FUND FLAVOUR

September 2014

What is in a name?

Diversified funds are those equity funds which have a diversified portfolio with at least 75% investment in equity. Being a diversified fund it cannot have more than 5% of the investment in one security and not more than 10% of the outstanding share in one security. Equity is their second name and that is where the bulk of their money goes. But, they also have the mandate to invest in debt and cash (including money market instruments).Within the equity asset class, there are a lot of differentiating factors too. Since diversified is their first name, that is what you can expect from such funds. The fund manager enjoys the flexibility to research the market and based on the research which takes into account market inputs, economic conditions, and political environment, he can modify his portfolio and vary the proportion. What you need to see is how diversified they are and whether or not they cater to your investment taste. Has your fund manager invested in too few stocks? Or is he very heavy on one market cap? Besides market cap and cash allocation, the funds will also differ on the number of stocks that each fund manager decides to invest in.

The varied assortment

 

While we talk about diversified equity funds as a category, it will be inaccurate to assume that they all have the same focus. In fact, nothing could be further from the truth. Take a sample of what is on offer. Some funds like Magnum Midcap, Franklin India Prima, Sundaram BNP Paribas Select Midcap, and Birla Mid Cap are focused on mid-caps. DSP Top 100 Equity invests in the 100 largest corporates. Funds like DBS Chola Contra, Kotak Contra, Magnum Contra, Tata Contra, and UTI Contra employ contrarian investing. They buy into fundamentally sound scrips, which have underperformed in the recent past or have not been discovered. Birla Sun Life Frontline Equity targets the same sectoral weights as the BSE 200 but retains the flexibility of selecting stocks within those sectors. Templeton India Equity Fund invests in stocks (India and overseas) that have an attractive (current or potential) dividend yield. A look at their portfolios reveals that they differ in their asset allocation, sectoral weightages, market cap allocation, and number of stocks that they invest in.

Why invest in Diversified Mutual Funds?

Diversified mutual funds do not keep all the eggs in one basket. There are multiple sectors where your money is invested so your exposure is limited and the fund manager has the flexibility to switch to another sector in case he gets inputs about a sector not doing well.

Diversified funds are known to outperform other equity funds in the long term (period more than 5 years). Thus it makes sense to align investments in the diversified funds with your long term goals like retirement, child’s education etc. Investing in diversified mutual funds ensure that you do not have to monitor them very closely.

Portfolio construction of a diversified fund depends on the fund manager and his research team. An in depth research goes into creating a portfolio of a diversified fund where the fund manager takes an investment call after considering multiple factors. The fund manager either adopts bottom up or top down investment approach in stock selection. In the bottom up approach, he first tries to analyze company fundamentals, interacts with the management, studies the sector outlook and then does macro analysis at economy level. Top down approach is exactly reverse of this, as first the macro economic factors are studied then sectors get shortlisted and then the stocks get selected for investment. In a nutshell, the fund manager plays a very active role in stock/sector selection and paves way for superior stock selection and professional fund management.

As the fund manager plays a very active role in diversified funds, the possibility of earning market beating returns are high and risk reward ratio tends to be high. But dependence on the skills of the fund manager increases as far as the performance of diversified equity fund is concerned. So, to track the past performance of the fund manager, consistency with which the fund manager has generated returns in the past and cost in terms of fund management are few of the important factors to consider while selecting diversified fund.

A good long term bet

India’s diversified equity mutual funds rose in 2013 but underperformed the broader markets for the first time in five years, as returns were dampened by the losses in the mid- and small-cap shares as well as financial companies. These funds gained 4.8% on an average in 2013, according to data from fund tracker Lipper, delivering lesser annual returns than the benchmark BSE Sensex.  Funds were hurt because of the significant exposure to smaller shares — data from Morningstar India showed that 35.54% of equity funds’ assets on average were allocated to such stocks. Allocation to certain sectors also weighed on the performance of equity diversified funds in 2013.

Over the last 10 years, diversified equity funds have returned 22.29% on an average, much more than any fixed-income instruments could have offered. Even if one chose to invest in passively managed Index Funds, the return stood at 18.14% over the same period. However, the one-year, three-year and five-year returns of average diversified equity funds stood at 4.49%, 5.73%, and 4.23%, respectively, much lower than interest rates offered by banks or post offices.

Pearls of wisdom

It is plain wisdom that to invest in a diversified equity fund, you need to pick the right one that suits your requirement the best. It is of utmost importance that your investment objective is in tune with the diversified equity fund’s investment objective. When evaluating a large cap diversified equity fund for investment, you must compare its yield with other matching large cap diversified equity funds. Diversified equity funds are designed to deliver returns over long period of years; you should invest in diversified equity funds with a foresight. You can observe the consistency of the returns of a diversified equity fund by its performance during different market phases combined with the category average. It is mandatory for every diversified equity fund to mention a benchmark index in its offer document. This benchmark index is the signpost to judge if the diversified equity fund has fared well. Apart from peers and benchmark index evaluation, a diversified equity fund must be judged by its historical performance. Those warriors who brave rough times and display stability are the ones to add to your portfolio. Besides performance analysis, you must consider the costs involved with making investment in that particular diversified equity fund scheme as this affects your net returns from that scheme. If you overlook the risk factor, you might lose your hard-earned money. So you must do risk-return analysis of a diversified equity fund before you invest in it.

To sum it up, a diversified equity fund with a proven track record of at least three years (five years is better) and from a fund house having prudent investment systems and processes in place is able to broadly outperform other equity funds. It has lower or similar volatility but better risk adjusted returns. However, before taking any investment decision, you as an investor need to evaluate your risk appetite, investment goals, etc. Though an equity diversified fund is bound to outperform other equity funds due to its diversification across different sectors and market capitalisation and the fund manager’s liberty to change his strategy based on his view on the market, you should adopt a prudent and systematic approach towards selecting and investing in the right diversified equity mutual funds (as not all diversified equity funds are well managed and able to provide superior returns).