This blog is the third article of the four-part blog series that I am doing on constructing and reviewing equity mutual fund portfolios.
In Part 1: Active vs Passive Funds: Where should you invest?, we discussed the merits and demerits of investing in index funds. In Part 2: How to leverage SEBI Product Categorisation to your advantage?, we focused on actively managed equity funds. SEBI guidelines on product categorization has ensured that each fund sticks to their basic investment mandate. This information can be used to construct equity fund portfolios that minimise underlying stock overlaps.
In Part 3, we focus our attention on what you can expect from your current fund portfolio. Will your investment returns be similar to the broad stock indices or are you positioned for a differentiated performance than the index?
Where are you currently invested?
AMFI data on Assets under Management (AUM) of equity funds shows that the largest fund categories amongst equity funds are the index, large cap and multi cap categories. These categories constitute more than 50% of all equity fund investments. Clearly investors prefer the comfort of equity funds that invest predominantly into large cap stocks. In any case, large caps generally constitute 70% of the market capitalisation and hence this seems logical.
What is the impact of investing a higher percentage of your investments in large cap oriented funds?
First, the large cap oriented fund categories (Index / Large Cap / Multi cap) invest predominantly in the top 100 stocks in the country in terms of market capitalisation. Hence, the investment returns would be very closely related to the returns of the large cap market indices (BSE Sensex / Nifty). In investment parlance we term these are Beta funds – all you are getting through this is a fair representation of the market performance in your portfolio.
Second, the performances of these funds are highly correlated (read similar). In other words, you are not getting the full benefit of diversification as each of the funds that you own amongst these categories are likely to give very similar level of performances.
Refer chart below. As you would notice that the fund performances of the large cap and multi cap categories are fairly similar.
What about the performances of the other categories?
If you notice from the above chart, if you would have invested in funds that do not invest in the Nifty stocks (Mid cap, Small cap, international) or invest very differently compared to the sectoral allocation of nifty (example – Sector or Thematic funds), you would see a huge differential in performance. For example, if you invested in a Thematic PSU fund, you would have underperformed the large cap funds significantly. Similarly, if you invested in the Pharma Fund, you would have outperformed the large cap funds significantly.
Further, there is a significant performance differential between the best and the worst performing fund categories. The difference is as high as 14.85% on a CAGR basis for 10 years. If you invested Rs 100,000 in the worst fund, you would have earned almost 0% over 10 years and the best performing category would have given you deliver a return of 14.85% (CAGR basis), which translates to your investment growing to almost Rs 400,000. The large cap and multi cap categories, as one would expect are practically middle of the road investment strategies and hence have delivered CAGR around 7.5% per annum.
Is there an ideal equity fund portfolio?
The answer is “Yes” and “No”. You should invest basis what you seek from your investment and hence I cannot answer this question on a generic basis. But what we hear from all investment experts is that diversification matters! If that is the case, you need to have all segments of the market well represented in your portfolio. Hence your portfolio should have large cap, mid cap, small cap and international funds. You may wish to add some sectoral of thematic funds basis your own conviction!
Conclusion
The bulk of the investments in India are in the large and multi cap categories. Till recently, most multi cap funds were skewed in their holdings and invest predominantly in large caps too! As a result, the investment returns are likely be in sync with the broader stock indices.
If you are keen to have a differentiated performance, you would need to consider investing outside of the large cap funds. There are several choices that you can make including mid, small, international, sector and thematic funds. As you invest differently from the index, you will experience performances that are different. In the next blog, we will discuss what it takes to beat beat the large cap indices!
