FUND FLAVOUR

September 2019

‘Diversified’ is the name of the game!

Diversified Equity Funds, as the name suggests, diversify their assets across companies and sectors. Investing in several securities across sectors and market-caps enables you to overcome the unsystematic risk that arises from investing in limited stocks or sector-specific funds. Diversified Equity Mutual Funds aim at diversifying investments in companies across a wide range of sectors, irrespective of their size or whether they are large-caps, mid-caps or small-caps. These sectors usually are Pharmaceuticals, Banking and Financial Services, IT, Engineering, FMCG, Oil & Gas, Power and Utilities, Automobiles, Real Estate, etc. Large-caps refer to large companies with vast market capitalisations. Similarly, as their names suggest, mid-caps refer to mid-sized companies that offer medium capitalisations and small-caps refer to smaller companies with small market capitalisations. The primary aim of Diversified Equity Mutual Funds is to achieve long-term capital appreciation through diversified investments across the stock market. Besides, investing in different sectors also minimise risks, proving to be a smart long-term investment option that accrues good returns even during inflation and challenging economic scenarios. Diversified equity funds help investors meet long-term financial goals like children’s education, marriage, retirement plans, etc. Diversified equity funds offer investors the opportunity to benefit from the economic growth of the company that they have invested in. When a company achieves financial growth, a certain percentage of these gains automatically get passed on to investors who have invested in the company by purchasing their stocks or shares. HDFC Equity Fund, Reliance Growth Fund and ICICI Prudential Dynamic Plan are some good examples of diversified equity funds.

 Size matters…

Diversified Equity Funds are categorised into the following on the basis of the size of companies in which investments are made.

·         Small-cap Diversified Funds: Small-cap Diversified Mutual Funds offer high returns and are best suited for young investors below 35 years of age and with a high risk appetite. It is essential to manage these funds judiciously to reduce the risk of losses and ensure good returns.

·         Mid-cap Diversified Funds: Mid Cap Diversified Mutual Funds invest in companies with market capitalisation between Rs. 4000 crores and Rs. 20,000 crores. These funds are less risky in comparison to small-cap diversified mutual funds and usually offer high returns in the long term.

·         Large-cap Diversified Funds: Large-cap Diversified Equity Mutual Funds invest in companies with market capitalisation of at least Rs. 20,000 crore. Investors invest in stocks or shares of renowned blue chip companies that consider Nifty as their benchmark index. Investments in leading global companies ensure minimal risk, fetching good returns at the same time.

 

Diversified Equity Funds - one up on other funds

Diversified Equity Mutual Funds are suitable across sectors and market caps. These funds are not completely risk-averse. However, if you understand the risks, you can take decisions accordingly and reap rich rewards that these funds offer.

Professional Management

Fund managers are experts in portfolio management because they have extensive experience and knowledge about financial research. If you are not a seasoned investor, you can seek the help of a fund manager to guide you through unpredictable economic scenarios. Other than the expertise to anticipate market movements, fund managers are equipped with a team of research analysts who keep a close watch on changing market trends. They abide by an investment procedure and apply risk management strategies that they have improved upon through the years. You can make the most of the years of experience of these professionals in lieu of a small charge, referred to as an Expense Ratio, which is deducted from the NAV or Net Asset Value (NAV) of your mutual fund.

 

Lower entry level

If you plan to create a diversified portfolio of over 50 stocks, you would need an investment amount of Rs 25,000 - above Rs 1 lakh, depending on the price of the individual stocks. For example, the stock price of Maruti Suzuki India is around Rs 6,000, while that of Eicher Motors alone is Rs 25,000. Therefore, if you plan to have these stocks in your portfolio, you will need much higher capital to create a well-diversified basket of stocks. You simply cannot own one stock of Rs 25,000. This will account for 25% of the portfolio, for an investment of Rs 1 lakh.

The advantage you receive through mutual funds is that you can invest as little as Rs 500 and benefit from the diversification over 50 stocks or more; an approach that would have otherwise posed to be challenge. This is especially encouraging for investors who start small and at the same time get exposure to multiple securities.

