Diversified MF Schemes
Identifying the top and bottom of the market is extremely difficult and even the most seasoned investors cannot vouch for it on a consistent basis.Hence, one of the best strategies is to invest in a diversified portfolio. The article takes a closer look at this strategy
Investors come in different shapes and sizes. They have different investment horizons and risk appetites that determine their investment decisions. They are broadly categorised into conservative, moderate and aggressive. Some investors keep adjusting their risk appetite depending on the prevailing market condition. When the market falls precipi-tously, the way it did in the last quarter of FY20, these investors become aggressive. Nonetheless, when the market is trading at a lofty valuation, they become conservative. These types of investors are ‘opportunists’.
There is nothing wrong with such investors; however, identify-ing the top and bottom of the market is extremely difficult and even the most seasoned investors cannot vouch for it on a consistent basis. Hence, one of the best strategies is to invest in a diversified portfolio. Diversification is the key to reducing investment risk. The fastest way to get rich in the stock market is to own the next Infosys or Bajaj Finserve. The fastest way to lose all your money is to own the next Yes Bank or Satyam Computers. Identifying either of them in advance is impossible.
Nevertheless, you don’t have to identify them (wealth creators)in advance to make a healthy return on your investment. If you buy a couple of equity mutual fund schemes, your investment is highly diversified and it is highly likely that these companies may be part of the portfolio. Is it possible to lose all of your money even after investing in such a diversified portfolio? Yes, but the odds of that happening are slim or next to none. If India’s 50 well-researched leading listed companies – assuming you have invested in large-cap dedicated funds – from India go down and their stock prices plummet to zero, the value of your investment portfolio will be the least of your problems as there would be something more to worry about.
Moreover, just like professionals in any other industry, in the equity market some active fund managers are bound to be better than others. Nevertheless, consistently high-performing managers are so rare that many attribute their consistent performance to luck. Check the ‘Best Fund Manager’ list published by many rating agencies and media houses every year. You will be surprised to see how faces and names keep on changing. Many of yesterday’s superstar managers and funds are today’s underperformers, and vice versa. Once again, identifying them in advance and knowing when they will do well is the problem. Hence, diversification pays in the long run.
Diversification is not a recent wisdom but has been followed from centuries. You can find its mention in both Indian and western literature. In the ‘Merchant of Venice’, William Shake-speare tells us why we should diversify: “I thank my fortune for it. My ventures are not in one bottom trusted, nor to one place. Nor is my whole estate upon the fortune of this present year. Therefore my merchandise makes me not sad.” This is spoken by the merchant who diversifies so that all of his risk is not tied up in just one ship, referred to in the quote as ‘one bottom’.
Surprisingly, much before this, it has been well articulated even in ‘Arthashastra’, a treatise on statecraft, economic policy and military strategy. The method the author suggested in the book to reduce the loss caused by the theft of high-valued items is that such items should not be shipped together. Rather, they should be distributed across several shipments and with other regular items. Diversification is not about investing in every possible mutual fund. It is about spreading your risk and maximising returns. However, you should not forget your risk profile in your quest to maximise your returns. Diversification is important; however, it needs to be followed intelligently.
Defining Diversification
Diversification in its simplest meaning implies investing in stocks or asset classes that do not move in tandem. Through the process of diversification you mitigate the portfolio risk by having exposure to a variety of different assets or stocks, which means not putting all your eggs in one basket, as the old cliché goes. The main purpose of diversification is to lessen the overall volatility of your investments. Where one may go bad, others go well, which means helping to even out the performance over the long term. In the current market situation, it’s a good time to diversify your portfolio.
This will help to smoothen the portfolio ride for an investor, which means investors may be less likely to indulge in panic-triggered selling and deviate from long-term investment strategies like many did in the last six months of 2020 when there was continuous net outflow from equity-dedicated funds. Investors can diversify their investments in various ways such as investing in different asset classes including equity, debt and commodities such as gold. Within this broader asset class they can invest in sub-asset class such as large-cap, mid-cap and small-cap when investing in equity.
However, what if an investor does not want to invest in different categories of assets and would like to stick to only equity-dedicated funds? Even within equity-dedicated mutual funds there are some which are well-diversified while others are not so diversified. The crux of diversification in a portfolio is that the price of their constituents should not move together. There are primarily three ways to check how diversified a portfolio is; however, we have used diversification ratio to know the degree of diversification of a fund.
This ratio is the portfolio’s weighted average asset volatility to its actual volatility. The result of this calculation gives us the diversification ratio. Since different asset classes are not perfectly correlated to each other, this ratio in general is greater than 1. In other words, a well-diversified portfolio is greater than the sum of its investments as the overall risk of such a portfolio is less than the weighted-average risk of its compo-nent holdings. The following metric defines the diversification ratio of a fund.
