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.
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