How to handle ‘Divergence’ in equity mutual fund returns?

The divergence in mutual fund performance poses a unique challenge to the plethora of young millennials and Do-It-Yourself (DIY) investors.

August 27, 2021 3:09 IST | India Infoline News Service
Volatility in equity funds is nothing new. It is the price you pay for higher returns. However, over the last 1 year, what is evident is a different type of challenge. It is divergence in returns among funds in the same category. You would normally expect large-cap funds or mid-cap funds or small-cap funds to perform approximately like the rest. But that is not the case in reality. Now, that creates a challenge for investors.

The divergence in mutual fund performance poses a unique challenge to the plethora of young millennials and Do-It-Yourself (DIY) investors. This is exactly where investors need to seek expert advice. There are a whole lot of factors that lead to this divergence and a number of ways in which you can handle this divergence. Let us first understand how and why divergence arises.

The starting point to understand divergence

Since the subject is divergence in returns, we only look at equity-related funds. Of course, debt funds also show divergence, but we will leave that for now. The second issue is materiality. To simplify the analysis of divergence, we focus on just 6 categories of equity funds with the highest AUM.
Fund Category AUM (Rs Crore)
Large Cap Funds Rs198,796cr
Flexi Cap Funds Rs193,422cr
Mid-Cap Funds Rs142,792cr
ELSS Funds Rs138,663cr
Sectoral / Thematic Funds Rs123,936cr
Small Cap Funds Rs94,015cr
Data Source: AMFI

The above six categories constitute 76% of the total equity fund AUM so they are representative of the equity fund universe. To understand divergence, let us look at how each of these categories performed in the last 1 year.

Did the 6 categories of equity funds show divergent returns?

Let us summarize the performance of these 6 categories in a table and then look at their divergence.
Fund Category Category Average (%) Top Performer (%) Bottom Performer (%) H/L Range Risk Adjusted Return Factor
Sector - FMCG 22.87 23.89 21.79 2.10 10.89
Sector - Financial Services 54.05 68.2 43.44 24.76 2.18
Large-Cap 42.63 53.75 30.65 23.10 1.85
Sector - Technology 95.27 108.3 51.77 56.53 1.69
Sector - Healthcare 33.71 46.27 26.06 20.21 1.67
Small-Cap 73.41 102.55 52.14 50.41 1.46
Mid-Cap 56.58 82.51 40.22 42.29 1.34
Flexi Cap 46.31 67.29 16.07 51.22 0.90
ELSS (Tax Savings) 47.18 87.03 26.13 60.90 0.77
Data Source: Morningstar

To understand divergence, the penultimate column covers high/low range of each category. In the case of sectoral funds, we maintained sectoral classifications, since comparing technology and financial services would be like apples and oranges. If you look at the ELSS category, the divergence is the largest at 60.9%. The best ELSS performer in the last 1 year returned 87.03% while the worst performer returned just 26.13%. Similarly, this range is above 50 in the case of small-cap funds, Flexi-cap funds and technology sector funds.

To make results more actionable, average category return are adjusted by divergence range. FMCG category has just 1 fund and may be misleading. However, on risk-adjusted factor, large caps as well as most sectoral funds have done better than mid-cap and small cap funds. ELSS funds rank lowest in divergence-adjusted returns, despite the 3-year lock-in.

Why does this divergence arise?

Divergence in performance can arise from a number of reasons. For example, funds are constrained by their exposure to a stock or group due to limits imposed by SEBI. Hence, fund performance diverges from index performance. Secondly, some fund managers take on more risk, and while it can be a two-way street, it does expand returns in the short term. Lastly, funds with smaller AUM have done better than funds with a larger AUM, especially in mid-cap and small-cap categories. How do you select funds with so much divergence?

Select the right fund amidst divergence

That is the million-dollar question. It is OK to say that equity funds create wealth over the long run. But, if you are in the wrong fund, there is opportunity loss you put up with. How do you predict top performing equity funds? “The answer is, you don’t”. Here are 5 points to ponder on fund selection.
  • Do it Yourself or DIY investing may sound simple and attractive, but it is fraught with risks. In case, you have a problem, seek help from your financial advisor.
  • The past may not be a guide to the future. If you look at annual performance of funds in each category on monthly basis, top performers are generally common over time.
  • Between high returns and high consistency, choose consistency. When you invest in consistent funds, you don’t worry about timing of entry.
  • Mutual fund investing is not a one-time event, but a life long relationship. Hence it is essential to continuously monitor the funds you invest in.
  • Last, but not the least, make a financial plan for your long-term goals and ensure that your mutual fund investments fit into your financial plan.

Remember, performance divergence is one of the risks for any mutual fund investor. Get the right advice and adopt the right investing discipline. The rest will follow!

The Author of this article is Mr. Sandeep Bhardwaj, CEO, IIFL Securities

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