FUND FLAVOUR

September 2013

Diversified Equity Funds – running out of steam?

If there is one element that makes a diversified equity fund a darling of investors, it is adaptability - much like an SUV. In other words, these schemes hold sway across the board. But curiously enough, when it comes to returns, these funds seem to be running out of steam. India's diversified stock funds posted their worst quarterly performance in over a year as fund managers' bets on small- and mid-cap shares and sectors like capital goods dented unit values, according to data from fund tracker Lipper. Such funds fell 7.5% on an average during the three-month period that ended in March 2013, under performing the Sensex's drop of 3% by a wide margin, and registering their worst quarterly show since Oct-Dec 2011. In March 2013, the funds registered a drop of 1.34%. Increased risk aversion hurt Indian stocks as disappointment over the annual budget and the central bank's cautious outlook on rates and political uncertainty after a key ally withdrew from the ruling coalition resulted in shares posting their first quarterly fall in five years. However, the poor performance of funds was largely attributable to the more volatile small- and mid-cap stocks, which fell much more than their larger peers during the quarter. Certain sectoral allocations also hurt overall performance. Financials and industrials, which collectively account for more than a third of such funds' assets and are among the favourite sectoral picks, struggled during the quarter as India continued to battle slowing economic growth.

Across categories…

Safe, reliable, and steady

Large cap funds may look disappointing during market rallies but during bear-market phases, their ability to check the fall makes them a compelling buy. Large cap funds are safe, have predictable returns, easy to understand and less volatile to market swings compared to other diversified equity funds. These funds mirror the performance of the economy and are geared to handle market cycles better. Unlike mid- and small-cap stocks that may not last through a long down market cycle, large-caps have the size and scale to weather the bad market phase. The large cap universe comprises some of the biggest companies, which are well represented in the more frequently tracked indices such as the Sensex and the Nifty. Widely tracked and analysed, large-cap stocks have a large floating stock, which provides immense liquidity in all market conditions. These traits make large-cap funds advisable as a core holding in the portfolio as they stand tall when the market turns downward. The flipside of investing in these funds is that they do not deliver exceptional returns in a rising market. The sheer scale and size of stocks in this category means their growth is not as high during a turnaround as it would be for mid- and small-cap stocks, which are nimble. For instance, the category dropped 23.14% in the market downturn of 2011 compared to 24.64% of the Sensex. In contrast, in 2012, the category posted 26.76% gains which pales in front of 41.41% by the mid- and small-cap fund category. 

A dare-devil of a category

Mid and small cap category is capable of touching great heights, only if you take necessary risks. It adds a lot of spice to the portfolio and is capable of offering above-average returns when the markets are rising. At the same time, funds in this category are more prone to volatility as mid and small cap companies are hit harder when markets tank. These funds can touch soaring heights when the markets are favourable, while it can also wipe out fortunes when the tide reverses. For instance, they gave an average return of 18.77% higher than other categories in the last 6 months of 2012 but it is also pertinent to keep in mind that they have fallen by 14.16% between February and July 2013.

Diversification and flexibility

The ability to invest beyond just large-cap stocks makes the large- and mid-cap category the mainstream fund category. Funds in the large- and mid-cap category provide diversification, with sufficient leeway to invest significantly in mid- and small-cap stocks. The number of funds in this category goes up in a booming market when several large-cap funds increase their mid-cap allocation, just the way multi-cap funds enter this category by increasing their large-cap allocation during bear phases. The allocation to mid-cap stocks is the key for the spurt in returns for funds in this category. For this reason during bull runs, this category does better than the large-cap category, and during bear phases it loses out due to the higher allocation to mid-cap stocks leading to a higher drop in returns. However, over long periods, this category does well. In the past ten years, the category average return has been over 22%, with the best performing fund, HDFC Top 200, earning an annualised 28.91%, and the worst fund, JM Equity, earning 16.66% indicating the disparity amongst funds. This category is the frontrunner for equity investments by investors as the maximum chunk of equity assets are in this category with 34.21% of the total equity assets in large-and mid-cap funds. The category also makes up for 21% of the total 258 diversified equity funds accounting for Rs 51,713 crore assets, which is about 27% of the total assets managed by equity funds.

