Do Equity Diversified MF Schemes provide Sector Diversification?

Why do you invest in a mutual fund ? There are three main reasons i) Professional Management ii) Portfolio Diversification & iii) Low transactional cost.  Out of the three, portfolio diversification is a key benefit that aims to reduce risk for the investors. In reality, by investing in diversified equity schemes, do you get the benefit of diversification ?

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I have analyzed two schemes.  Can the results be taken as a guide to all the diversified schemes in the market ?  I cannot guarantee that.  But the analysis throws up interesting data that cannot be ignored.

HDFC Top 200, an equity diversified scheme, had exposure to various sectors in the last 3 years, as given in the following table.  This data is taken from 31st of Oct 2011 to 31st of Oct 2014.

Click the image below 

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Out of the holdings, top 3 sectors are highlighted in green and bottom 3 sectors are highlighted in pink.  It is obvious from the table that throughout the entire 3 year period, the fund is overweight on banking & technology.  These two sectors occupy 30 to 40% of the portfolio throughout the 3 year period.  There is no other sector that comes close to banking exposure which is maintained at more than 20%.

This is how the combined weightage of banking and technology looks like in the portfolio.

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Having said that, there are other sectors including pharma, auto, finance, petroleum products etc., that are given exposure.  But if banking or technology does not perform then it is obvious that the portfolio would be hit because of that, unless all other sectors or a majority of the remaining sectors outperform.  This comes to you, the investor, as part and parcel of active management.  Though there are merits in actively managing a portfolio, does this provide enough sectoral diversification ?

Let me take another example in HDFC Equity Fund.  For the same period mentioned above, 31st of Oct 2011 to 31st of Oct 2014, the numbers look like this. Click the image below

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This is how the combined weightage of banking and technology looks like in the portfolio.

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Banking is a key sector that has a weightage of more than 18% throughout the 3 year period.

By blindly assuming that mutual fund schemes provide portfolio diversification, you are actually investing in a scheme that is predominantly a banking and technology oriented scheme rather than a pure diversified scheme.  I also did a random check on the portfolio of HDFC Top 200 in July 2009.  Banking exposure was 18.28% again.

The questions that come to my mind immediately are

  1. Do you get better returns because of this strategy ?
  2. What is wrong in this kind of active management ?

Let us look at a diversified portfolio with equal weightage to core sectors like banking, technology, pharma, auto & ancillaries & FMCG.  I will also include two more to this a) Infrastructure and b) Media and Entertainment.

Fortunately, there are sector funds available in these areas.  I have picked ICICI Prudential Banking & Financial Services, ICICI Prudential FMCG, ICICI Prudential Technology, Reliance Pharma, UTI transportation & logistics, Reliance Media and Entertainment & IDFC Infrastructure.

A portfolio built out of this looks like this. Click the image below

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This portfolio is built based on the principle of constant allocation to the sectors chosen.  Rebalancing, as an alternative to active management, is done at 1 year intervals.  Two interesting points emerge out of this activity.  These invariably are the answers to the questions raised earlier.

Do you get better returns ?  The following graph answers that question straightaway ! If you had invested in HDFC Top 200 during Nov 2011, the returns would have come and vanished by Sep 2013 and you would be staring at a capital loss !  During the same time this custom made portfolio would have given you around 15% returns.  Does this make sense to you ?

Click the image below

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To answer the second question, I checked what is the advantage the portfolio built using sector schemes provides.  Surprisingly, it is reduced volatility !  The following table confirms that beautifully.  Though the individual schemes exhibit higher volatility, the portfolio does not capture the same.  Moreover, the portfolio does not have stock overlap.  No single stock is present in two or more schemes and it is obvious with this kind of a custom made portfolio.

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With reduced volatility and increased returns, are you really missing a lot by choosing to invest in equity diversified schemes ? Is this true of HDFC schemes alone ?  Not really.  I again did a random check with Birla Sun Life Frontline Equity & Franklin India Prima Plus.  In addition to Banking & Software, Prima Plus has reasonable exposure to pharma.  Frontline Equity falls in line with HDFC’s schemes with regard to exposure to banking and software.

Conclusion :

In my experience, Investors fail to multiply money or lose capital while investing in equity, as they do not display patience that is very much essential.  Hence, during volatile times, investors prematurely exit the investment and either book a loss or forego returns.  To counter that, here is an alternative that provides investors better returns with lower volatility.  Having said that, this does not come without troubles.  There are only few sector schemes available from specific AMCs.  Not many options to choose is a bane that cannot be avoided.