Mutual funds are the ideal options for retail investors as far as investments in market linked instruments are concerned. Those wanting to invest for long term wealth creation equity funds are the best options because, as per historical evidence, equity as an asset class outperformed other asset classes with a good margin over a sufficiently long investment horizon. Apart from wealth creation another important investment consideration for retail investors is risk minimization.
There are two kinds of risks in equity or equity mutual fund investments – systematic risk and unsystematic risk.
What is systematic risk- Also known as market risk, is intrinsic in all equity assets. This risk is caused by macro-economic factors which individual investors, retail or institutional, cannot control. Hence this risk is known as uncontrollable risk. That is why, mutual fund investors will find the disclaimer, “Mutual Funds are subject to market risk” in all product literatures/ offer documents etc.
What is unsystematic risk – It is caused by company specific risk or industry specific factors. This risk is diversifiable by investing in a large number of companies across different industries and sectors. In a sufficiently diversified portfolio, unsystematic risks of different stocks in the portfolio cancel out each other and the overall portfolio in aggregate is only subject to systematic risk or market risk.
Diversified equity funds, which invest in a large number of companies across different industry / sectors and market capitalization segments, reduce investment risks for investors.
The benefit of investing in mutual funds is that it takes lesser capital to diversify unsystematic risk (company or industry specific risks) compared to investing directly in stocks. It takes a considerable amount of capital to achieve sufficient diversification in a stock portfolio because one has to invest in a large number of stocks.
Mutual funds pool monies of different investors and invest the AUM in a portfolio of securities and stocks. Investors are allotted units based on their proportional ownership of the assets at the current price (NAV). The pool of money mobilized by a mutual fund scheme is usually large enough to achieve sufficient diversification. A retail investor can enjoy beneficial ownership of a diversified equity portfolio through a relatively small investment (e.g. Rs 500). Hence from the perspectives of risk as well as capital appreciation objectives by investing in different stocks, diversified equity mutual funds are ideal investment options for retail investors.
Another major advantage of diversified equity mutual funds is the diversification across different market capitalization segments. There are broadly three market capitalization segments –A company is classified as large cap if it has over Rs 15,000 to 20,000 Crores of market capitalization, companies with market capitalizations ranging from Rs 5,000 Crores to Rs 15,000 – 20,000 Crores are classified as midcap companies and companies with market capitalization of below Rs 5,000 Crores can be classified as small cap companies.
Each of these market capitalization segments, large cap, mid cap and small cap has their own risk / returns characteristics. For example – Large cap companies are perceived as less volatile equity investment options compared to small and mid-cap companies which are perceived as being more risky than large cap companies. In fact small cap companies are the most risky.
The downside risks of large cap companies are limited in bear markets compared to small and midcap companies and therefore, it should be part of the core portfolio of retail investors. But as the universe of large cap stocks in India is still fairly limited; a mutual fund manager’s ability to deliver high risk adjusted returns compared to the benchmark is upto a great extent restricted in the large cap stocks.
However, midcap and small cap companies can give superior capital appreciation for investors in the long run as these companies are relatively less well known and under-researched. Historical data shows that, high quality midcap stocks, over a sufficiently long investment horizon can deliver superior returns, compared to a large cap stock. This applies in case of returns received from large cap mutual funds and mid and small cap mutual funds.
See the historical returns of large cap mutual funds and also the historical returns of mid and small cap mutual funds.
Diversified equity funds, which invest across market capitalization segments and industry sectors, can have 45 – 75% of their portfolio invested in large cap funds and the balance in small and mid cap funds. 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 at the starting phase of the bull market. During bull market rallies, the valuations (P/E multiples) of large cap stocks can run up fast and the valuations can look stretched, making the investors wary. Midcap companies start outperforming large cap companies in the mid and end phases of the bull market cycle. Diversified equity mutual funds have both large cap and midcap companies in their portfolio, and therefore, have the potential to deliver superior return on a more consistent basis in the long term.
While in bull markets small and midcap stocks rally, in bear markets they suffer sharp declines and liquidity issues. Consequently, purely small and midcap funds can face liquidity constraints when redemption pressure increases in bear markets. The other advantage of investing in diversified equity funds is that it does not face liquidity issues, since large cap stocks comprise a substantial portion of the portfolio. Mid and small cap stocks may suffer sharp declines and can have liquidity issues during the bear market phase.
You may like to read what are the different types of equity mutual funds in India
To select a top performing diversified equity mutual fund, do visit this section on our website –Top 10 diversified equity mutual funds