Managing Drawdowns Lessons From Mutual Fund Volatility

Drawdowns are a natural part of investing in mutual funds. While they can test investor patience, history shows that funds with strong fundamentals and a disciplined approach tend to recover and generate long-term wealth. This article explores the lessons we can learn from mutual fund volatility and how managing drawdowns is the key to achieving long-term financial goals[EasyDNNnews:PaidContentStart]

Imagine you are on a road trip to a dream destination. The route is scenic, the weather is perfect, and your playlist is on point. Suddenly, you hit a rough patch of road riddled with potholes. Your speed drops, your car wobbles, and for a moment you wonder if your journey is worth continuing. But as you persevere and navigate carefully, the road smoothens, and you are back on track, enjoying the journey once again. 

Investing in mutual funds can feel remarkably similar. The destination? Wealth creation or achieving your financial goal. The rough patch? Market drawdowns—those inevitable, sometimes jarring declines in portfolio value that test your patience and resolve. But just like a skilled driver, a savvy investor knows how to navigate these drawdowns and stay on course. This article explores the lessons we can learn from mutual fund volatility and how managing drawdowns is the key to achieving long-term financial goals. 

What is Drawdown?
In mutual fund investing, a drawdown refers to the decline in the value of your investment from its highest point to a lower point during a rough market phase. Think of it as a dip in the journey of your investment. For instance, if your mutual fund was worth ₹1 lakh at its peak and then dropped to ₹80,000 during a market correction, that ₹20,000 loss represents the drawdown. While it might seem alarming, drawdowns are a normal part of market cycles and often temporary. They serve as a reminder that markets can be unpredictable, but with patience and the right strategy, recovery and growth are often just around the corner. 

The perfect example of the above is what we saw during the start of the corona virus pandemic. Most investors saw their investment value declining by more than 30 per cent as equity indices themselves declined by more than 35 per cent in a span of few months. Nonetheless, the market regained all its lost value within some months and the portfolio of most investors might have not only recovered, it might have also gained by the end of the year. 

Key Aspects of Drawdowns in Mutual Funds
1. Peak-to-Trough Decline: It is measured from the highest net asset value (NAV) of the fund to the lowest NAV during a specific timeframe.
2. Temporary in Nature: Drawdowns do not reflect permanent losses unless investments are redeemed at the lowest point.
3. Risk Indicator: A drawdown highlights the risk and volatility of a fund, helping investors assess how much value a fund can potentially lose during market downturns. 

Many investors have doubts regarding drawdown, volatility and correction. The following table gives you a glimpse of the difference between these three. 

Key Differences

By understanding these distinctions, investors can better evaluate risks and respond to market changes with the right perspective. 

Examples of Drawdowns in WellKnown Mutual Funds
Understanding drawdowns becomes clearer when we look at real-life examples from well-known mutual funds. Here are some significant instances: 

HDFC Flexi-Cap Fund (earlier HDFC Equity Fund) - Global Financial Crisis (2008)
■ What Happened: During the 2008 financial crisis, equity mutual funds across the board, including the once top-performing HDFC Equity Fund (now HDFC Flexi-Cap Fund), experienced steep declines due to a broad-based market crash.
■ Impact: The NAV of HDFC Equity Fund fell by almost 60 per cent from its peak during this period, exceeding the Sensex and Nifty drawdowns.
■ Lesson: Despite the drawdown, the fund recovered as markets rebounded, reinforcing the importance of staying invested during downturns. Since 2006, the fund has generated return of more than 15 per cent every year. If you had exited while it was still falling at the start of 2009, you would have missed annualised return of 19.3 per cent, which means you would have opportunity loss of Rs 18 lakh profit on every Rs 1 lakh invested. 

SBI Small Cap Fund - Mid-Cap and Small-Cap Correction (2018-2019) 
■ What Happened: After a sharp rally in 2017, small-cap and mid-cap stocks corrected heavily in 2018-2019 due to high valuations and weak earnings. Even during the pandemic fall they saw a drawdown of 40.26 per cent.
■ Impact: SBI Small-Cap Fund, a popular scheme, saw a drawdown of about 28 per cent from its peak NAV during this period. The value of NAV dropped from Rs 66.2 at the start of 2018 to Rs 49.7 by the end of February 2019.
■ Lesson: Small-cap funds are more susceptible to drawdowns, and investors need to have a long-term horizon to ride out the volatility. From the lows of March 24, 2020, the NAV of the fund is now at Rs 209.47, which means the fund has given a CAGR of 41.05 per cent. 