Where: wi = portfolio weight in asset i, σi = the risk of asset i and σp is the total risk of the portfolio
The way to interpret this equation is that a higher ratio means the fund is more diversified. For example, sectoral funds will have the lowest diversification ratio while a well-balanced fund having stocks from domestic as well as international markets from different sectors will be the most diversified with a higher diversification ratio. To understand this we calculated the ratio for a sectoral fund, Aditya Birla Sun Life Banking and Financial Services in the financial services sector. Based on its August 2021 holding the fund has a diversification ratio of 1.146, which is much lower than that of Parag Parikh Flexi-Cap that has a diversification ratio of 3.34. In between them are thematic funds that have diversification ratio higher than the sectoral funds but lower than the well-diversified funds.
Most Diversified Equity MFs
To come out with the most diversified equity-dedicated funds, we calculated the diversification ratio of all the funds belonging to large-cap, mid-cap, small-cap and flexi-cap category. We excluded other categories such as sectoral or thematic because by nature and their construction they have a limited scope of diversification.
Most Diversified Large-Cap Funds : In the case of large-cap-dedicated mutual funds there is very less difference between the diversification ratios of funds. The fund with highest diversification ratio is DSP Top 100 Equity with diversification ratio of 2.236 while Franklin India Bluechip at the bottom of the ladder has a diversification ratio of 1.511. The reason for such a tight range is that a limited number of stocks are available for large-cap funds to invest in. They will have to invest 80 per cent of the corpus in the top 100 market capitalised companies. Besides, most of the large-cap funds more or less try to imitate the benchmark and hence take a bet accordingly in terms of weightage of stocks. The following table shows the top 10 diversified large-cap funds.
Following Table Shows The Top 10 Diversified Large-Cap Funds
Most Diversified Mid-Cap Funds : Mid-cap funds on an average have a higher diversification ratio compared to large-cap funds. The reason for such higher diversification is because mid-cap funds have a larger universe to select stocks for their portfolio. Mid-cap funds need to invest 65 per cent of their portfolio in companies with market capitalisation ranking between 101 and 250. Rest they can invest in any other instruments including large-cap and small-cap-dedicated funds. Hence, they have more space to invest and that explains the higher diversification ratio. The following table shows the top 10 diversified mid-cap funds.
Following Table Shows The Top 10 Diversified Mid-Cap Funds
Most Diversified Small-Cap Funds : Among all capital funds, small-cap funds are the most diversified. They have average diversification ratio of 2.82 times compared to 1.9 times of large-cap-dedicated funds. Small-cap funds have the largest universe of stocks to select and invest in. All the stocks beyond 250 in terms of market capitalisation are technically small-cap stocks. The follow-ing table shows the top 10 diversified small-cap funds.
Following Table Shows The Top 10 Diversified Small-Cap Funds
Most Diversified Flexi-Cap Funds :This is the youngest category of funds introduced in India recently. These funds can invest across the category; however, most of them are tilted towards large-cap stocks and hence lower diversification ratio. Nonetheless, the top diversified funds have international exposure also and hence have a higher diversification ratio.The following table shows the top 10 diversified flexi-cap funds.
Following Table Shows The Top 10 Diversified Small-Cap Funds
Investment Based on Diversification Ratio
The way an investor invests has evolved a lot in the last couple of decades. Now risk and diversification is taking the driver seat and expected return is not the only focus point. The reason for such a change is due to the higher degree of unpredictability in asset returns. Most diversified funds do not necessarily provide the same level of risk reduction during times of severe market turmoil they do when the economy and markets are operating normally. Highest diversification does not mean higher returns; however, it definitely means lower risk. The following graph shows the relation between diversification ratio and last one year returns.
The following graph shows the relation between Diversifica-tion Ratio and last one year returns.
It clearly shows there is inverse relationship between diversifica-tion ratio and last one year returns. Nevertheless, it should not be extrapolated for long term as last year we saw the market moving up vertically where a concentrated portfolio generated better returns. As the market will return to normalcy, a diversified portfolio is expected to generate better risk-adjusted returns. Therefore, while selecting funds for your portfolio you should first decide your broader asset allocation and what percentage of your investment should go to which class of assets or sub-assets.
Once this is decided you can select the most diversified funds from each of these asset classes as part of the portfolio. This is especially true if you are making a lump sum investment when the market is trading at an all-time high and stretched valuation. The bottom-line is that the maximum diversification approach is a perfect tool for investors who are searching for a highly diversified portfolio which tends to perform reasonably well in every market environment. Since it can fully utilise the benefits of diversification, the portfolio is able to reduce drawdowns considerably, especially in times of market turbulence.