Mutual funds performance when stock markets are stable?

Mutual funds have long been considered a relatively stable investment option for small investors to harness the power of the stock market. Investing in a mutual fund demands less in terms of research than when compared to investing directly in stocks.

But how does the performance of the stock market affect the performance of the mutual fund you invest in?

Logically, equity funds may perform better when the stock market is stable, as the portfolio comprises primarily equities. Read on to understand the impact of a stable stock market in your mutual fund portfolio.

• Table of contents

• Impact of market stability on mutual fund performance
• Different types of mutual funds’ reaction to stability
• Mutual funds vs. stocks in a stable market
• Risk and return in a steady market
• Key benefits of investing in mutual funds during stability
• Should you invest more in mutual funds when markets are stable?
• Strategies for optimizing returns in a stable market

Impact of market stability on mutual fund performance

Equity mutual funds that invest in stocks tend to perform relatively better when markets are stable. This is because stable stock prices allow fund managers to follow long-term buy-and-hold approaches, leading to potentially higher portfolio returns.

With low volatility, fund managers need not modify equity allocations frequently. The absence of wild price swings enables methodical building of exposure to quality stocks across market caps and sectors based on growth potential, valuations and earnings consistency.

Hence, equity funds can generate potentially higher returns from compounding in stable markets when stock prices appreciate gradually over long periods.

Moreover, during stable markets, equity funds can maintain higher exposure to mid cap and small cap stocks to tap into their growth potential as the risk of sharp drawdowns diminishes.

In contrast, high volatility requires fund managers to dynamically adjust equity exposure and stock selections to manage risks. This defensive approach may limit participation in rallies, creating performance drag. Do remember that equity funds can still underperform benchmarks even in stable markets if stock selection is sub-optimal.

Read Also: How to Check Mutual Fund Performance in 2025: Key Metrics & Tips

Different types of mutual funds’ reaction to stability

Besides equity funds, other mutual fund categories also benefit from stock market stability in different ways.

For debt funds, steady bond yields due to low volatility may help keep interest rate risks contained. This provides stability to debt fund NAVs, allowing investors to earn relatively stable returns with minimal uncertainty.

Credit risk funds do well too as default risk perceptions on bond issuers are favourable when business conditions are stable.

For hybrid or balanced funds, stability enables fund managers to maintain exposure to equities while meeting income needs through the debt portion. With assured equity returns and steady debt income, hybrid funds can deliver consistent performance.

Even during stable markets, conservative hybrid funds tilt towards debt while aggressive ones are equity-heavy to optimise the risk/return balance. Market-linked hybrid funds can accurately capture market upsides through equity derivatives when volatility is low.

Mutual funds vs. stocks in a stable market

In a stable market, actively managed mutual funds can potentially outperform individual stocks. Fund managers have the expertise to identify sectors and segments poised to outperform and underweight or avoid those vulnerable to downside risks. This focused stock selection is hard for retail investors to replicate on their own. Through diversification across carefully picked stocks, mutual funds can cushion the impact of some underperforming stocks.

Direct equity investing requires getting a suitable stock selection consistently to outperform in a stable market. This is challenging even for seasoned investors. Further, some stocks may carry greater liquidity and concentration risks versus mutual funds.

However, in a low volatility environment, the broad market itself tends to generate steady returns over time. So, index funds and ETFs that passively track the market can match or even outperform active fund performance.

Risk and return in a steady market

While a stable market supports mutual fund returns through lower volatility, it also limits extraordinary upside potential. In assessing mutual funds for investment during stable periods, don't equate low volatility to low risk. Consider these aspects.

• Stability may lead to complacency regarding lurking risks. Review the portfolio composition and risk metrics.
• Lower returns than historical highs are likely. Moderate return expectations accordingly.
• Stability encourages mispricing of risk, which eventually gets corrected. Look for funds with quality orientation.
• Passively managed index funds become relatively more fitting. However, active funds can still outperform.
• Stability may prolong overvaluation. Funds with valuation discipline offer better downside cushion.

Key benefits of investing in mutual funds during stability

• Professional fund management expertise to tap into opportunities.
• Diversification across assets reduces concentration risk.
• Liquidity to enter or exit investments at short notice.
• Low ticket sizes may enhance accessibility for small investors.
• Tight regulation may provide strong investor protection.
• Potential to earn market-linked returns while outsourcing investment management.

Should you invest more in mutual funds when markets are stable?

Rather than timing the markets, use a stable period to review your asset allocation and fund selections. If the mutual fund portion is lower than required as per your risk appetite and investment horizon, deploy more systematic investment plan flows to increase mutual fund assets gradually. Redeem funds only if you are overallocated or portfolio rebalancing is needed to align with original asset allocation.

Avoid shifting large lumpsums into equity funds or moving into risky instruments under the impression that the stable environment mitigates risks. Stick to your predetermined investment plan.

If already adequately invested in mutual funds, stay put and continue SIPs during stability to benefit from rupee cost averaging. Change course only if personal circumstances or goals necessitate portfolio changes, irrespective of market conditions.

Read Also: Mutual Fund Factsheet: How to Read a Mutual Fund Factsheet

Strategies for optimizing returns in a stable market

• Prefer index funds or ETFs over active funds to save on costs.
• Consider value funds oriented towards reasonably priced quality stocks.
• Opt for dynamic asset allocation funds able to move tactically between asset classes.
• Among hybrid funds, conservatively managed balanced advantage funds work well.
• Avoid thematic funds chasing stability-induced market fads.
• Review and rebalance mutual fund portfolio periodically.
• Stay invested for long term; don't let stability entice market timing.

Conclusion

Periods of stability in stock markets foster a supportive environment for generating consistent mutual fund returns aligned with their mandated risk levels. While volatility is muted, stability can instill complacency about risks. Avoid excessive exuberance or major portfolio changes. Rather, make disciplined mutual fund investments, focus on risk management and stick to long-term plans. Maintain realistic return expectations and leverage stability to make tactical mutual fund moves for optimising portfolio growth and balance.

FAQs:

Do mutual funds give relatively better returns when stock markets are stable?

Potentially yes, mutual funds may yield higher risk-adjusted returns under stable stock market conditions because volatility is kept within limits. Then, fund managers can have maximum asset allocation freedom and exposure to operate better.

Which types of mutual funds benefit from market stability?

Equity funds, particularly actively managed diversified equity funds generally fare well when the stock market is stable as the fund managers have the option of long-term stock selection. Even hybrid funds and debt funds work well if the market is not volatile.

How does market volatility compare to stability in mutual fund performance?

High volatility compels fund managers to adopt defensive strategies, like cash raising or changing asset allocation often, which can restrict participation in market rallies. This can hold back mutual fund returns than from low volatility stable markets.

Should investors increase SIP investments during stable market periods?

Instead of market timing, investors must keep their SIPs going during stable times. Even when a rise in mutual fund allocation is necessary, stable times are a convenient period to do it with less uncertainty.

What are the risks of investing in mutual funds even in a stable market?

Stable markets may lead to complacency about risks. Overvaluation can continue and get corrected when stability fades. Also, mispricing of risks can happen. Therefore, optimal risk management by selecting suitable funds continues to be important even in stable market times.

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