Markets
BSE See NSE See 39,103.62
-348.45 (-0.88%)
collapse Related Readings collapse

Diversification: When it doesn't pay

| 3/8/2012 9:00 PM Thursday

For those who know nothing about the markets, extreme diversification makes sense said legendary investment guru Warren Buffett, who is known for concentrating his assets into a few key opportunities. This sounds somewhat contradictory to normal investment philosophy that says “do not put all your eggs in one basket”. There is no denying of the fact that diversification greatly reduces and can even eliminate the specific risk that comes with the ownership of just a few individual stocks or bonds. However, when we speak about mutual funds there are investors who have invested in various mutual fund schemes in the hope of diversification and risk mitigation.

Moreover, even the regulator has been a proponent of diversification which is evident in the guideline suggesting that not more than 10 per cent of a scheme’s assets under management should be invested in a single stock. This is however not applicable to index funds and sector/industry specific schemes. Simply put, owning four different schemes specializing in the same sector such as financials, infrastructure or pharma is not diversification because if an event or economic cycle impacts that particular sector, all the funds will be impacted simultaneously. This defeats the very purpose of diversification. After all diversification is intended to mitigate risk associated with investing in one particular sector as all the sectors do not perform badly at the same time and downside in one sector may be accompanied by an upside in some other sector. For example if we look at the performance of the Banking Sector in the last one year, it has under-performed the marketwhereas Pharma and FMCG dedicated funds in the same time have outperformed the market. Nevertheless, if we see the performance of the same sector funds their returns are in a very narrow range.

The reason for such a performance is, there are many common stocks in every portfolio and form a major chunk of the net assets. The little dispersion in performance is mainly due to difference in weightage of different stocks. For example ICICI Bank, HDFC Bank and State Bank of India can be found in almost all the schemes, what changes is only the proportion of holding as a percentage of the net assets that determines the little difference in performance. Even if we look at equity diversified schemes we find that many stocks are common in the portfolios of top performing funds. For example, if we analyse the holding of the top performing schemes (five star rated by www.valueresearchonline.com) there are some stocks like Tata Steel, Wipro, HDFC Bank, Bajaj Auto etc found invariably in every schemes. So what this means is that even if you are investing in top performing schemes there is no guarantee that in any bad year your portfolio or fund will outperform the market because most of the stocks are common and in all probability will move in the same direction. The same logic can be extended to other sector funds too.

This leads us to other important concept of spreading your investments across various sectors or industries with a low correlation to each other. This is because different industries and sectors don’t move up and down at the same time or at the same rate - if you mix things up in your portfolio, you are less likely to experience major declines because when some sectors experience tough times, others may be thriving. Therefore we tried to find the correlation of returns between different sector funds and equity diversified funds. For this we took the monthly returns of almost 180 equity diversified funds for the last five years and studied their returns correlation. It was no coincidence that most of the equity diversified funds had very high correlation of more than 0.95. The way to interpret this is, 95 per cent of the time these fund’s returns move in the same direction. However, if we look at the correlation of returns between equity diversified funds and some of the sector dedicated funds like FMCG or Banks or funds dedicated to a particular theme like dividend yield, we find the correlation weakening. For example if we look at the correlation of average returns of banking dedicated funds and equity diversified funds it stands at 0.91. The higher correlation may be due to a higher weightage of financials in equity diversified funds. Nonetheless, there are certain sectors and themes that have clearly shown lower correlation of returns. Case in point is the FMCG sector and dividend yield theme which has a return correlation of less than 0.7 when compared with equity diversified funds.

Therefore we believe that though diversification helps in risk mitigating, one needs to understand the return dynamics of different funds or asset class before committing your funds. Just increasing the number of equity mutual funds in your investment portfolio does not automatically reduce the risk. It is better to invest in one or two large equity diversified funds instead of investing in five or six funds as both will be generating almost the same returns.

