the BSE Sensex and is managed by Anand Radhakrishnan.

Tata Equity P/E Fund: This is an open-ended equity fund. According to fund manager Bhupinder Sethi, “Tata Equity P/E Fund follows a value-conscious style of investing. It is a multi-cap fund, which invests at least 70 per cent of its net assets in shares which at the time of investment have a trailing 12-month P/E ratio that is lower compared to the trailing 12-month P/E ratio of the BSE Sensex.” The remaining portion can be invested in growth companies with an upper ceiling of 30 per cent. It can go only up to 20 per cent in debt. It is benchmarked against the BSE Sensex.

Principal Smart Equity Fund. This fund decides how much it will allocate to equity assets based on the equity market's price-earnings ratio (P/E Ratio). When the market becomes expensive in terms of P/E ratio, the fund reduces its allocation to equities and moves assets into debt and/or money market instruments, and vice versa. The fund can go up to 100 per cent in either debt or equity. Unlike the other two funds, it benchmarks itself against the Crisil Balanced Fund Index. This fund is relatively new as it was launched in December 2010. Anupam Tiwari has been managing it since August 2011.

While there are other asset allocation and equity funds in existence they do not explicitly mention P/E as the deciding factor to determine their asset allocation. Some funds like Pramerica Dynamic Fund use a proprietary model to decide their asset allocation.

Next, we compare the three funds on the following parameters:

Returns

 

1-Year

3-Years

5-Years

Since Inception

FT Dynamic PE Ratio FoFs

20.02

7.80

7.64

18.04

Tata Equity P/E Fund

29.53

4.88

1.63

20.90

Principal Smart Equity

30.67

NA

NA

6.90

BSE Sensex

25.70

3.61

-0.86

-

All figures in % as on December 31, 2012; Returns above 1 year in CAGR terms

Although FT Dynamic PE Ratio fund lags behind the Sensex over the one-year horizon, it has beaten it over the three- and five-year periods. Its return since inception is also higher than that of its benchmark. Tata Equity P/E, on the other hand, has outperformed the Sensex over the one-, three- and five-year periods. Principal Smart Equity has given the highest return in the one-year period.

 

 

2007

2008

2009

2010

2011

2012

FT Dynamic P/E Ratio FoFs

27.42

-25.74

51.66

11.02

-5.44

20.02

Tata Equity P/E Fund

83.60

-54.78

98.94

16.83

-23.76

29.53

Principal Smart Equity

-

-

-

-

-13.17

30.67

BSE Sensex

47.15

-52.48

76.35

17.43

-24.64

25.70

 

In terms of calendar year returns, FT Dynamic PE Ratio FOFs managed to limit its losses by a larger margin in the declining markets of in 2008 and 2011. In the bull markets of 2007, 2009, 2010 and 2012, Tata Equity P/E Fund delivered superior returns. When asked about the fund’s outperformance in 2012, Bhupinder says: “In CY12, the factors that aided performance were stock-specific winners in software, FMCG and banking, and overweight positions in sectors like auto ancillaries and cement.”

It is clear that Tata Equity P/E is a more aggressive fund that does better in a rally while underperforming in a falling market.

Risk

In terms of risk measures such as standard deviation and beta (measured over the last three years) FT Dynamic PE Ratio has a lower level of risk compared to Tata Equity P/E. (Principal Smart Equity is excluded because it does not have a track record of three years).

 

 

Standard Deviation

Beta

FT Dynamic PE Ratio FoFs

0.4708

0.4108

Tata Equity P/E Fund

0.9363

0.7741

 

Portfolio Strategy.

FT Dynamic P/E Ratio FOFs: The PE ratio is calculated as the weighted average PE ratio of the 50 stocks that are part of the S&P CNX Nifty Index. This fund endeavours to eliminate subjectivity by following a unique in-built buy-sell discipline based on market valuations.

 

Weighted average PE ratio of NSE Nifty

Equity component

(%)

Debt component

(%)

Up to 12

90 – 100

0 – 10

12-16

70 – 90

10 – 30

16-20

50 – 70

30 – 50

20-24

30 – 50

50 – 70

24-28

10 – 30

70 – 90

Above 28

0 – 10

90 – 100

 

For instance, in September 2008 when the stock market was badly hit by the global financial crisis, the Nifty was at a P/E of 17. At that time, the fund had a 58 per cent exposure to Franklin India Bluechip Fund and 42 per cent exposure to Templeton India Income Fund. When market P/E fell to 14 in March 2009, the fund increased its allocation to Franklin India Bluechip fund to 90 per cent. So when P/E levels are high the fund increases its debt exposure and vice-versa. Rebalancing is done in the first week of the month. Currently the fund has allocated 61 per cent to the equity fund and 41 per cent to the debt fund.

Tata Equity P/E Fund.  According to Bhupinder Sethi, “The fund-of-funds approach follows an asset allocation strategy like taking cash calls and increasing weightage to equities based on the P/E ratio of the overall market or some key indices. Tata Equity P/E Fund follows a strategy of picking value stocks with the primary filter being the P/E ratio. While fund-of-funds focuses on mere asset allocation, Tata Equity P/E Fund focuses on creating wealth over a period of time by buying companies at attractive valuations, i.e. relatively lower P/E ratios.” The rolling P/E of the last completed quarter is considered for the company as well as for the BSE Sensex.

Principal Smart Equity. It is an open-ended equity fund that uses an asset allocation approach very similar to that of FT Dynamic P/E Ratio FoFs. It invests in large-cap companies. It defines large-cap stocks as those with market cap equal to or above the market cap of the lowest market-cap stock in the BSE 100 Index. The pre-defined PE bands are narrower than in the case of FT Dynamic P/E Ratio FoFs. Rebalancing is done before the end of the month.

 

Weighted average PE ratio of NSE Nifty

Equity component

(%)

Debt component

(%)

Up to 16

100

0

16-18

80-100

0-20

18-20

60-80

20-40

20-24

30-50

50-70

24-26

10-20

80-90

26-28

0-10

90-100

Above 28

0

100

It is clear that Principal Smart Equity has a riskier strategy between P/E Ratios 16 to 20 compared to FT Dynamic P/E Ratio FoFs. Therefore, it is not surprising to see that the latter fell 5 per cent compared to the former’s fall of 13 per cent in 2011.

Expense Ratio. Tata Equity P/E has the lowest expense ratio of 2.21 per cent followed by 2.48 per cent for Principal Smart Equity and 2.71 per cent for Franklin Templeton Dynamic P/E Ratio FOFs.

Exit Load. Principal Smart Equity has an exit load of 1 per cent for two years while the other two funds have an exit load of 1 per cent for a year.

Conclusion

FT Dynamic P/E Ratio is suitable for conservative investors who are averse to volatility, yet want to participate in equity markets at good valuations. Principal Smart Equity has a short track record, yet going by the data available it is suitable for moderate investors with a slightly more aggressive allocation to equities. Tata Equity P/E Ratio Fund uses the multiple to select 70 per cent of its portfolio, hence it is suitable for aggressive investors who want value picks for long-term wealth creation in their portfolio.

 

 
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