The famous saying “Don’t put all the eggs in one basket” has been inculcated in investing by many. It means never invest all the money in one type of investment. Investors have to spread their risk by investing in multiple assets and across industries as well. This is the concept of diversification.
Mutual funds offer natural diversification by giving investors access to many companies. But these companies can be from a single sector. Hence, mutual funds offer diversified funds that diversify across market capitalisation and industries. One can consider diversified mutual funds to invest in achieving long term financial goals.
What is diversification in mutual funds?
Diversification in equity mutual funds comes with investing across sectors and market capitalisation. Diversification is also done with multiple mutual funds in a portfolio. It helps in reducing the risk in a portfolio. Diversification cushions the negative impact of the performance of a few securities/mutual funds in a portfolio. The main aim of diversification is to protect the portfolio returns from extreme market conditions.
There are fund houses that offer diversified mutual funds. They can be of any category of funds. By investing in one fund, the investor can invest in securities spread across market capitalisation and industries. These funds are still affected by market volatility. However, they are less affected than pure sector funds or funds concentrating on one single market capitalisation (pure large cap, mid cap and small cap funds).
What are diversified mutual funds?
Diversified mutual funds are mutual funds that aim at diversifying investments across multiple sectors, irrespective of the size or market capitalisation. These funds aim at long term capitalisation through diversified investments that will help achieve better returns during adverse market conditions.
Diversified mutual funds have considerably less risk than certain other mutual fund categories such as mid cap and small cap funds . The fund manager of diversified funds switches between large cap, mid cap and small cap stocks based on the market conditions. This way, the investors won’t lose out on good market opportunities.
Since diversified funds invest in companies across market capitalisation, the returns from them are amplified and lead to growth for the investors. However, diversified funds are not immune to market volatility. They can be affected by adverse market conditions, but the impact would be a little less than non-diversified funds.
Diversified funds give a broad market exposure to investors. Multi cap funds are often considered as diversified equity funds as they invest across market capitalisation. They save the time of investors and clear the confusion of choosing between different market capitalisations for investing. The risk in these funds is balanced. This is because, in the bullish phase, small cap funds will fair well. While in falling markets, the large caps will act as a support to the mutual fund portfolio returns. Investors with a decent understanding of equity markets and its risk, with moderate risk tolerance, can consider investing in diversified mutual funds.
Classification of diversified mutual funds
Diversified mutual funds are classified based on their investment strategy. Following are the different types of diversified mutual funds:
Multi cap mutual funds
A Multicap fund is a type of diversified mutual fund. The fund manager of a multicap fund has the freedom to invest across any sector or market capitalisation. The asset allocation of a multi cap fund depends on the fund manager. He/she has the flexibility to change the asset allocation based on the market conditions. Multi cap funds invest across large cap, mid cap and small cap stocks. Therefore, these diversified funds have a slightly higher risk when compared to pure large cap funds.
Value fund is a diversified equity fund. They follow value investing as their investment strategy. These funds invest in stocks that are considered to be undervalued. Also, value funds invest across sectors and market capitalisation. The fund manager identifies stocks based on their fundamental valuations. Value funds invest in stocks that are trading below their intrinsic value. The funds have a lower downside. In other words, these are undervalued stocks and the probability that they fall further is very less. Therefore, the risk associated with value funds is them being consistent underperformers even during a bull phase.
Large and Mid cap mutual funds
Large and mid cap funds invest across large and mid cap stock. They are a type of diversified equity fund. These funds have a minimum investment requirement. They have to invest a minimum of 35% of total assets in large cap companies. And a minimum of 35% of total assets in mid cap companies. These funds diversify investments across large and mid cap stocks. Also, these diversified funds are slightly riskier in comparison to pure large cap funds.
Hybrid Funds (formerly known as balanced funds)
A hybrid fund invests across asset classes, namely equity and debt. Some of the types of hybrid funds are Arbitrage funds, balanced hybrid funds, aggressive hybrid funds, conservative hybrid funds, multi asset funds and equity savings funds. Previously hybrid funds are known as balanced funds. The hybrid fund offers diversification only across asset classes.
