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Analysing the diversity in diversified equity funds

LiveMint logoLiveMint 20-06-2017 Kayezad E. Adajania

The most common terms can sometimes be the most confusing or misleading. Take the case of a diversified equity fund. Your distributor says you must invest in one. Your fund house says it’s the most basic of all equity funds and you must invest in it. But what exactly is a diversified equity fund? Where to find it and how to make money from it? Is it a multi-cap or a flexi-cap fund? If yes, then isn’t a large-cap or a mid-cap fund diversified? It’s important to know what this term diversified equity fund means because that’s what a typical adviser sells to most of us, especially if we are first-time mutual fund investors. 

At the very least, a diversified equity fund is one that diversifies across scrips and sectors. A multi-cap fund makes the cut here. Some financial advisers refer to multi-cap funds as diversified equity funds when they advise their clients. “Ideally, a multi-cap fund is a true diversified equity fund because it’s a multi-season fund. A large-cap fund works only when markets favour large-sized companies, a mid-cap fund works only when market prices of mid- and small-sized companies are shooting up and so on. But in times when such scrips (mid-caps) see market corrections, can investors stomach the volatility? That’s why a multi-cap fund is a true diversified equity fund,” says N. Vishwanath, founder and chief executive officer, Blue Ocean Financial Services Ltd. 

Predictably, definitions change with advisers. Gajendra Kothari, chief executive officer, Etica Wealth Management Pvt. Ltd believes a diversified equity fund is one whose portfolio is titled towards large-cap scrips; something he recommends “60% of the times. We generally try and avoid investing in pure mid- and small-cap funds.” 

So, does that mean that mid- and small- cap funds aren’t diversified equity funds? Poornima Katpadi, founder and investment specialist at Simplesolution4u, a Mangalore-based distributor disagrees. “We do recommend multi-cap funds as well as large-, mid- or small-cap funds to our investors. However, investors must understand the distinct characteristics of each of these type of equity funds. If the time horizon is more than 8-10 years, it makes sense to add a mid-cap or a small-cap fund to the portfolio as the stocks in the portfolio could eventually increase in market capitalisation (and therefore stock prices). But if the time horizon isn’t as long, stick to large-cap or multi-cap funds,” she says. 

Kunal Valia, director, Credit Suisse Securities India, says that all equity funds, apart from thematic and sector funds, are diversified equity funds “provided they invest in various sectors and stocks.” 

Experts say that diversification should not just be limited to whether your funds invest across sectors and/or market capitalisations. It’s a much broader term. Amol Joshi, founder, PlanRupee Investment Services says that exposures across asset classes should also be there in your portfolio to achieve, what he says is “true diversification.” Joshi explains that if a client invests just in fixed deposits or just gold or just real estate, then the portfolio is not diversified. “Diversification in a financial planning process is more about asset allocation and investing across asset classes like equity, fixed income and gold, based on investors’ risk profile and suitability,” adds Valia. 

Once you or your adviser decides what the right mix of large-, mid- and small-cap funds are suitable for you, based on how long you want to remain invested and how much volatility you can stomach; most financial advisers recommend a portfolio of around 5-7 equity funds. “If Fund A is bullish on corporate banks and Fund B is bullish on automobile sector, that way your portfolio gets the necessary diversification across sectors. If either works, you benefit,” says Joshi. 

But here’s where it gets tricky. What happens if two or more funds in your portfolio invest in the same stocks or sectors? As per Value Research, 111 of 177 equity funds (large-cap and multi-cap) have banking stocks as their maximum allocation. If most funds in your portfolio do the same thing—chase the same stocks and/or sectors, can you really achieve diversification? 

As per a Morningstar analysis, a US-headquartered mutual fund tracking and research firm, there is a high percentage of commonality between the 10 largest large-cap equity funds (around 40%). But other categories don’t have such a high correlation. The 10 largest mid- and small- cap funds have only about 16% commonality in their portfolios on an average, tax-saving funds have around 22% and multi-cap funds have about 20%. These figures are averaged. “The investment universe for large-cap funds is typically the top 100 stocks, thus there tends to be a fair bit of overlap between funds. That said, a portfolio overlap of 40-50% isn’t too bad, as the remaining portfolio can provide significantly different allocations and thus different returns profile. Mid-cap funds will tend to have little portfolio overlap due to the size of the available universe,” says Kaustubh Belapurkar, director, fund research, Morningstar India. 

“Banking sector, by virtue of being the largest sector in the benchmark indices, will be the largest sector exposure for many funds. That said, the remaining 65-75% of the portfolio can have a very different allocation. Even within the banking sector, stock allocations can be different—private sector versus state owned, or retail versus corporate banks. It is important to look at actual stock-level overlap and base your decision on that,” says Belapurkar. 

Fund manager styles also matter. And that too leads to diversification. Katpadi says that even if you see common stocks or sectors across multiple funds in your portfolio, each fund has its unique investment approach, style and reason why your fund manager has bought shares of companies belonging to the same set of sectors. Portfolios or the fundamental attributes of the schemes are different and also undergo numerous changes over time. “Hence, investors should focus on their goals rather than on the portfolio, which are uncontrollable aspects,” she says. 

So, the next time your adviser tells you that you should invest in a diversified equity fund, ask her what diversification means to her and what sort of funds would she recommend to ensure that your portfolio is truly diversified. 

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