Economies of scale

By investing in diversified equity funds, you can save lakhs in transaction costs over the long run. Imagine if you plan to invest some amount in equity stocks every month. Assuming you own a basket of even 20 stocks, you will incur high transaction costs. Going ahead if you actively manage your portfolio by scrapping laggards or booking profits and moving to other high growth stocks, you will incur further transaction costs. If you sell a stock before a year, the gains will attract a short-term capital gain tax @15%. Therefore, when investing in stocks directly, do not ignore the costs. If the costs work out to greater than 3% of your portfolio value and the returns are lower than the average equity funds, it is time you move to equity funds. When you invest in mutual funds, the voluminous purchase or sale of securities by the fund house results in greater economies of scale, than if you were to buy and sell a handful of securities yourself. In addition to this, the fund house does not incur short-term capital gain tax. This translates into better return on investments for you, while bearing a small expense ratio annually in your journey to wealth creation.

 

Save on Additional Costs

Investments in diversified equity mutual funds save you from spending on monthly transaction cost that is applicable on non-equity fund investments. Regular portfolio management to overcome booking profits and laggards, and opting for other stocks that show the promise of high capital gains lead to further transaction costs. Purchase or sale of these funds in volumes ensures higher economies of scale, even if you opt for the guidance of a fund manager. What is more, you also do not incur short-term capital gain tax, enabling you to avail higher return on investments. The only additional cost that you need to pay is the minimal expense ratio, which is an annual expenditure.

Innovative plans/services for investors

If you wish to invest directly with the fund house, direct plans are the way to go. These plans come with a lower expense ratio and you will save much more over the long term. The regular plans cost higher because they include distributor commissions. Hence, if you route your transactions through a distributor, you will get access only to the higher cost regular plans. Besides, there are two modes of investing: Systematic Investment Plans (SIPs); and Systematic Transfer Plans (STPs). You can set up a monthly SIP, through which a predefined amount is deducted from your bank account and invested in the selected mutual fund. This will allow you to average out your investment cost and will develop a regular saving habit. Under STP you can set up a monthly transfer from a debt fund to an equity fund. Further, some funds facilitate tactical asset allocation plans and trigger the facility to manage your portfolio from a financial planning perspective too. Also, if you wish to withdraw a certain amount at regular intervals, you have Systematic Withdrawal Plans (SWPs). These features allow you to seamlessly enter/exit funds, or switch from one fund to another.

 

Steps in the selection…

There is an extensive range of over 450 diversified equity mutual funds offered by as many as 44 asset management companies (AMC). This makes it a challenge for investors to select one that is a perfect fit for their risk appetite and meets their financial goals. While selecting a fund, you need to analyse the fund from different angles. There are various quantitative and qualitative parameters, which can be used to arrive at the best Diversified Equity Funds in accordance with your requirements. Additionally, you need to keep your financial goals, risk appetite, and investment horizon in mind. Let us look at a few criteria that you need to consider while purchasing a diversified equity mutual fund.

Quantitative criteria:

Fund returns and risk analysis

Fund performance by way of annualised returns is considered to be a crucial factor for the selection of funds. Investors may look for returns for a period of at least five years to ten years. One may, in fact, select funds that have consistently beaten their benchmark indices (index to which a fund’s returns are compared). They should also fare reasonably well when compared with their peer set over the longer time frames. You need to ensure that the fund has the ability to perform consistently across multiple market cycles, i.e. bull and bear phases. Therefore, compare the performance of the schemes vis-à-vis their benchmark index across bull phases and bear market phases. A fund that performs well on both sides of the market should rank higher on the list. The fund needs to be ranked on quantitative parameters like rolling returns across short-term and long-term durations, such as 1-year, 3-year, and 5-year periods, and on risk-reward ratios like Sharpe Ratio, Sortino Ratio, and Standard Deviation over a 3-year period.

 

Compare Estimated Returns Across Funds under the same Category

One of the primary factors to be considered for benchmarking is comparing funds that are enlisted under the same category. If you are aiming to invest in a certain large-cap diversified equity mutual fund, you have to compare its estimated returns with other large-cap diversified equity funds. Comparing it with small-cap or mid-cap funds cannot be a suitable yardstick for accurate estimates, since the risk-reward relationship varies among the market caps. While evaluating diversified equity funds, you also have to assess the long term returns that they are expected to deliver on the basis of their performance in the recent past. This is because equities offer higher returns when you invest in them for a period between 3 years to 5 years. Therefore, calculating their expected returns for a period below 3 years would not give you a conclusive picture of how the fund has been performing over a stock market cycle. Evaluating the performance of the fund across various market phases in comparison to the category average will help you in analysing the consistency of returns that has been generated by the fund.

