FundsIndia Strategies: The why and how of portfolio diversification

August 23, 2017 . Bhavana Acharya

Diversification helps mitigate risks inherent in a product as well as behavioural risks

Short on time? Listen to a brief overview of this week’s review.

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Looking at double-digit returns in the stock market, it may seem perfectly logical to invest in an all-equity portfolio. But equity markets do not linearly go up. The 15% 5-year returns of the Nifty 500 index are simply the returns at a single point in time. During these five years, stock markets have gone through phases of correction. An all-equity portfolio, thus, would see the entire investment correcting. A lower equity allocation, on the other hand, would result in smaller corrections.

Consider 2015, a year in which stock markets started out with a bang and then lost the way. The Nifty 100 index lost 2.5% in that year. Large-cap funds lost 0.37%. Holding only equity, then, would have seen portfolio value fall to a similar extent. Now throw in a 20% debt allocation. A large-cap plus long-term debt combination would have seen portfolio value actually rise 1.1% in 2015. The same holds true in 2016 as well. Large-cap funds gained 3.5%. An 80:20 equity and debt combination would have seen portfolio returns rise by 5.2%.

Why diversify

Diversifying a portfolio involves spreading of risk. This risk takes different avatars. It may be the risk of concentration in an asset class, concentration in the same category of funds and finally concentration in same styles of investment.

  • Asset class risk- An all-equity portfolio would have delivered lower returns in some years and higher returns in others. Introducing debt into the portfolio reduces the risk that portfolio value falls or at the very least, reduces the extent to which the value falls. For example, consider monthly investments in a 70:30 mix of the BSE 100 (large-cap index) and the CRISIL Composite Bond fund index (representing gilt and corporate debt) for the 10 years to December 2016. Your investment value would actually be higher by 1% with just 70% in equity than with the entire 100% in equity. Note that this would include corrective periods such as 2008 and 2011, when you would have been able to average out equity costs, and the rises of 2014 to 2016.
  • Category risk – Within equity, you can invest in mid-cap funds, diversified funds, or large-cap funds. Again, going by returns alone, it’s tempting to invest mostly in mid-cap funds. But already in the past month, mid-cap funds have lost double of what large-cap funds have. An all-mid-cap portfolio thus would drop like a stone on continued corrections. On the debt front, dynamic bond and gilt funds looked attractive at the end of 2016 given their high double-digit returns. The subsequent drop in returns post-February 2017 would have pulled down returns.
  • Fund style risk – Holding several funds that do the same thing doesn’t benefit your portfolio much. Funds typically follow different styles of selecting instruments. In equity, it could be growth, or value, or a combination. It could be a focused portfolio or a diversified one. In debt, funds could stick to high-quality papers and trade on them or it could look for higher yields in lower quality papers. Different styles have different ways of performing across market cycles. Mixing them up will ensure that underperformance of some funds in some markets is made up by others.

Your mix of funds should be such that it covers the three risks explained above. There are two factors before figuring out how to diversify. The first is the amount to be invested. It’s hard to do any sort of asset/ category allocation or even different funds if the investment amount is low, at say Rs 3,000 or Rs 5,000. One or two funds are more than enough for such amounts. It’s when you have amounts higher than this that diversification comes into play. The second factor is the time horizon. It’s longer term horizons that afford diversification, either through different assets or through different categories.

Diversifying across asset classes

The first level of diversification, asset allocation between equity and debt (or equity, debt, and gold), depends on your timeframe. For longer horizons of 4 years and over, a majority equity allocation is fine. The extent to which equity forms a part then depends on your risk level.

For very high-risk investors, an 80% allocation will be workable. But for moderate risk investors, a lower 60-70% allocation will be more prudent. Conservative investors cannot suffer losses for long, and a lower equity allocation serves that purpose. Shorter timeframes of 2 years or below should have no equity allocation at all, even if you’re a high-risk investor. Rolling 2-year returns for the Nifty 100 index since 2007 shows that losses occurred more than 20% of the time. At FundsIndia, you could use our online risk questionnaire or talk to your advisor to understand your risk tolerance and your risk capability.

Diversifying across categories and funds

Within the limits set by the asset allocation, portioning off the portfolio into different categories can change the risk-return dynamic. The following pointers should help here.