Benefits of investing in diversified funds
Diversified mutual funds suit all investors with different investment plans. They provide the following benefits to its investors:
Access to a wide range of industries and companies of varying market sizes
Diversified funds give investors’ access to a wide range of industries and companies with different market sizes under one umbrella. Investors who cannot individually invest in all sectors due to lack of money or knowledge can invest in diversified funds.
Acts as a cushion during market volatility
During adverse market conditions, diversified funds act as a cushion for portfolio returns. Investing across sectors and market capitalisation helps in marinating the portfolio returns. It reduces the downside risk in a portfolio.
Helps in achieving long term financial goals
One can consider diversified equity mutual funds to invest in achieving long term financial goals. Diversified mutual funds help in achieving long term financial goals like retirement, child’s education and marriage, etc. Investors who stay invested in these funds for the long term will benefit from the compounding effect of returns—hence helping in meeting the long term financial needs of an investor. Investors can invest in diversified equity funds through SIP and lump sum route. They can calculate their potential SIP return using Scripbox’s SIP Calculator.
Reduces the time spent on monitoring a portfolio
A well-diversified portfolio doesn’t require continuous monitoring with changing market conditions. The fund manager manages a diversified fund’s portfolio. However, even investors need not worry about reviewing or rebalancing their mutual fund portfolio regularly.
Helps investors get acquainted with different strategies
Diversified equity mutual funds can be funds investing across different market capitalisation like a multi cap. Alternatively, they can also be investing across different sectors and can be based on multiple strategies. There are value funds which focus on value investing. However, there are multi cap funds which can be growth oriented. Hence investors get to invest using multiple strategies in the market.
Access to global market
Diversified funds can also give investors access to international equity. There are few diversified equity mutual funds which invest in global equities and diversify across global companies. Investing in such funds can help investors diversify globally. Investing in the global market is as essential as investing in the domestic market. It protects portfolio returns during a recession or any other crisis in the country.
Things to keep in mind before investing
Following are the things that an investor needs to keep in mind before investing in diversified funds:
Diversified mutual funds are suitable for investors with a long term investment horizon. However, an investor needs to stick to the period of investment. This will help them in obtaining significant returns.
Diversified mutual funds are quite volatile. Hence they experience high fluctuations in the short term. However, in the long term, the returns pan out to be good. For investment in diversified mutual funds, the minimum recommended investment horizon is five years.
Investment Objective of the investor
Diversified mutual funds have an investment strategy that will benefit the investors in achieving long term objectives. For example, a child’s education planning, retirement planning, child’s marriage etc. These funds have a good asset allocation that will help in churning good portfolio returns in the long term.
Therefore, investors should invest in diversified funds for the long term. Also, it is advisable to have a financial goal attached to their investment.
Similar to other categories of mutual funds, diversified funds also charge a fee for managing the investor’s money. The fee is known as the expense ratio. As the funds are structured to take advantage of the changing market dynamics, diversified funds have a higher turnover ratio. As a result, they have higher transaction costs.
Though these funds have higher costs, they outperform many funds in the market. Returns from diversified funds have been better than some large cap funds and small cap funds.
As the name suggested, these funds have a diversified investment strategy. These funds aim to create wealth by investing across sectors. Diversification is the key strategy for the portfolio. Therefore, they invest across market capitalisations and sectors.
The fund manager, along with his team, conducts thorough research on companies and invests in the best stocks. Some of the factors they consider before investing in stock are EPS, PE ratio, etc.
Past returns do not guarantee future returns. It is a well-known fact that investing purely based on past performance is not a good practice. However, understanding the past performance of a fund is necessary. Studying past performance will help in understanding the fund’s reaction to various market scenarios. A fund that has fared well in the long term amidst all the market chaos has a good probability of generating significant returns in the future.
Mutual funds are market-linked instruments. Diversified mutual funds also face risks depending on the market conditions. Therefore, the fund manager plays a vital role in managing the asset allocation of the portfolio to take advantage of the dynamics markets. Also, in terms of risk, these funds have a lesser risk in comparison to pure mid cap or small cap funds.
Apart from the above parameters, investors should also consider Sharpe ratio, standard deviation, alpha, beta and Treynor’s ratio. However, few investors lack the time and knowledge to calculate the Sharpe ratio, standard deviations, etc. Hence they can always take the help of a financial advisor. To know more about mutual fund basics and asset classes read our mutual fund’s guide.