FUND FLAVOUR

September 2017

Broad approach with…

Diversified equity funds, also known as multi-cap or flexi cap funds, invest in stocks of companies across market capitalization i.e., large cap, mid and small cap stocks. In other words, they have the flexibility to adapt their portfolios according to the market. They typically invest anywhere between 40-60% in large cap stocks, 10-40% in mid-cap stocks and about 10% in small-cap stocks. Sometimes, the exposure to small-caps may be very small or none at all. Diversified funds do not have any limitations on market caps from an investment point of view. They do not follow a sectoral approach. Instead, they adopt a growth or value investing strategy, buy stocks whose prices are relatively lower than their historical performance, book value, earnings, cash flow potential and dividend yields. These funds balance out the risk and reduce the volatility that usually comes with stock investments by investing across market capitalizations and sectors. Larger companies tend to perform better during tough market times than the smaller companies, and they can provide investors with better investment returns. Mid-cap stocks can stabilize portfolio returns with higher growth potential than the large cap stocks and lower risk than the small cap stocks.

…superior risk-adjusted returns

However, irrespective of the market caps, all stock investments carry a certain level of risk, and investors should closely monitor their investments as business conditions can change daily. Given that the underlying investment is equity, there is a risk of loss of capital that can occur in the short term. Nevertheless, diversified funds have exceptionally performed well over the past 3 and 5 years, returning 23% p.a. and 21% p.a. for the last three and five years, respectively. Research shows that in terms of risk return characteristics, diversified equity funds have given superior returns than large cap funds. The annual returns of diversified equity funds as a category have always been superior to large cap funds in most of the last 12 years -- starting from 2004 to 2015 -- except in the years 2006, 2008 and 2011. 2006 was an exceptional year when large cap returns were better than that of diversified equity funds. 2008 and 2011 were the years when markets gave negative returns. Even after the great fall in 2008, the diversified equity funds gave almost 85% return in 2009 when the markets rallied, compared to around 65% returns by large cap funds. Similarly, after a subdued performance in 2013 by both the categories, the diversified equity funds again bounced back by giving 50% return compared to around 35% return by large cap category in the year 2014. Even in terms of annualised returns, the trailing returns of diversified equity funds were superior to that of large cap funds over the last 1, 3, 5 and 10 year periods. In this context, however, you may find that while investing in diversified equity funds is a better option for seasoned investors, for new investors, large cap mutual funds can still be the best option.

Better bet in the long term…

Large cap funds offer higher safety on the relative basis, particularly during high volatility. Such funds restrict their investments to blue-chip companies. Large cap companies are generally associated with better liquidity, are well-researched and are managed by promoters or management with good track record. This helps infuse a sense of comfort and safety among investors. Large cap stocks are inherently less volatile as compared to mid and small cap stocks, as their businesses are generally quite evolved to sail through business vagaries. Within active equity mutual funds, large-cap schemes are least volatile and are relatively safer bets. In the past one year, however, mid-cap and small-cap schemes have outperformed large cap funds.  One year average return for midcap and small cap schemes is 26% and 30%, respectively as against 20% in the case of large cap funds. If you have an investment horizon of five years or more, which generally takes care of the risks in the stock markets, it is preferable to have two-thirds of exposure to largecaps and rest to mid-caps. Portfolios focusing on stocks with adequate diversification are still likely to deliver better point-to-point returns than large cap portfolios over the long term, provided you are ready to take possibly higher intermittent volatility.

…with a clear edge

As diversified funds or multi-cap funds invest across market caps, they have several benefits compared to funds focused on any one particular market cap. Some of these are discussed below:

·         The foremost advantage of diversified funds is that it reduces the need to keep a track on multiple funds in the portfolio distinctly. The need to maintain separate large cap funds, mid and small cap funds is eliminated.

·         During bull market phases, diversified funds tend to outperform large caps (in the long term) by capturing some of the upside offered by small and mid-cap funds. In the bull market rallies, the large-cap valuations (P/E multiples) run up faster to a point where they appear stretched.  In such scenario mid-cap stocks tend to outperform.

·         Since, diversified funds have all three large cap, mid cap and small cap companies in their portfolio, they have potential to deliver good performance on a consistent basis.

·         In the bear market phases, small and mid-cap stocks tend to suffer sharp declines and liquidity issues. Also, consequently, they face liquidity constraints when redemption pressures increase during phases of bear markets, especially when investors are exiting investments. On the other hand, diversified funds do not face liquidity problems as much—as large cap stocks comprise a sustainable portion of the portfolio.

·         Investing in diversified or multi-cap funds helps to prevent the tendency of investors to switch between large cap funds and mid-cap/small-cap funds based on short-term performance.

·         Different sectors play out differently in various market cycles. While the large cap holdings of the diversified equity fund provide a certain degree of stability in volatile market conditions, the small and midcap holdings enhance the returns over a long investment horizon. 

·         Instead of choosing many funds from different categories you can choose a couple of diversified funds and remain invested for the long term.

·         Diversified funds can provide superior returns compared to large cap and sector funds over a long investment horizon. The underperformance of one sector or market cap segment gets compensated by good performance of another sector or market cap segment. 

·         Diversified fund rebalances the risk. As you are investing across sector/market and capitalisation, your risk also gets rebalanced.

First time investors, investors not well-versed with the technique of asset allocation in respect to investments and investors who have a lower risk appetite and who wish to have an exposure in equities can park their funds in diversified equity funds.