You don’t need diversification in large-cap funds or balanced funds: Most large-cap funds stick to the top 100 stocks in varying degrees. Of the 55 large-cap funds, ten stocks feature in more than 80% of them and these ten stocks together account for nearly half the aggregate portfolios (as of July 2017). Holding multiple large-cap funds will simply mean that you’re holding the same stocks in different funds. If you must hold multiple funds, mix up styles of investment if you understand them. For instance, from FundsIndia’s Select funds, a low-volatile, value-conscious pure-bluechip fund is Franklin India Bluechip, while one that takes some mid-cap allocation is SBI Bluechip. Or you could mix a value-oriented fund like the Franklin fund or ICICI Prudential Focused Bluechip Equity with those that follow a more growth-oriented approach such as Aditya Birla Sun Life Frontline Equity, Mirae Asset India Opportunities, and SBI Bluechip. Or you can combine a concentrated investment style with a diversified style. This is how our advisors go about mixing funds for you when diversification is sought within the category.

Balanced funds can be used either to introduce debt for aggressive investors or equity for conservative investors. Most balanced funds follow a 70-30 equity debt ratio, move across market capitalisations in the equity holdings and stick to top-rated papers or gilts in their debt holdings.

Diversified funds have different uses: Diversified funds, being go-anywhere funds, can take up different portfolio roles. Some funds stick to a large-cap orientation and thus are suitable for moderate risk and high-risk investors. Franklin India Prima Plus and Kotak Select Focus are classic examples, from the Select list. Such funds can be used by high-risk investors to skip a large-cap allocation altogether. Blending styles here is, however, easier because the funds are so dynamic, and the problem of stock overlap is less stark here than in large-caps. Our advisors aim at such style blends when they build portfolios.

Don’t go overboard on mid-caps: Mid-cap is a large universe and one may think there can be no overlap here. However, the universe of ‘investible’ stocks is not high. And a stock picked by one fund is soon added by another. The very aggressive funds may pick up obscure or small stocks and may, therefore, remain unique but very risky. Anything over a 25-30% allocation towards these at the highest risk level is generally not prudent from a risk-containment perspective. With this allocation, you cannot possibly hold more than a couple of funds. In such a case, go for a fund that is less aggressive. Talk to your advisor to know the less aggressive ones from our list.

Go by timeframe for debt funds: In debt funds, the aim should be to combine portfolio maturities and risk profiles. As a general rule, short timeframes of less than 2 years should have only short-term or ultra short-term funds and that too those with low risk. Investments for a few months should have only liquid funds. Holding 1-3 funds, depending on the amount is enough.

For 2-3-year timeframes, MIPs are an additional option for aggressive investors. For timeframes longer than this, consider just 1-2 debt funds with different strategies. A mix of a fund that plays on the interest rate cycle (dynamic bond funds) and one from the income accrual space (gains mainly from interest on the underlying instruments) should do the job. Credit opportunity funds are barred for all but the highest risk-takers.

Be careful with international funds: The diversification that international funds provide depends on which market you’re looking at. Emerging market, China, or Asia-focused funds have the same drivers as Indian markets so there wouldn’t be any benefit in investing there. Markets such as Europe or the United States provide counters to our markets, as they have historically had a lower correlation with us. But ensure that it doesn’t account for more than 10% of your portfolio.

Of course, in equity funds, simply holding a fund in each category provides enough diversification without going into the details of diversifying across styles. For the same reason, you wouldn’t need to add in themed funds since your equity funds would anyway latch on to themes that do well. In the end, diversification has less to do with the number of funds in your portfolio, and more to do with the asset class and fund category.

Investing behaviour calls for diversification

Over and above the risks we mentioned above, diversification is required to mitigate your own behavioural risks. You might call yourself long-term and yet want to take some money out in three years, seemingly booking profits. You might say you are a high-risk investor but still be spooked when your 100% equity portfolio sinks in a market correction. You might call yourself a value investor but be unable to hold an underperforming value fund for long.

  • Diversification helps you contain downsides better especially when your timeframe is short (read less than 10 years). A 20% chance of equity delivering negative returns in 2 years (based on our analysis) suggests that you could be among those who lose capital in an all equity portfolio.
  • Diversification helps protect profits when your timeframe is long. An equity fall in the 15th year of your holding could cut into accumulated profits and not allow you time to recover if you need the money at that time.
  • Diversification helps avoid the stress of seeing your portfolio falling deep in the red on a random day you log in to your account.

Mutual fund investments are subject to market risks. Read all scheme related documents carefully. Past performance is not indicative of future returns.

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