As Sensex soars on large-cap rally, diversified funds find the going tough

The Sensex has made modest gains so far this year, clocking a return of 7.7 per cent. But most diversified equity funds have faced difficulty in even keeping up with this level of performance.

Over 90 per cent of the 183 equity schemes lagged the index from January 1 to December 12. Their average returns stood at a measly 2.5 per cent. This is in sharp contrast to the trends seen during the previous market rallies when a majority of funds were trouncing the Sensex. During the bounce back of 2012, two-thirds of the schemes managed to outdo the Sensex.

In 2009, nearly 60 per cent of diversified equity schemes performed better than the bellwether.  

The muted gains for funds this year could be due to three reasons, explain fund managers.

Concentrated Index First, it was the top stocks in the Sensex, such as Infosys, TCS, Sun Pharma and ITC, that contributed the most to its positive returns, propping it to a new high.

But equity funds remained underweight on these stocks, perceiving them to be overvalued.

For instance, many funds were circumspect about ITC and Hindustan Unilever (trading at about 32 times FY13 earnings), which account for 15 per cent of the Sensex. Thus, these funds which had lower exposures to these stocks suffered.

“Even as the index has concentrated positions in stocks such as ITC, Infosys and TCS, a diversified equity scheme will not place similar bets on these stocks. We take differentiated bets when we believe it to be risky to mimic the index. In the process, we don’t mind underperforming in the short term, given that our focus is on long-term performance,” says I.V. Subramanian, Director, Quantum Mutual Fund.

Anand Radhakrishnan, Senior Vice-President and Portfolio Manager, Franklin Templeton Asset Management, expresses a similar view. “People have asked me why I do not own ITC in Franklin Bluechip Fund. I felt it was very expensive despite being a good business to own. While the stock has done very well, growth at any price is not a good investment strategy,” he explains.

Second, many diversified funds invest a portion of their assets in mid- and small-cap stocks. With these stocks not keeping up with the bellwethers, this has impacted performance.

“Most Indian equity managers use mid-cap stocks to deliver alpha. This time around, not all mid-cap stocks have kept up with the markets or performed well. They haven’t necessarily beaten large-cap stocks. That’s why funds have found it difficult to outperform,” says A. Balasubramaniam, CEO, Birla Sun Life Mutual Fund.

Third, relentless buying by foreign institutional investors in index stocks also contributed to the Sensex zooming ahead of the rest of the market. “Higher inflows from the top-down kind of foreign investors who either buy into exchange-traded funds or just mimic the index may have also driven the rally in these index stocks,” says Radhakrishnan.

Though the one- and three-year performance of diversified equity funds has been weak, most schemes have managed to beat the benchmark over a five-year timeframe.

Most fund managers believe that if the recent market rally is sustained, more stocks outside the index will participate, lifting equity fund net asset values.

Winners and losers While investors who chose diversified equity funds may have been disappointed this year, those who bet on index funds which mirror the benchmark indices are likely to be happy. Most of them have, in fact, delivered returns higher than the index.

But a few diversified equity funds did manage to clock double-digit returns. Birla Sun Life India Opportunities Fund, Religare Invesco Equity Fund and ICICI Pru Dynamic Fund topped the returns chart gaining 13-17 per cent this year. While being overweight IT and auto stocks helped Religare Invesco Fund, timing the market right and buying at the bottom helped ICICI Pru Dynamic Fund.

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