FUND FLAVOUR

September 2018

Diversified Equity Funds

Key to excel amidst volatility

The word diversified means variegated or different. We all have heard the phrase “Strength lies in differences and not in similarities”. The same is conceptualized in the mutual fund industry as “Diversified Equity Funds”. In diversified equity mutual funds your investment is broken down into small segments and then re-invested into diversified categories of listed stocks. As, diversified funds invest across market caps such as – large cap, mid cap and small cap, they master in balancing the portfolio. Diversified Equity Mutual Funds invest in a combination of assets from various sectors e.g. Pharmaceuticals, IT, Banking, Real estate, Oil & Gas, FMCG, Telecom, etc. with the aim of achieving long-term capital appreciation. The mutual fund portfolio focuses on equity investments and is not restricted to a specific sector. This diversified allocation of funds across various sectors ensures that risk is minimized. The heart of diversified equity mutual funds is security. While investing in different categories and diversified schemes of the same category the money invested is secure from the sudden shock that the market gives. By investing in the best diversified equity funds, investors can earn slightly more stable returns. However, they would still be affected by the volatility of equities during a turbulent market condition.

One up on other funds…

·         Diversified equity funds invest across various sectors and market capitalization. Different sectors play out differently in various market cycles. For example – if the markets are rising the largest market cap stocks tend to perform well during the initial phase of the bull market. Mid and small cap stocks also tend to do very well when large cap valuations look stretched. However, when in bear markets, mid cap and small funds tend to be more volatile than large cap funds. Therefore, we can say that while the large cap holdings of the diversified equity fund provides a certain degree of stability in volatile market conditions; the small and midcap holdings enhance the returns over a long investment horizon.

·         Diversified funds are all season funds. As an investor, instead of choosing many funds from different categories you can choose a couple of diversified funds and remain invested for the long term. For example – you can choose funds from large cap, small cap, mid cap and sector funds and create a diversified portfolio. Whereas, if you are choosing good diversified equity funds then you need not select many funds from different categories.

·         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 capitalization, your risk also gets rebalanced. For example – you can invest in mid and small cap funds and take much higher risk but if you are investing in diversified equity funds the risk gets mitigated to a greater extent due to the large cap stock holding in the portfolio. While you may take moderate risk investing in large cap funds, in diversified equity funds, though your risk rises to moderately high level (due to mid / small cap holdings), you can be compensated by the superior returns.

In fact, Diversified Equity Funds work well in dynamic market conditions.

…beating them in their terrain

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  – excepting in the year 2006, 2008 and 2011. 2006 was an exceptional year when large cap returns were better than that of diversified equity funds. Year 2008 and 2011 were the years when markets gave negative returns. After the great fall in 2008, the diversified equity funds gave almost 85% return in 2009 when the markets rallied, compared to around 65% return 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. The trailing returns of diversified equity funds were superior then large cap funds over the last 1, 3, 5 and 10 year periods.

Through the crystal ball…

Well, no one has a magic crystal ball that can foretell which mutual fund schemes will top the list over the next decade. However, through years of experience, one can define a process that can be used to shortlist potentially the best diversified mutual fund schemes for the future. There are various aspects within a mutual fund scheme, which are vital for investors to analyse before investing; which are:

·        Performance: The past performance of a fund is important. But, remember that past performance is not everything, as it may or may not be sustained in future and therefore should not be used as a basis for comparison with other investments. It just indicates the fund’s ability to clock returns across market conditions. And, if the fund has a well-established track record, the likelihood of it performing well in the future is higher than a fund which has not performed well.

Under the performance criteria, we must make a note of the following:
 
   

1.    Comparison: A fund’s performance in isolation does not indicate anything. Hence, it becomes crucial to compare the fund with its benchmark index and its peers, so as to deduce a meaningful inference. Again, one must be careful while selecting the peers for comparison. For instance, it does not make sense comparing the performance of a mid-cap fund to that of a large-cap. Remember: Don’t compare apples with oranges. 

2.    Time period: It is very important that investors have a long-term horizon (of at least 3-5 years) if they wish to invest in equity oriented funds. So, it becomes important for them to evaluate the long-term performance of the funds. However this does not imply that the short term performance should be ignored. Besides, it is equally important to evaluate how a fund has performed over different market cycles (especially during the downturn). During a rally it is easy for a fund to deliver above-average returns; but the true measure of its performance is when it posts higher returns than its benchmark and peers during the downturn. 

3.  Returns: Returns are obviously one of the important parameters that one must look at while evaluating a fund. But remember, although it is one of the most important, it is not the only parameter. Many investors simply invest in a fund because it has given higher returns. Such an approach for making investments is incomplete. In addition to the returns, one also needs to look at the risk parameters, which explain how much risk the fund has undertaken to clock higher returns. 