Compare Returns against the Benchmark Index

All funds are expected to mention their individual benchmark index in their Offer Document. Apart from keeping a tab on the past performance of the fund, you also need to evaluate it on the basis of its benchmark index. Most equity funds perform better than their benchmark indices over the long-term of 3 years to 5 years, unless the economy is faced with turbulence.

Compare Against its own Past Performance

Besides comparing a fund with others from the same category and benchmark index, investors should take into consideration the past performance of the same fund as well. This will give you a clear insight into its stability and sustainability during market downturn and across the market cycle. This way you can track the most consistently performing funds and invest accordingly.

Check the Additional Charges Involved with the Fund

Check the additional charges, including the expense ratio that you will have to bear on investing in the fund as it will affect the net returns of the fund. Expense ratio is the annual expense incurred by funds, expressed as a percentage of their average net asset. It is charged from the overall returns earned by the fund. Expense ratio is what the mutual funds charge investors for investing on their behalf to manage their money. Direct mutual funds tend to have lower expense ratio as compared to regular mutual funds. You can save a lot on distributor commissions. You need to choose a fund which has a lower expense ratio. You also have to be aware of the exit load, that is, the fees levied by a mutual fund scheme on redemption before the pre-determined stipulated period. However, the exit load will not be applicable if you invest in the fund over a long term.

Qualitative Parameters:

Fund Objectives

Diversified Equity Funds aim at achieving wealth accumulation by investing in stocks that offer the best combination of high growth, risk, and value. The stock picking is based on investing style, which can be value investing or growth investing. Additionally, the fund manager may consider other quantitative measures such as P/E ratio, EPS, etc. to ensure that the portfolio is composed of only quality stocks.

Investment Horizon

Diversified equity funds are suitable for individuals having a medium or long-term investment horizon. Usually, the fund experiences a lot of fluctuations during the short-run which averages out over the long-run. Those who choose diversified equity funds need to be prepared to stick around at least for the said period to enable the fund to realise its full potential.

Financial Goal

Diversified equity funds are ideal wealth creators because these funds may accumulate more substantial wealth for achieving long-term financial goals like children’s higher education or retirement planning. Being a high risk-high return haven, these funds are capable of generating enough wealth, which may help you to retire early and pursue your passion in life.

Portfolio Quality

The portfolio quality of a fund points at how it is likely to perform in the future. Here is what you should pay attention to:

Adequate Diversification - The fund should not hold a highly concentrated portfolio. A concentrated portfolio heightens the risk involved. Hence, the portfolio of a fund should be well-diversified and the exposure to the top-10 stocks should be ideally under 50% while concentration to one particular sector should not exceed 30-35%.

Low Churn - Engaging in high churning of your portfolio can result in trading and high turnover cost. Therefore, you also need to consider the portfolio turnover ratio and expenses and penalise funds involved in high churning, i.e. those funds with a turnover ratio of above 100%.

Fund history and Fund manager

In case of diversified equity funds, along with the fund history, fund manager plays a vital role in running the entire show on expected lines. A strong parentage from a trusted fund house is necessary before you invest in a fund. You need to look into the past performance and reputation of the asset management company. Ideally, it should also have a clean and long business history of at least say five years. It ensures that the fund has seen all the market cycle of slumps and rally.

Quality of Fund Management

Further, consider the fund manager’s experience, his workload, consistency in clocking returns, and proportion of the Assets Under Management of the fund house that are actually performing. Therefore, check the following points before investing:

The fund manager’s work experience – He/she should have a decent experience in investment research and fund management, ideally over a decade. But also note that mere experience is not enough. Some schemes managed by fund managers with 15-20 years of experience have never done consistently well for a long time.

The number of schemes managed – A fund manager usually manages multiple schemes. Thus, you need to check if the fund manager is not loaded with a large number of schemes. If he is managing more than five open-ended funds, it should raise a red flag.

The efficiency of the fund house in managing your money – You need to check if the fund house is consistent in performance across schemes or if only a few selected schemes are doing well. A fund house that performs well across the board is an indication that sound investment processes and risk management techniques are in place.

The above list is a lot for an average investor to look at. It involves a lot of number crunching and much of the data is not easily available in one place. But if you do need to narrow down on the top funds, these factors are of utmost importance.

