FUND
FLAVOUR
September 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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