Flexibility with a dash of risk

Adapting to the changing market scenario makes multi-cap funds invest in companies growing faster than the market. The multi-cap fund invests in companies of all sizes. Adopting a mix of growth and value strategy, these funds seek opportunity to outperform the market by shifting their allocation across market capitalisation. Often referred as all-cap or go-anywhere funds, such funds come with their share of risks because of the dynamic nature of fund management required with these funds. In the past one year, the large-cap category has posted the best results, with the multi-cap funds languishing at the bottom. In the past six months, the average multi-cap fund exposure to large-cap stocks is 56%, which has resulted in its performance to almost match the large- and mid-cap, as well as large-cap category. Ideally, funds in this category should always do well because the fund manager has the mandate to move across capitalisation to ride the one that drives the market. It is for this reason that such funds are risky and suitable to investors with a high-risk appetite. The unique characteristic of such funds is the flexibility and convenience that they offer to investors. Moreover, the probability of succeeding in any given market condition is high. For instance, if the large-cap segment is not performing well at a particular point, there is a very good chance that the mid- or small-cap segment will be doing well. The ability to exploit such opportunities makes funds in this category a must have in an aggressive portfolio. Multi Cap funds generate the best returns during market rallies, which is next only to the mid and small cap funds. In the bull-run from March 9, 2009 to November 9, 2010, multi cap funds posted 87.10% returns compared to 69.60% by large cap funds. In the market crash from January 8, 2008 to March 9, 2009, multi cap funds lost 56.88% compared to 62.23% by mid and small cap funds. The trailing 10-year returns as on June 30, 2012 witnessed the highest returns posted by multi cap funds at 24.89% compared to other categories. 

The verdict…

Large caps have escaped relatively unscathed in the recent market downturn. S&P BSE Sensex fell about 8.1% over last 3 months. Decline in the mid cap space has been severe with S&P BSE Mid-cap falling by around 17.5%. S&P BSE 200, which represents broader markets, registered a loss of 11.9% over last 3 months. However, it is noteworthy that performance of all diversified equity funds has been satisfactory, as about two-third of them have outpaced S&P BSE 200 on 3-month returns. HDFC Top 200 and HDFC Equity, which together have a corpus in excess of Rs 20,000 crore, have miserably under performed S&P BSE 200 over last 3 months. Moreover, they have under performed on YTD basis. HDFC Top 200 is a large cap-oriented while HDFC Equity is a flexi cap fund. Reliance Equity Opportunities Fund, which focuses on investment opportunities across sectors and market capitalisation segments, has also under performed broader markets. Among others, Reliance Growth, a mid cap oriented fund and UTI Dividend Yield, which follows the tenets of value investing have made losses in excess of those made on S&P BSE 200. 

It would be rare to find an investor who is unmoved even after the recent fall in Indian equity indices. Considering the dire state of India’s economy, falling equities should not surprise investors but the manner in which they are shunned nowadays, is worrisome even for an experienced investor. In the short term, funds can be volatile and may even under perform the broader markets. Mutual funds essentially are for long-term investors. Current underperformance of some of India’s biggest mutual fund schemes may be just a blip caused by economic aberrations. However, investors need to be watchful of their performance over a little longer time horizon. Consistent underperformance would highlight weakness of these funds. As noted above, funds catering to different market capitalisations and following different investment styles have under performed broader markets. However, long-term performance of most of them remains promising even now. Importantly, they come from fund houses following sound investment processes. It remains to be seen when these funds would start bucking the downtrend. Buying popular funds does not guarantee any success. There is no alternative to meticulous assessment of available options and making diversified equity funds the core of your portfolio.