Monday, September 05, 2016

September 2016
Diversified equity mutual funds are the most popular category of mutual funds among retail investors. Diversified equity funds invest across market capitalizations and sectors. Such active diversification ensures that the negative performance of one sector does not affect the entire portfolio and increases the possibility of making a sustainable return. These funds aim for medium to long term capital appreciation and are suitable for investors having moderate risk profile and investment horizon of at least three to five years. The investments of these funds could be vertical in nature where various sectors and a mix of various market caps are considered for investments. Diversified Equity funds with vertical investments tend to be more diversified than horizontal investments as it provides sectoral and market cap diversification and provides better cover against risk. Having too many large cap funds in your portfolio could stagnate your investment returns. Investing solely in mid and small cap funds could make your portfolio volatile and risky. Diversified Equity funds are that middle path which allows you to invest in all the market caps through one fund. Diversified equity mutual funds which invest across market capitalizations and sectors are ideal long term investment options for retail investors. As such these funds should form a substantial part of an investor's mutual fund portfolio.
Benefits of Investing in Diversified Equity Funds
Diversified equity funds, which invest across market capitalizations, have several advantages compared to funds focused on any particular market capitalization.
Stability in Bull and Bear Markets: Diversified Equity Funds comprise of all markets cap stocks. Large cap stocks due to high end market capitalization tend to be stable in bear markets and show moderate appreciation in bull markets. Mid and small cap stocks respond to market stimulations. While, they show higher appreciation in bull markets, their depreciation is in sync with the bear markets. The differences in the performance of these market caps get balanced in the Diversified Equity Funds. In a bear market the mid and small cap stocks have a tendency to be volatile even if the large cap stocks show moderate depreciation, thereby maintaining a steady balance. Due to this stability it allows investors with a varying risk appetite to park their investments in these funds.

Reduces the Need to Diversify: It is said that diversification in various asset classes determines the return of the portfolio and not the individual funds. Investing in Diversified Equity Funds reduces the need to diversify your portfolio as you choose an already diversified fund depending upon your investing needs and risk taking ability. As an investor, if you are looking for stability in your investments, you could allocate a larger portion of your investments in Diversified Equity Funds and the remaining in small and midcap funds. However, if you are an aggressive investor and ready to take high risk for long term appreciation then mid and small cap funds could be ideal investments for you.
A universal Appeal: The fund has a component to appeal to all kinds of investors: the risk takers, the safe players and the flexible investors. It also reduces the need to diversify. Hence, as an investor if you like to manage your own portfolio then this reduces your need to diversify to a certain degree. It provides stability to your portfolio along with a return range of moderate to high.