How they have fared…

 

The year 2018 was a volatile one for equity markets, which is an ideal situation to study the effect on equity funds as there was no steep rise or fall through the year. If we study the performance of systematic investment plans (SIPs) of diversified equity funds till November end, it will reveal a sorry picture for 1-year return, with 126 out of the 137 funds or almost 92 per cent of the diversified equity funds generating negative returns for the investors. The most battered funds were risky small-cap ones with as much as -33.3 per cent loss, while most of the 11 funds that gave positive returns were part of relatively lower-risk large-cap category with highest 1-year return of 5.75 per cent. By seeing the 1-year performance, you must be thinking, it would have been better to invest in fixed deposit (FD) with higher and guaranteed return. Now move to 2-year SIP returns of the same category of funds. In two years, 42 out of the 137 funds or 30.66 per cent diversified equity funds had generated negative returns with steepest loss of -15.81 per cent and highest return of 13.13 per cent. Now the category is still risky, but the highest return, again from large-cap category, is nearly double the prevailing FD returns. As we examine the 3-year returns of the diversified equity funds, we may see that the effect of market volatility further fades and only 5 out of the 137 funds or only 3.65 per cent of the funds end up in negative zone with maximum loss of -4.87 per cent, while the highest compound annual growth rate (CAGR) moves up to 14.03 per cent. The 4-year returns see that only 1 fund out of 134 funds has ended up in negative zone with -1.1 per cent return and rest 99.25 per cent funds giving positive returns with the highest CAGR of 14.56 per cent and average CAGR of the category hitting 7.81 per cent, which is equivalent to prevailing FD interest rates. From fifth year onwards, the impact of market volatility was completely faded out and no diversified equity fund had given negative return. The 5-year average CAGR of the category hit 10.45 per cent mark, with highest CAGR of 19.05 per cent of a small-cap fund and lowest of 2.51 per cent of a mid-cap fund. The average 6-year CAGR of diversified equity funds category was 12.91 per cent, with highest CAGR of 23.11 per cent and lowest of 3.47 per cent, while the 7-year average CAGR was 13.98 per cent, with highest of 24.26 per cent and lowest of 3.32 per cent. As we move to 10-year performance, the average CAGR was 14.15 per cent, with highest CAGR of 21.77 per cent and lowest of 8.17 per cent and the 12-year average CAGR was 12.78 per cent, with highest of 19.58 per cent and lowest of 7.59 per cent. Going to further long-term performances, the 15-year average CAGR was 13.47 per cent, with highest CAGR of 18.36 per cent and lowest of 7.86 per cent, while the average 20-year CAGR of the diversified equity funds category was 18.18 per cent, with highest of 22.01 per cent and lowest of 10.78 per cent.

About 75% diversified equity schemes have trailed the benchmark index. Fund managers faced a tough time beating the benchmark in 2018, with nearly three in four diversified equity schemes underperforming their respective underlying indices. A study of 235 equity schemes that includes direct plans shows that 168, or 71 per cent, have underperformed their respective benchmarks. This can be attributed to large sums chasing too few stocks, and the impact of regulatory changes such as categorisation of schemes as well as the introduction of total returns index, in lieu of a simple price index.

Over the last one year, despite the market turbulence Axis Equity Fund, UTI Equity Fund, Canara Robeco Equity Diversified Fund, ICICI Prudential Multicap Fund and Mirae Asset India Equity Fund have generated luring returns. The other diversified equity funds, which are not in the aforesaid list, but hold the potential to do well in 2019 and beyond are Aditya Birla Sunlife Equity Fund and Franklin India Equity Fund. Relying only on large caps might save you from volatile markets to an extent, but in case markets take a U-turn and rise sharply, large-cap funds might underperform  mid and small cap schemes. Thus, investing in diversified equity funds in 2019 makes a lot of sense. But remember not to pick a diversified equity fund by giving importance to the short-term market outlook, ignoring your personalized asset allocation, depending extensively on the past track-record of a scheme, relying blindly on star ratings, disregarding qualitative aspects associated with mutual fund selection and relying on the advice given by friends and relatives unqualified to give you advice on mutual funds.

 Is it for you?

For an investor with appetite for equities and long-term goals like retirement planning, saving for child’s education or child’s marriage, diversified equity funds either on a standalone basis or in a portfolio with other investments can prove useful. If you are one such investor, planning to invest in equity mutual fund schemes that have no market capitalisation bias, Diversified Equity Mutual Funds are the right choice for you.