Diversified equity funds are dead

So far in December 2007, various Asset Management Companies have filed offer documents for twelve new equity-oriented fund offerings. All of them are either thematic or sector funds. If one were to go by just this fact, then yes, diversified funds are dead.

So what are sector/thematic funds?

Well, a sector fund invests all its monies in predetermined sector/s. So, a pharma fund will invest in pharma stocks and so and so forth. A thematic fund usually has a broader investment mandate as compared to a sector fund. One example of a popular theme these days is infrastructure. Such thematic funds invest not only in companies executing the infrastructure projects, but also those which provide raw materials and financing for the same. Effectively this broadens the mandate to also invest in companies from various other sectors including cement, steel and banking.

Diversified equity funds on the other hand, have the flexibility to invest across sectors, depending on where they are able to find investment opportunities. However, unlike in the case of sector/thematic funds, the overall exposure of such funds, atleast the well-managed ones, to a particular sector or theme is capped. So a fund manager may have some exposure to the infrastructure sector in present times. But he will also own stocks from other sectors or themes. So, he is 'diversified'. And then of course he has the flexibility to move out of a stock/sector/theme, if he chooses to and invest in other opportunities.

The rush to launch sector/thematic funds

Quite a few AMCs in India are effectively great marketing set ups. They are able to sell you funds which are almost guaranteed to disappoint. Not to mention the fact that such funds do not find a fit in the portfolios of a large number of their investors! But then you buy into such marketing gimmicks, time and again. These AMCs are definitely very good at what they do!

So, it is not surprising that AMCs these days are feeding the frenzy for sector/thematic funds. Take a look at the list of draft offer documents filed with the regulator in December 2007 so far. Need we say which themes are popular these days?

Personalfn's view on sector/thematic funds is well documented. We recommend to our clients that they avoid investing in such funds. But invest if they must then the overall exposure of such funds, cumulatively, should be restricted to 10% of their portfolios. So, far this year, this view appears to have not worked to the advantage of our clients.

Take a look at the table alongside. It lists out the best performing equity funds, year-to-date. The list is dominated by sector/thematic funds. Conspicuous by their absence are what can be termed as possibly the best-managed diversified funds in the country today. These funds include the likes of HDFC Equity and Franklin India Flexicap. As an investor in the diversified funds you are probably feeling that you have missed out on a great opportunity.

So, we are in times when AMCs are not interested in talking about the regular diversified equity funds. All the interest is focused on launching new fund offers which feed the appetite for sector/thematic funds. And then there is the actual performance, where too sector/thematic funds have stolen the limelight.

So are diversified equity funds really dead?

It definitely would appear so. Recently we received an email from a potential client located in Afghanistan. To being with, he said, he had invested in a real estate mutual fund in India.

Now, he wanted our view on whether it was the right decision (after getting invested he had probably read that this fund was not really a real estate fund; this is fairly common misunderstanding that afflicts most investors nowadays). Of course, in more rational times, one would typically have avoided such a situation by investing in diversified equity funds.

In meetings with our clients, we are increasingly being quizzed on the possibility of adding sector/thematic funds into portfolios. A couple of weeks back this author met a client for the purpose of reviewing the portfolio and deciding on where to invest surplus monies. This client is what one would call a high networth individual. He is retired, but has an adequate risk appetite.

Also, he is not dependent on income from his investments. His mutual fund portfolio is therefore evenly split between equity and debt-oriented funds. Our view to the client -- put money as per the plan, in the same schemes, in the same ratio. Of course, there were no sector/thematic funds in the portfolio.

But the media and the recent return charts had struck a chord with the client. And he was keen on adding a power sector fund to his portfolio. We were at pains to explain to the client that power sector stocks were already present in the funds he is invested in, albeit in smaller, but more rational, allocations. And that there is a lot of investor euphoria surrounding these stocks, which should make a rational investor step back. But the client was insistent. Then came the final clincher from the client - if I have to lose money so be it; but I want to invest in this power sector fund.

While we hope the client does not lose money on this investment, the investor euphoria that has engulfed some sectors/themes leads us to believe that sooner or later some investors are going to take a hit.

History is on our side

In January 2000, we were cautious of the euphoria surrounding the Technology-Media-Telecom (TMT) sectors. Mind you, we did believe that these sectors had a great future. But what we doubted was whether at such high valuations these companies would make attractive investment propositions. In hindsight we know that the companies have done very well, but on a point-to-point basis, their stock prices have disappointed. [Read More…]

Post the TMT meltdown, the interest shifted to the pharma sector. Then mid-cap stocks followed. Then large-cap stocks. Now it's back to small and mid-cap stocks. And, of course, the theme that is the hottest now and is still playing out – infrastructure stocks.

We know for a fact that the investor interest will shift. But what we do not know is the 'when'. We leave this to your judgment. If you are able to time your exit, well, go ahead and make the investment. But if you are not great at timing, then be prepared shoulder the blame of having lost money on a speculative investment.

What we do know is that during all these cycles, well-managed diversified equity funds have been consistent performers [Click here]. And don't be surprised, but the well-managed ones do tend to underperform in times of euphoria. In fact we prefer it this way (do you really want to give money to someone who is playing the momentum out there?). What we do expect, from our recommended funds, is that over a stock market cycle, as the sentiment evens out, the stronger discipline and process of such funds will help them deliver the desired risk-adjusted returns. And this suits us, and our clients, just fine i.e. as they are long-term investors.

To conclude, what amazes us is despite the consistency with which investors lose money in sector/thematic funds, money just keeps flowing in. Investor memory is indeed very short. Sad, but true.

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