FUND FLAVOUR
July 2021
Diversified Equity Funds…
A Diversified Equity
Fund refers to any equity fund that invests in companies across multiple
sectors and industries. While an ordinary equity fund selects stocks, from a
pool of listed stocks, that comply with
the investment strategy, a diversified equity mutual fund invests in stocks
across companies, industries and market capitalization. These mutual funds seek
to participate in the overall economic growth, considering they are not limited
to a specific industry or market capitalization. Generally, a diversified
equity fund can invest in companies across the Pharmaceuticals, Automobiles, Engineering,
Power/Utilities, Technology, Oil and gas, Banking and finance and FMCG sectors.
Diversified Equity Funds are categorized into the following on the basis of the
size of companies initiating the investments.
·
Small-cap Diversified
Funds: Small-cap Diversified Mutual Funds offer high returns
and are best suited for young investors below 35 years of age 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 capitalization 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 capitalization 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.
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 minimize risks, proving to be a smart long-term
investment option that accrues good returns even during 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.
Investing in diversified equity funds is a
prudent long-term investment strategy that has the potential to generate
sizeable returns even when the market is not performing at optimum capacity.
Some of the benefits have been stated below:
·
The key benefit of a diversified fund is its potential to contain volatility as a result
of its diversified investment portfolio which helps distribute the equity
investment risk across multiple investments. Additionally, as these schemes
invest primarily in equities, they have the potential of delivering high
returns, especially in the long term. They invest in companies across different
market caps and hence reduce the amount of risk in the fund. Diversification
helps prevent events that could affect a single sector and hence reduce risk. Since
equity investments are inherently risky in nature, investors with moderate to
high-risk tolerance can consider investing in diversified equity funds. Investing
in companies across industries and market capitalization helps avert
unsystematic risks that may result from sector or market cap-specific stocks or
funds.
·
A diversified
equity mutual fund invests in stocks starting from Rs.500 to ones that may run
into lakhs. This is beneficial particularly for first-time investors seeking
exposure to the equity market. Investors with a smaller risk appetite can benefit as well.
·
Investments in diversified equity mutual funds saves expenditure on monthly transaction
cost associated with regular portfolio management to overcome booking
profits and laggards, and opting for other stocks that show the promise of high
capital gains leading to further transaction costs. Purchase or sale of these
funds in volumes ensures higher economies of scale, even if the guidance of a fund
manager is opted for. What is more, short-term capital gain tax is not incurred,
enabling higher return on investments. The only additional cost that needs to
be paid is the minimal expense ratio, which is an annual expenditure.
·
An expert fund manager, with his professional management
skills, can help tide
over challenging economic scenarios by enabling informed decision-making,
thereby keeping market volatility at bay.
·
Systematic Investment Plan (SIP) that allows investment in small
amounts periodically (can be weekly, monthly or quarterly) instead of a lump
sum can be leveraged. This serves to encourage financial discipline.
Criteria for choice…
·
Diversified equity funds are suitable for investors who have a long-term
investment horizon. The important factor here is to stick to the period of
investment in order to obtain handsome high returns. These funds experience a
lot of fluctuations in the short-term but are better performers in the long
run.
·
Diversified equity funds come with a diversified
investment strategy, they are considered beneficial for achieving the long-term
objectives of the investors like retirement planning, child’s education etc. If
the investors are invested for their investment period, these funds accumulate
a substantial level of wealth in terms of returns.
·
Similar to various other funds, diversified
funds also charge a fee to manage investor’s money, also known as the expense
ratio. Since these funds are managed to take advantage of the changing market
scenarios, these funds might have a high turnover
ratio and related transaction cost. However, despite having the costs at a
higher-end, these funds perform better than large-cap and small-cap stocks in
terms of returns.
·
Diversified equity funds aim to achieve wealth creation by investing in stocks
across market capitalization. Their portfolio comprises large-cap, mid-cap
and small-cap stocks and are relatively less risky as compared to pure mid-cap
stocks. The fund manager also considers factors such as PE ratio, EPS etc.
before investing in a stock.
·
As with other funds, diversified equity funds also
face market-risks depending on the overall market conditions. A fund manager plays an important role in changing the
sub-asset allocation across the portfolio to take advantage of the changing
market conditions.
·
In the case of diversified equity funds, it is
important to evaluate the history of the
fund along with the fund manager. A fund manager plays a crucial role in
terms of taking advantage of the market conditions and creating wealth for
investors. Ideally, investors should be looking for past performance, market
reputation and the workings of the fund. Furthermore, it is important to keep a
track on the fund manager and the changes, if any.