What is considered good diversification?
Here are some rough guidelines:

  • Don’t own schemes that bet heavily on a particular sector or industry. Even if you are one of that investor who likes to take more risk despite this warning, make sure that you don’t have a huge portion of your funds invested in them.
  • Don’t keep all of your funds within the same fund family. By spreading your assets out at different companies, you can mitigate the risk of internal turmoil, ethics breaches, and other localized problems.
  • Finally don’t just think stocks – there are also other funds like fixed income funds, arbitrage funds, convertible funds, and much, much more. Although it is probably wise to have the core of your portfolio in domestic equities over long periods of time, there are other areas that can offer attractive risk-adjusted returns.

 

Find More Articles on: DSIJ Magazine, MF Special Report, Personal Finance, Mutual Funds

news letter

More for the early bird.

Get the post-market reports and breakfast news right in your inbox. See latest »

DSIJ Mindshare

Index trend and stocks in action June 17, 2019

Karan DSIJ / Article rating: 5.0

In case Nifty falls below the level of 11,770, it may test the 11,600 mark in the near term. To move upside, the bulls need to move above the 20-DMA once again and sustain for at least two to three days. Only then, the bulls will gain confidence. Stocks in news: BHEL, Elecon Engineering Company, PG Electroplast, FDC, Divi’s Laboratories, Symphony, Coromandel International, Voltas.

12345678910Last

Tiger Logistics topline to grow by 10%--buoyant over infra sector status to logistics sector

Tiger Logistics topline to grow by 10%--buoyant over infra sector status to logistics sector

Logistics sector will play a vital role in making the concept of ‘Make in India’ a success. This will be further aided by some of the recent steps taken by Government of India such as granting of infra sector status to logistics sector.

Best and worst Performing Sector Funds of Year 2017

Best and worst Performing Sector Funds of Year 2017

As the year-end has approached most of you are eager to know the mutual fund movers and shakers of the year 2017. Read on to find the performance of various sector dedicated funds.

Markets may start positive, but volatility likely due to F&O expiry

Markets may start positive, but volatility likely due to F&O expiry

The start of the F&O expiry day is likely to be in the green, but volatility may creep in with the progress of the session. The SGX Nifty suggests that the Nifty could open at 10,525 with gains of 32 points at the opening bell. 

Pidilite announces buyback of Rs 500 crore

Pidilite announces buyback of Rs 500 crore

The buyback offer comprises purchase of up to 50,00,000 equity shares. The buyback offer size comprises 0.975 per cent of the total paid-up equity capital of the company.

Bank Nifty drags markets to close in the red

Bank Nifty drags markets to close in the red

The late session fall in Bank Nifty changed the direction of the market, leading to a marginal fall in the benchmark indices. Bank Nifty yet again resisted at its multiple point downward sloping trendline level at 25733.

Six major underperforming MF schemes having higher expense ratios

Six major underperforming MF schemes having higher expense ratios

Mutual funds with a large size of assets under management (AUMs) are supposed to have lower expense ratios. However, there are schemes with large AUMs but having higher expense ratios and generating lower returns. 

Nifty Pharma supports market; Sun Pharma at bullish reversal

Nifty Pharma supports market; Sun Pharma at bullish reversal

Nifty Pharma index has come in as the healer in an otherwise sluggish market. Index has given a consolidation breakout at the 9420 level today and if the it sustains 9420, followed by 9628 on the upside, it has a long way to go.

Ten stocks close to their 52-week low

Ten stocks close to their 52-week low

Following stocks are close to their 52-week low as at 12.35 p.m. on December 27.

Ten stocks close to their 52-week high

Ten stocks close to their 52-week high

The markets on December 27 opened gap down. BSE Sensex is trading at 34,068.15, up by 57.54 points and the Nifty is trading at 10,539.45, up by 7.95 points.

Five stocks with selling interest

Five stocks with selling interest

Overall volumes in futures & options currently stand at 62.75 lakh contracts with a turnover of Rs. 5,19,204.72 crore.