This post details a backtesting analysis based on the investment strategy to be adopted by the NFO IDFC Dynamic Equity Fund. It is inspired by a thread in facebook group Asan Ideas for Wealth started by Anup Maheswari.
IDFC Dynamic Equity Fund (IDEF) is a quantitative tactical asset allocation fund along the lines of Franklin's PE fund and DSP BR Dynamic Asset allocation fund (see details here)
From scheme information document Excuse the long verbatim extract.
The scheme aims to dynamically manage equity and debt exposure in the portfolio. We are of the belief that such strategy will minimize the risk and optimize the risk return proposition for a long term investor.
The extent of equity exposure would be guided by an underlying quantitative model. The balance will be invested in debt and money market securities. The fund managers will follow a passive investment strategy and take equity exposure depending on opportunities available at various points in time based on the month-end weighted average PE ratio and 200 Day Moving Averages of the CNX Nifty Index.
Equity market exposure will be taken as per the quantitative model outputs. These exposures will then be passively maintained by tracking any of the market indices (subject to tracking error). The Scheme will endeavour to invest in stocks in a proportion that it is as close as possible to the weightages of these stocks in the underlying Index, taking into account the change in weights of stocks in the index as well as the incremental collections/redemptions from the Scheme.
The index to be invested in (tracked) will be determined on relative valuation of indices (month-end weighted average P/E ratio of the respective index) amongst themselves. The scheme proposes to track (subject to tracking error) CNX Nifty and CNX Nifty Junior indices as its investment universe. The Scheme will switch between indices when the current ratio of the indices’ PE ratios (PE of CNX Nifty/PE of CNX Nifty Junior) is above or below its 18 month standard deviation.
The scheme shall invest in various types of permitted debt and money market securities (including G-Sec) across maturities. The allocation to various types of debt / money market securities would be based on the fund manager’s view on interest rates and the market conditions.
Use of equity derivatives:
Under normal circumstances, the scheme shall primarily invest in equity and equity related instruments in the range of 65% to 100% and fixed income securities including money market instruments in the range of 0% to 35% for capital appreciation. The scheme will vary its investment in equity and equity related instruments and move towards exposure to equity derivatives when it needs to bring down the equity exposure below 65% depending upon the quantitative model.
In the periods where the model indicates a bullish market, the exposure of the scheme in equity and equity related instruments will increase of up to 100%. However, if the market movement reflects a bearish tint, the scheme will restrict its investment in equity to 65% and if necessary shall hedge this equity exposure in underlying stocks up to the extent of 35% of the portfolio by taking offsetting position in the derivative segment, therefore resulting into an equity market exposure going below 65% bringing it down up to 30%. In such a scenario the balance will be invested into debt market instruments.
Determining the equity exposure:
A quantitative model will be used to determine the exposure in equity and debt markets. The portfolio shall be rebalanced on the last working day of the second week of every month.
The quantitative model approach used to determine the equity and debt allocation employs valuation and momentum factors namely month-end weighted average P/E Ratio and 200 Day Moving Averages (“DMA”) of CNX Nifty index. Valuation (P/E ratio) is used to determine whether markets are cheap or expensive relative to their 10 year history. We believe that the P/E ratio captures broader market valuations very well and thus helps judge market cycles while the moving average (200 DMA) help determine near term market sentiment.
The funds asset allocation will follow a two step approach. First, the band in which monthly average of the Nifty PE falls is determined. Then depending on the 200 day daily moving average, the equity allocation will be fixed.
I was curious to check how this strategy works using past Nifty data. I have used the same asset allocation strategy but with only one index – the Nifty.
Unlike the fund I have assumed changes to the equity allocation on a daily basis (possible only on Excel!).
1) Monthly average of Nifty PE was computed.
2) The equity allocation was determined with this on the above basis
3) The daily index returns were computed.
4) The daily fund-strategy return was computed according to the calculated equity allocation.
5) The 1-year and 5-year rolling returns for the index and the fund-strategy were computed.
Note: This analysis brings out the flavour of the funds strategy and is not an attempt to replicate what the fund aims to do.
The 200 Day Daily Moving Average (DMA)
Notice that when the Nifty is above the 200-DMA, it represents an upward trend and when the Nifty is below the 200-DMA, it represents a downward trend. In a sideways market, the Nifty could repeatedly cross the DMA either way.
The 1-year rolling returns
Notice that outlined strategy is less volatile than the Nifty. It has good downside protection and at the same time does not lose out too much when there is an upswing.
The 5-year rolling returns
This results in superior ‘long-term’ (relative to 1-year!) performance. The outlined strategy seems to have comfortably beaten the Nifty.
I will discuss more about such tactical asset allocation strategies (including Franklin's PE fund) in future posts.
IDFC Dynamic Equity Fund seems to be a better bet than DSP BR Dynamic Asset Allocation Fund (which in my opinion is a dud. The yield gap strategy it follows is too conservative and will lose out during bull runs).
IDEF’s strategy appears to be much better in this regard. Unlike the DSP BR fund (which is a fund of fund) this is an ‘active’ index fund!
Franklin's PE fund has a decent track record and it will be interesting to see how IDEF compares with it down the line.
Existing equity mf investors can give this fund a miss. For first time investors, this could be a suitable entry fund, provided they do not mindlessly buy other funds down the line.