Diversified funds have outperformed large cap funds on a fairly consistent basis
Over the last ten years diversified funds, which invested across market capitalizations and sectors, outperformed large cap funds on a fairly consistent basis. Diversified funds have outperformed large cap funds in most years in the 10 year period from 2005 to 2015. Even in the market downturns the performance of diversified funds and purely large cap funds were more or less similar. Thus we have seen that, while diversified funds have outperformed large cap funds in bull markets, their downside risk is limited almost to the same extent as the large cap funds. While diversified funds which invested across market capitalizations and sectors outperformed large cap funds as a category, the difference in returns of top performing funds in both categories on the basis of the last 3 years annualized returns is even bigger. On a 3 year trailing basis, top performing diversified funds have 2 -10% higher returns than their large cap counterparts. The diversified funds which invested across market caps have generated superior risk adjusted returns in terms of alphas compared to the large cap funds.
Choose Diversified Funds wisely
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. In reality it is easier said than done. When there are more than hundred equity funds claiming best returns in their schemes, it is quite puzzling to zero in on one. You need to have a set of objective factors serving as parameters while selecting the right diversified equity fund. What matters is the performance of a diversified equity fund against all the parameters. The fundamental thing to remember is that not just one factor makes a diversified equity fund worthy enough to be a part of well-performing mutual fund portfolio. An ideal diversified equity fund must pass all these 6 parameters.
1. Match your investment objective with that of the diversified equity fund
It is of utmost importance that your investment objective is in tune with the diversified equity fund’s investment objective. For example, if you want to avoid risk, it is advisable for you not to invest in a small cap diversified equity fund that invests in small sized companies and can yield volatile returns.
2. Evaluate returns across diversified equity funds within the same class
To compare diversified equity funds within the similar category is one of the essentials for benchmarking a fund. When evaluating a large cap diversified equity fund for investment, you must compare its yield with other matching large cap diversified equity funds. Comparing it with mid cap diversified equity funds will not give you the real picture as the risk-reward relationship between both is too wide to compare. Another factor in evaluating a diversified equity fund is timeframe. Diversified equity funds are designed to deliver returns over long period of years; you should invest in diversified equity funds with a foresight. Evaluating a diversified equity fund over a longer timeframe helps you gauge its performance during boom and bust periods. 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.
3. Check diversified equity fund returns against the benchmark index
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. While evaluating the performance of a diversified equity fund against its benchmark index, you should take into account the longer time period. Those diversified equity funds that outperform their benchmark indices constantly are best suited for investment. In India, most diversified equity funds do better than their benchmark indices over long timeframe. But during choppy times you may find many diversified equity funds lagging behind their benchmark indices. Those diversified equity funds that stay ahead of their benchmark indices during rough times must be earmarked.
4. Evaluate the consistency of the diversified equity fund
Apart from peers and benchmark index evaluation, a diversified equity fund must be judged by its historical performance. Many diversified equity funds do not stay stable over the years. They take a dip during recessions and sometimes even dip below their benchmark indices and category average. Only a handful diversified equity funds perform strongly against all odds and display steady performance. Those warriors who brave rough times and display stability are the ones to add to your portfolio.
5. Check the costs associated with the diversified equity fund scheme
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. Before you make the final decision of investing in a diversified equity fund, you must check its expense ratio. Along with that you should also know the exit load (charges levied by a mutual fund scheme when redeeming within the stipulated period) while asking for redemption from a diversified equity fund scheme.
6. Risk-return analysis of diversified equity funds
To evaluate the performance of a diversified equity fund, it is common to look at its absolute returns. However, that is not enough as diversified equity funds being market-linked are susceptible to stock related risks. Hence, you should not only assess a diversified equity fund on the basis of returns but also take into account the risk involved with the fund.
Safeguard Your Mutual Fund Portfolio From 2008-like Scenarios
If there is one thing that is certain about the equity markets, it is that they will rise and fall. Most of these movements will be minor turbulences, whereas some will be earthshaking. Undoubtedly, a fair degree of risk aversion ensues after every such market cycle, with a number of retail investors 'swearing off' investing in the equity markets (or mutual funds), only to return and repeat the very same mistakes that led to losses in the first place. Unfortunately, renouncing Mutual Fund investments may prove to be an unwise decision for long term savers, who will miss out on the potential for wealth creation that these products offer. And yet, when you put into perspective that there have been times when even established funds with long term track records have seen values dip by 40-50 per cent in bad years, it suddenly becomes apparent why a single such event is enough to scare investors off for a lifetime. These situations can lead to opportunity losses in the long term. There are no iron clad promises in investing. A fund no matter how safe or risky could always surprise you and Diversified Equity Funds are not an exception. Historically it has been seen that long term investments in Diversified Equity Funds have beaten the returns of Bank Fixed Deposits, Gold and PPF returns with a decent margin.
Typically, the core purpose of investing in a mutual fund is not just to get higher returns but also to diversify and reduce your risk. This is more crucial when you are using these equity mutual funds to plan your long term goals like retirement, children’s education etc. You cannot afford to take the risk of sector funds as any negative news on the sector will mean that your long term goals are in trouble. That is surely not something you want. The moral of the story, therefore, is that if you are looking at long term goals it always makes sense to focus on diversified equity funds. You prefer investing in equities through mutual funds for the reduction of risk through diversification. You surely do not want to move away from that core idea.

To conclude, if you would want to continue participating in the long term growth that can only be afforded by equities, while at the same time ensuring that you do not get caught up in a 2008 like scenario, invest in plain vanilla funds, in accordance with your asset allocation policy, continuously through SIPs for the long term for time in the market wins over timing the market.

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