FUND FLAVOUR - SEPTEMBER 2008

FUND FLAVOUR

During the past one year, commencing from September, 2007, I have been enabling you to savour one “fund flavour” in the first week of every month. From September, 2008, I shall give you an update of the flavour dealt with in the previous year. Gem Gaze, NFO Nest and Fund Fulcrum will appear in the second, third and fourth weeks respectively.

Diversified Equity Funds – an Update

The Best Bet!

As the name suggests, Diversified Equity funds invest in a wide basket of stocks, picked from several industries. Diversified funds are particularly suitable when the market rally is across the board, i.e., when many sectors and stocks are expected to do well. They provide capital appreciation over a long period (5-10 years). They invest in stocks from a diverse array of industries. They prevent adverse impact due to a downturn in one or two sectors and are hence less volatile.

While soaring stock markets during the past four years led the party at Diversified Equity Funds, the allure has dimmed considerably ever since the bears gripped the market in January 2008. Investors who laughed all the way to the bank till last year, have started fretting. Although there is optimism about the future direction of the market, caution should be exercised in terms of your portfolio exposure. If you are unsure as to which equity fund category to look at, Diversified Equity Fund is the best option…given that the India growth story is intact.

The Euphoria…

The top-100 list, carved out from a set of 24,887 funds tracked by global fund intelligence firm Lipper includes five India-dedicated offshore funds. Over the 10-year period ended December 2007, Indian funds are clear winners with seven of the world's top 10 funds from India. Indian funds had a revelling year, with the broader markets faring well and the mid- and small-cap segments outperforming their bluechip peers by a significant margin in 2007. India’s main stock index, the Sensex, rose 47 per cent in 2007, as foreign funds, attracted by strong economic growth and corporate performance, poured more than $17 billion in local shares, the highest in a single year. Globally, equity funds showed an average return of 2.52 per cent, but the 306 Indian funds among them delivered an average 55.64 per cent gain.

…and the Downturn

Actively managed diversified stock funds in India, which posted their best annual returns in four years in 2007, lost all their gains of 2007 in the first half of 2008, according to Lipper data. These funds' net values plunged 38.8 percent on an average as weak global markets and concern on domestic economy under pressure of inflation triggered a fall in the stock market. Contraction in the benchmark index by a third in the first half of 2008 forced fund managers to seek safety in cash, which rose to more than a five-year high of 11.84 percent on an average in June 2008, data from fund tracker ICRA Online revealed. 80 % of India's actively managed diversified equity funds underperformed the benchmark BSE index in July 2008 on higher cash holdings and relatively lower returns from their mid and small-cap bets. Net asset values of diversified equity funds (only 38 of 201 diversified funds beat India's benchmark index), the biggest group of stock funds by assets and number, rose an average 4.29 percent as compared to 6.64 percent rise in the benchmark index, according to data from global fund tracker, Lipper.

Diversity is the Spice of the Portfolio

Funds are now embracing diversification with alacrity. Predicting the peaks and troughs in any business cycle to perfection is a tough call. So, while sector funds are in the high-risk and high-return zone, over a long term, diversified equity funds tend to outperform sector funds with a big margin. But no matter what your view on market efficiency is, you can still argue that widespread diversification is the best policy. The human ego being what it is, it is all too easy to convince yourself that you are a Warren Buffett, able to spot great investments. Humility counsels you that no, you are not that good, and would be better off hedging your bets through diversification.

This diversified approach creates many advantages. First, it reduces the risk from concentrated holdings in select stocks or sectors. Performance is not dependent on the returns of a small set of stocks or a particular sector. If some sectors/stocks are not doing well in the portfolio, the other ones may be expected to outperform and deliver better returns and, therefore, compensate you.

Second, diversified funds can invest across market capitalisation — small, mid and large — and take advantage of any rally in these stocks. Of course, there are exclusive large, small and mid-cap funds as well. However, a fund that has the flexibility to invest in stocks of varied market capitalisation may be in a better position to capitalise on prevailing trends in the market and could deliver superior returns over the long term.

Third, even as they stick to the principle of diversification, diversified funds can step up exposures to themes that are in market fancy at any given time and gain from the momentum in those sectors. Therefore, investing in diversified funds does not mean that you will miss out on prevailing ideas.

Fourth, a diversified fund reduces the importance of timing the market. This is because there is a long window of opportunity for different sectors to outperform and deliver superior returns. A diversified fund can also quickly switch its preference between sectors and themes and continue to outperform the market over a long period.

Because of these features, diversified funds are suitable for long-term investors.

The Evergreen Fund

The case for Diversified Equity funds in the context of current volatility is strong in view of the following factors:

* Given strong fundamentals, diversified funds are likely to do well over the long-term.
* A broader portfolio reduces risk.
* Diversified funds offer better selection and variety of stocks.

Given the market condition we are in, mutual funds are looking at a long-term time horizon. Considering a time span of 5 to 10 years, you should only think of diversified equity funds; you should not get tactical and not become a fund collector. You should choose a few solid funds, review these investments every 12 months and continue doing it. You can accumulate substantial wealth through systematic investment in Diversified Equity Funds.