How to achieve the right diversification in Mutual Funds?

The efficient market hypothesis (EMH) was developed by Eugene Fama who argued that stocks always trade at their fair value, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. So it is better to buy and hold broad index fund rather than picking individual stocks. Fama believed that returns earned above the index are an outcome of pure luck. However, research indicated that there are sources of Alpha (excess returns over benchmark) in plain sight because of behavioural biases of market participants, or structural/liquidity issues of the market. These factors are acknowledged by Eugene Fama who went on to publish 5 factor model. Andrew L. Berkin and Larry E. Swedroe have highlighted following strategies as primary source of Alpha over long term in their book “Your Complete Guide to Factor-Based Investing”.

Every fund manager follows a process and has a natural inclination to some of the following Process/Factors that leads to outperformance. We study what are these Processes and why they work in long term.

Value

What is value investing?

Value investing buys stocks that are under-valued with the expectation of prices rising to fair value. Investors in the market focus on short term performance and chase performing ideas irrespective of valuation. If a company is undergoing a downturn, however temporary that is, it’s stock would fall hard as investors sell them exaggerating short term pain. This leads to the stock price falling below its fair value. Empirical evidence suggests that historically buying undervalued stocks leads to higher than market return over long term.

Why it works?

Value investing requires contrarian bend of mind and hence not easy for everyone to follow. Besides, value investing doesn’t perform in every short investment period, there will be few years of underperformance, hence it is not very widely practiced. Typically, value investing underperforms in fast rising markets as there are fewer bargains but over an entire cycle it does very well as it contains losses in falling market.

Momentum

What is Momentum Investing?

Momentum investing buys stocks that are trending upwards. In markets, there will be few stocks that would have a tailwind and they would continue to do well over short to medium term as more and more investor will buy the stock taking it higher. A company may have come out with a rockstar product, or has favourable raw material prices, or is simply a beneficiary of some government policy. Buying a stock with existing strength can generate marketing beating performance. Rotating the portfolio to always have such stocks leads to higher returns in the long term.

Why Momentum Investing works?

Investors over-react on positive news thereby piling up on recent performing stocks. Though this strategy can be very volatile but over long periods say, across one bull market to the next bull market cycle, it does very well. Since Momentum investing performs very well in rising markets, it complements well with Value Investment style that may lag behind market in good times. This provides good diversification to value investment style. Once again, momentum investing doesn’t perform in every short period.

Quality

What is Quality Investing?

Quality investing means buying companies with strong competitive advantage. Competitive advantage helps companies maintain high profitability versus its peers. Competitive advantage comes from brand, patent, regulation, low cost, etc. Over a long cycle, quality companies outperform low quality companies due to strong balance sheets, less cyclicality and better management. A portfolio of quality companies may not have any pattern of outperformance but over a long period, it tends to perform well versus the market.

Why Quality Investing works?

Good quality stocks often look over-valued with lower potential upside in short term. However, they could be undervalued from long term perspective which is why they generate higher returns in the long term. Good quality stocks often look dull and predictable with lower potential upside in short term. Investors and some Fund Managers are drawn to the riskier stocks with better upside irrespective of downside. Hence they miss out on obvious high quality businesses. This may lead to undervaluation in quality stocks from long term perspective even if they look optically expensive in short term.

Size (Small)

What is Size based investing?

Size based investing means buying companies with smaller market capitalization. The universe of small cap companies tends to be under researched and prone to mispricing. Over long term, these mispricings correct themselves and generate superior returns. There could be some periods of under performance, especially during bear markets, but over a full market cycle it tends to perform better than the market.

Why Size based investing?

Institutions are the large participants in the market. Institutional investors like MFs and Insurance funds have large assets under management. Since they have to deploy significant sums, their hunting ground is mostly large cap companies. Hence, brokers and analysts do not research smaller sized companies. Hence, smaller size companies are prone to mispricing thereby leading to better upside in the long term.

While these are the main Processs that lead to market beating performance, timing when each of these Processes would beat the market is very difficult. Since empirical evidence suggests that over 10-15 year period, all these Processes outperform the market, it’s wise to have all the Processes as part of portfolio. This way, buying 4 different Process funds, one would achieve right diversification across funds rather than just buy 4-6 different names based on past performance. Having all four Processes in portfolio would mean running a car on all four cylinders. At least one of the cylinders will be firing at all times, this will not make you regret missing out.

This doesn’t reduce volatility of the portfolio since all of these funds invest in stocks. In shorter term of 6-12 months, all funds will move together with the market, but over medium term some would do better than other. For reducing volatility of portfolio one must follow asset allocation principles which means buying non-correlated assets like debt/fixed income and gold in addition to equity.

To assess how much of your monthly saving you should allocate to debt/fixed income +gold we recommend you do your Financial Planning using the MoneyWorks4me Financial Planning Tool. This can be invested in FD/RD in the largest & safest banks like SBI, HDFC and ICICI or in safe Liquid Fund.