ICICI Prudential Value Discovery Fund - Value Style Underperformance (2015- 2016) 
■ What Happened: Value-focused funds struggled during a phase of market preference for growth stocks. It was particularly during the last decade (2015-16), however, that we saw value-dedicated funds struggle to maintain their position.
■ Impact: ICICI Prudential Value Discovery Fund saw its NAV generate a return of around over 20 per cent from its peak during this period, despite the broader market holding up relatively well.
■ Lesson: Investment styles (growth versus value) can affect fund performance, and cycles should be accounted for in long-term strategies. 

Patience During Downturns
Investing, especially in mutual funds, comes with its ups and downs. During downturns, markets often experience temporary declines, and mutual fund portfolios can see their value drop too, imitating the market. However, these phases are usually short-lived in the context of a long-term investment horizon. 

Why Patience is Crucial
History shows that markets have a natural tendency to recover and grow over time. Panicking and withdrawing investments during a downturn lock in losses and eliminates the possibility of benefiting from a recovery. 

Importance of Staying Invested to Ride the Recovery
Market recoveries often happen quickly and unpredictably, making it essential to stay invested to capture these gains.
■ Missed Opportunities: Investors who exit during a downturn may miss the best-performing days of the market, which typically occur shortly after a correction or crash. As seen in the above cases, funds generated superior returns post their drawdown, which would have been missed if you had exited during the drawdown.
■ Compounding Benefits: Staying invested allows compounding to work uninterrupted, helping to grow your wealth over time. 

Importance of SIPs in Mitigating Market Drawdowns
Systematic investment plans (SIPs) are one of the most effective tools for reducing the impact of market drawdowns while enhancing long-term returns. By investing a fixed amount regularly, investors can take advantage of rupee cost averaging, purchasing more units when the market is low and fewer when the market is high. This helps mitigate risk and smoothen returns over time. 

Let’s understand this with two real-life examples:
HDFC Flexi-Cap Fund
If an investor had started a SIP of Rs 1,000 every month on April 1, 2006 (FY07), they would have invested a total of Rs 2,26,000 till now. This amount would have grown to Rs 13,27,420, generating an XIRR of 16.7 per cent. In contrast, if the investor had invested a lumpsum of Rs 10,000 on April 1, 2006, it would have grown to Rs 1,46,487, giving an XIRR of 15.42 per cent. 

The additional 1.26 per cent XIRR from SIPs can be attributed to consistent investments during market lows, which improved the overall returns.

ICICI Prudential Value Discovery Fund
A similar pattern can be observed in the ICICI Prudential Value Discovery Fund. Here too, the SIP investment generated significantly better returns than a lumpsum investment. If an investor had invested Rs 1,000 every month through SIP since April 1, 2006, the total investment of Rs 2,26,000 would have grown to Rs 16,57,983, delivering an XIRR of 18.62 per cent. On the other hand, a lumpsum investment of Rs 10,000 on April 1, 2006 would have grown to Rs 1,75,433, generating an XIRR of 16.54 per cent. 

The difference of 2.08 per cent XIRR further highlights how SIPs allow investors to take advantage of market volatility.

Why SIPs are Effective During Drawdowns
1. Rupee Cost Averaging: SIPs help investors accumulate more units when the markets are down, leading to a lower average purchase cost.
2. Mitigating Volatility: Regular investments cushion the impact of sharp market corrections, reducing the overall risk.
3. Discipline and Consistency: SIPs encourage disciplined investing, allowing investors to benefit from market upswings over time. 

SIP investments not only provide better long-term returns but also protect investors during market downturns. The above examples clearly show how SIPs outperform lumpsum investments, making them an ideal choice for investors looking to generate wealth while managing risks effectively. For long-term goals, SIP is a powerful strategy that ensures you stay invested, benefit from market lows, and ultimately achieve higher returns. 

Takeaway for Investors
These examples highlight that drawdowns are a natural part of investing in mutual funds. While they can test investor patience, history shows that funds with strong fundamentals and a disciplined approach tend to recover and generate long-term wealth. Staying invested during turbulent times and having a well-diversified portfolio can help mitigate the impact of drawdowns. 

"Volatility is not something to fear. It is simply the price of admission to a world of long-term rewards." 
Howard Marks
American Investor and Writer 

[EasyDNNnews:PaidContentEnd] [EasyDNNnews:UnPaidContentStart]

[EasyDNNnews:UnPaidContentEnd]