A common myth among investors is that the more mutual funds one invests in, the better diversified the portfolio. However, in reality the benefits of diversification cease beyond a certain number of funds and having more than these can be counterproductive. Diversification should not be restricted to funds and should also include managers and portfolios. Most investors buy multiple funds that have similar portfolios or end up with high index replication in portfolios. The correct thing to do is to look at largely different portfolios or those that are not correlated.
The selection of mutual funds also cannot rely only on point-to-point returns. This is because such returns can be misleading and the performance of mutual funds has to be understood in context. Two funds with similar point-to-point returns can be very different. Factors such as volatility, risk-adjusted return and portfolio composition are critical in determining the suitability of a mutual fund. Quantitative research can depict an incomplete picture unless it is augmented with qualitative research.
Transparency, too, should be a factor while investing. The recent regulatory changes have increased transparency and bolstered the image of mutual funds as being the safest investment mechanism. Increased transparency has encouraged investor participation and interest; the average monthly purchase value for all mutual funds during the three months following the regulatory changes in August 2009 was about 30 per cent higher than for the three months preceding the change. This dispelled speculation that investments would dip after regulatory changes.
Sometimes it is wiser to exit investments and book losses rather than hold on to them. This is corroborated by the three-year compounded annualised returns—24.53 per cent, 10.97 per cent and 9.17 per cent—of the best, peer average and worst funds, respectively (returns as on 23 April 2010). A huge difference was observed between the results of best and worst diversified equity funds.
Unlike the markets in most developed nations, the Indian equity market offers opportunities for generating alpha and beating benchmarks. In the past three years, despite the market fluctuations, some of the top ranked diversified equity funds, on an average, outperformed the S&P CNX Nifty by an absolute return of around 38 per cent. This performance is valuable as it is relatively cheap for the investor. Besides, unlike other investment vehicles, mutual fund managers do not demand a performance fee.
Shikha Hora is Director, Advisory & Insurance, Religare Macquarie Private Wealth