·
It is important to compare the 5 – 10 year returns of the fund. The funds that have
beaten their benchmark indices can be considered for the investments.
Furthermore, it is also important to compare the returns of the fund with
peers. This will lead to a better understanding for the investors.
·
Apart from the benchmark index evaluation,
investors should also evaluate the historical performance of a fund and weigh the consistency of the fund. In
the long term, many diversified funds tend to plunge during the market
downturn, with the plunge even below their benchmark indices and category
average. Only a few tend to sustain their performances in all market
conditiohns. Picking a fund that performs well in upturns and downturns is
important, else the fund selected may do well, but only to see later that all
returns get wiped out in a downturn. Thus, an investor should make sure that the
most consistent performers are included in the portfolio.
·
Sharpe ratio is considered as an important
metric when it comes to diversified equity funds. The Sharpe ratio measures the performance of the investment as compared
to a risk-free asset. It is calculated by taking the difference between the
returns of the investment and the risk-free return divided by the standard
deviation of the investment. The higher the Sharpe ratio, the better is the
risk adjustment of that fund.
Performance estimate…
Return
on diversified mutual fund can be estimated through the following formula:
Diversified Fund Returns = Real GDP
Growth Rate + Inflation + P/E expansion delta + Market segment risk premium +
Fund Manager Alpha
The
real GDP growth and inflation determine the Earnings Per Share (EPS) growth of
the overall economy. When P/E expansion (Price-to-Earnings) of the market,
which is the benchmark, is added the estimated return on diversified mutual
fund is obtained. Market segment risk premium is unique to every fund.
Historical returns do not usually determine future returns, but an estimate of
market benchmark index returns may enable investors to get an idea of the alpha
that the fund manager has created. The alpha generated by the fund manager is
directly proportional to the wealth created over a long term, that is, the
higher the alpha created, the higher will be the return on investments.
…and reality
The category is
facing a mini crisis as most of the large diversified equity funds have
underperformed their benchmark like BSE Sensex and NSE Nifty 50 index. Their
underperformance has been really stark during the COVID-19 pandemic. Reliance
Industries alone accounts for nearly 30 percent of the rise in Nifty 50 index
from March lows and two-thirds of all returns in the last six months has come
from six stocks. Diversified mutual funds, however, by definition invest in a
diversified portfolio containing dozens of stocks so as to minimize downside
risk from any particular stocks. The industry regulator Securities and Exchange
Board of India (SEBI) also caps the maximum exposure of a fund in a particular
stock. This is pushing investors to sector-specific funds. For example, the
last six months have been one of the best periods for Pharma or IT &
Technology Funds. The period also saw the rise of index funds whose portfolio
mimics the composition of benchmark indices such as Sensex or Nifty. Till a few
months back, index funds and other such passive funds were a niche category in
India as actively managed funds usually did better. All said and done, diversified funds are still the best for equity investors
especially retail investors.
On the pedestal…
Diversification
is an important aspect of investing that helps mitigate the risk. As a result,
most equity mutual funds hold around 50-80 stocks in their portfolio. Diversified
equity mutual funds are now a popular investment vehicle for investors because
of poor show by other assets, with the exception of gold, in the last 5-6
years. However, gold is a pure play capital asset and it does not provide any
yield or interest on the initial investment. In contrast, most top stocks pay
annual dividends to investors. Moreover, equity mutual funds are a convenient
means for investors and savers to take exposure to equity. The process has been
aided by a massive investment in the mutual fund industry in marketing and
distribution. Historically diversified mutual funds were the default port of
call for investors and the industry. The category became so popular with investors that five biggest
diversified funds now have combined assets under management of Rs 1.17 lakh
crore, according to data from Mutual Fund India. The sectoral and
thematic funds may provide superior returns in the short-to-medium term but
they are very risky. A big negative news in one top stock in that sector or a
global development in that sector can wipe-out years of gains in a matter of
weeks. In comparison, returns in diversified funds are much less dependent on a
particular stock or a sector. There is now a similar risk in index funds due to
the ever-growing weightage of top stocks. The top 5 stocks now account for 45
percent of the combined market capitalization of all 50 stocks in the Nifty 50
index. Five years ago, the share of top five stocks was only 29 percent. Even
worse is that top 3 stocks now account for nearly 35 percent of the index
market capitalization against 19 per cent five-years ago. What this means is
that a big negative development in any top stocks could translate into a sharp
correction or volatility in the index and the index funds that mimics it. Given
this, diversified equity funds provide the best risk reward ratio to investors
even if they underperform in the short to medium term, so much so that most investors concentrate on diversified mutual funds, which play a
vital role in the stock market.
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