Understanding business cycle mutual funds

The economy moves through distinct cyclical phases known as the business cycle. It comprises four key stages - expansion, peak, contraction and trough. As an investor, recognising this cycle and adapting investments accordingly can optimise the return potential and mitigate risks. This is where business cycle or economic cycle mutual funds come into play. But first, let us understand the business cycle in greater detail.

• Table of contents

• What is a business cycle?
• How do business cycles impact investing?
• Business cycle mutual funds
• How do business cycle funds work?
• Benefits of investing in business cycle funds
• Factors to consider before investing
• Who should invest in business cycle funds?

What is a business cycle?

The business cycle refers to the repetitive sequence of expansion and contraction in economic activity over months or years. There are four definitive phases in a business cycle.

Expansion phase: Recovery after a slowdown where demand, production, employment and incomes start rising. Consumer and business confidence improves.

Peak phase: Growth peaks and economic indicators flatten before starting to decline. Inflationary pressures may emerge.

Contraction phase: Decline after the peak, marked by falling demand, profits, employment and incomes. Investor sentiment turns cautious.

Trough phase: Bottoms out as the lowest point of activity and spending before the next expansion begins.

The business cycle is a key dynamic shaping the economy that investors need to track.

How do business cycles impact investing?

The business cycle and its distinct phases significantly influence investment decisions and returns in several ways.

• Timing of investments: Determining the current cycle phase can inform whether to increase stock or bond allocations.
• Sector rotation: Different sectors outperform in different cycle stages. Rotating between defensive and growth sectors is key.
• Risk management: Expansions encourage risk-taking while contractions warrant caution.
• Long-term planning: Recognising cyclical ups and downs allows developing long-term strategies resilient to short-term fluctuations.

Business cycle mutual funds

Business cycle or economic cycle mutual funds aim to generate reasonable risk-adjusted returns by allocating dynamically across stocks, bonds and cash based on the prevailing business cycle stage.

These funds invest more in equity during expansions when the economy is strengthening. As growth peaks, they rotate into relatively stable defensive stocks. In downturn phases, fixed income and cash allocations rise to prioritise preservation of capital.

The fund manager actively adjusts the portfolio by identifying leading indicators of the cycle stage and positioning accordingly.

How do business cycle funds work?

Business cycle funds follow three key strategies.

Macroeconomic analysis: Fund managers analyse various high frequency economic indicators like GDP growth, industrial production, credit growth etc. to determine the current and forecasted cycle stage.

Sector and asset allocation: Equity sectors with growth sensitivity and defensive stocks are included for expansions and contractions respectively. Fixed income and cash weights are also adjusted.

Risk management: Downside mitigation strategies are utilised such as hedging equity exposure with derivatives or increasing cash and defensive assets.

Dynamic asset allocation allows potentially capitalising on upcycles while limiting drawdowns in downturns.

Benefits of investing in business cycle funds

Market timing: Fund managers can make timely asset allocation calls using economic indicators to better time equity and fixed income exposures.

Active management: Specialised experience in economic analysis to dynamically rotate across asset classes and sectors.

Diversification: Exposure across both growth and defensive stocks, bonds and cash acts as a cushion against volatility.

Lower volatility: Tactical asset allocation and risk management helps curtail potential losses in bear phases compared to pure equity funds.

Hedge against cycles: Provides a mechanism to balance portfolios across business cycle fluctuations compared to passive funds.

Long-term growth: Capable of generating inflation-beating returns over multiple market cycles despite interim churn.

Factors to consider before investing

However, business cycle funds come with certain considerations that investors should evaluate.

• High reliance on fund manager's skill in forecasting cycle turns.
• Potential for mistiming the cycle or reallocation lags poses risks.
• Underperformance relative to equity in bull runs due to lower net equity exposure.
• Higher expense ratios than passive funds due to active management involvement.
• Subject to volatility as cyclical equity rotations can be unpredictable.
• Liquidity risks if defensive assets chosen are not sufficiently marketable.

Who should invest in business cycle funds?

• Investors seeking a fund manager's expertise in dynamic asset allocation over market cycles.
• Moderately conservative investors aiming to limit losses in downturns through tactical capital preservation.
• Long-term investors focused on generating inflation-beating returns across 5-7 year periods.
• Those near or in retirement looking for equity participation with relatively lower volatility.
• Investors looking for active management to time markets rather than passive funds.

Conclusion

While not easy to execute, cyclicity is an inherent trait of markets. Business cycle mutual funds offer active management aiming to efficiently rotate across growth and defensive segments over economic cycles. For investors concerned by volatility, these funds can provide a way to harness the upside potential in expansions while insulating against bear market risks. However, the success is contingent on the fund manager's foresight and timing abilities. As with any actively managed product, analysing historical performance across business cycles, portfolio characteristics and risk metrics is advisable before investing.

FAQs:

What are the key phases in a business cycle?

The four main stages are expansion, peak, contraction and trough. Expansion denotes recovery, peak is the height of growth, contraction indicates a downturn while trough is the bottom.

What is the benefit of business cycle funds?

The aim is to generate equity-like return potential over the long run with relatively lower volatility by increasing equity allocation in upcycles and getting defensive in downturns.

How do business cycle funds work?

They dynamically adjust asset allocation and rotate between sectors based on economic indicators and the fund manager's cycle outlook.

What are the risks of business cycle funds?

Key risks are manager risk in forecasting turns, mistiming rotations, underperformance in bull markets, and higher costs due to active management.

Who should invest in business cycle mutual funds?

They can suit moderate investors, retirees seeking equity exposure with lower volatility and those focused on long-term inflation-beating return potential.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.