Diversified funds, which invest across market capitalizations, have several advantages compared to funds focused on any particular market capitalization.
- Different segments of the market outperform each other in different market cycles. For example large cap companies outperform midcap companies in bear market conditions and in the initial phase of the bull market. When large cap valuations run up in bull markets, midcap companies tend to do well. The midcap stocks which had been trailing the large cap stocks for the greater part of 2013, in terms of returns, caught up with the large cap stocks by the end of the year, and over the past few months, especially after the elections, have outperformed the large cap stocks. Diversified funds have both large cap and midcap companies in their portfolio, and therefore have the potential to deliver good performance on a more consistent basis.
- Diversified funds have the potential and tend to outperform large cap funds in the long term. The diversified funds have 25 – 50% of their portfolio invested in small and midcap companies. Small and midcap companies have the potential to give higher returns than the large cap companies, because of their earnings growth potential and relatively lower valuations. During bull market rallies, the valuations (P/E multiples) of large cap stocks run up faster and unless earnings growth keeps pace, the valuations can look stretched, making the investors wary. Small and midcap stocks tend to outperform large cap stocks in bull markets. As a result, diversified funds tend to outperform purely large cap funds in bull market conditions.
- While in bull markets small and midcap stocks rally, in bear markets they suffer sharp declines and liquidity issues. Consequently, small and midcap funds face liquidity constraints when redemption pressure increases in bear markets. Diversified funds on the other hand do not face liquidity problems, since large cap stocks comprise a substantial portion of their portfolio.
- Retail investors tend to be influenced by “recent” outperformance. In bull markets investors tend to shift from large cap to midcap funds, which give higher short term returns. Similarly in bear markets, investors tend to redeem or stop SIPs in their midcap funds due to the volatile NAVs. However, short term performance may not be a good indicator of future performance. Long term performance depends on fundamentals like economic outlook, company and sector growth potential, fiscal policies etc. Fund managers of diversified funds invest in large, mid and small cap stocks based on the long term growth potential. They also change their portfolio allocations between market capitalizations and sectors, to maximize fund performance within defined investment objectives. Investing in diversified funds precludes the tendency of investors to switch between large and midcap funds based on short term performance.