4.    Risk: To put it simply, risk is a result or outcome which is other than what is / was expected. The outcome, when different from the expected outcome is referred to as a deviation. When we talk about expected outcome, we are referring to the average or what is technically called the mean of the multiple outcomes. Further filtering it, the term risk simply means deviation from average or mean return. Risk is normally measured by Standard Deviation and signifies the degree of risk the fund has exposed its investors to. From an investor’s perspective, evaluating a fund on risk parameters is important because it will help to check whether the fund’s risk profile is in line with their risk profile or not. For example, if two funds have delivered similar returns, then a prudent investor will invest in the fund which has taken less risk i.e. the fund that has a lower SD. 

5.    Risk-adjusted return: This is normally measured by Sharpe Ratio. It signifies how much return a fund has delivered vis-à-vis the risk taken. Higher the Sharpe Ratio better is the fund’s performance. As investors, it is important to know the same because they should choose a fund which has delivered higher risk-adjusted returns. In fact, this ratio tells us whether the high returns of a fund are attributed to good investment decisions, or to higher risk. 

Alpha is a measure of diversified fund’s performance on a risk-adjusted basis. It measures how much the fund has performed in the general market on a risk adjusted basis. A positive alpha of 1 means that the fund has outperformed its benchmark index by 1%, while a negative alpha of -1 would indicate that the fund has produced 1% lower returns than its market benchmark. So, basically, an investor’s strategy should be to buy mutual funds with positive alpha.

Beta measures volatility of a diversified fund compared to its benchmark index. Beta is denoted in positive or negative figures. A beta of 1 signifies that the mutual fund NAV moves in line with the market. A beta of a greater than 1 designates that the mutual fund is riskier than the market, and a beta of less than 1 means that the mutual fund is less risky than the market. So, lower beta is better in a falling market. In a rising market, high beta is better.

6.     Portfolio Concentration:  Ideally, a well-diversified fund should hold no more than 50% of its assets in its top-10 stock holdings. Remember: Make sure your fund does not put all eggs in one basket.

7.      Portfolio Turnover: The portfolio turnover rate refers to the frequency with which stocks are bought and sold in a fund’s portfolio. Higher the turnover rate, higher the volatility. The fund might not be able to compensate the investors adequately for the higher risk taken. Remember: Invest in funds with a low turnover rate if you want lower volatility.

·        Fund Management: The performance of a mutual fund scheme is largely linked to the fund manager and his team. Hence, it is important that the team managing the fund should have considerable experience in dealing with market ups and downs. As mentioned earlier, investors should avoid funds that owe their performance to a ‘star’ fund manager. Therefore, the focus should be on the fund houses that are strong in their systems and processes. Remember: Fund houses should be process-driven and not 'star' fund-manager driven.

·         Costs: If two funds are similar in most contexts, it might not be worth buying a mutual fund scheme which has a high costs associated with it, only for a marginally better performance than the other. Simply put, there is no reason for an AMC to incur higher costs, other than its desire to have higher margins.

The two main costs incurred are:

1.   Expense Ratio: Annual expenses involved in running the mutual fund include administrative costs, management salary, overheads etc.  Expense Ratio is the percentage of assets that go towards these expenses. Every time the fund manager churns his portfolio, he pays a brokerage fee, which is ultimately borne by investors in the form of an expense ratio. Remember: Higher churning not only leads to higher risk, but also higher cost to the investor. Also Direct Plans exclude distribution costs, hence, a cheaper alternative to Regular Plans.

2.      Exit Load: Due to SEBI’s ban on entry loads, investors now have only exit loads to worry about. An exit load is charged to investors when they sell units of a mutual fund within a particular tenure; most funds charge if the units are sold within a year from date of purchase. As exit load is a fraction of the NAV, it eats into your investment value. Remember: Invest in a fund with a low expense ratio and stay invested in it for a longer duration. 

After all, you require mutual fund schemes that stand by you in good times and in bad – meaning, the schemes need to manage the downside of the market well, apart from generating sound returns in a market rally.

…taking steady SIPs

In times of volatility, a SIP would undoubtedly be a prudent route as compared to investing your corpus as a lumpsum. If the markets do not turn out in your favour and your SIP delivers disappointing returns, do not be dismayed. When investing in equity, it is important to keep a long-term investment horizon of three to five years or more, even if you are investing via a SIP. The returns may be a few percentage points lower as compared to a lumpsum investment, but it will still be sufficient to meet your financial goals. It is important to note that there are several benefits of investing via a SIP as a regular form of investment - a hassle-free investment route, deals with market volatility and devoid of behavioural biases. For the long term, equities still remain the best route to create wealth. Hence, when investing in diversified equity funds, adopt the systematic approach to investing.