Do Equities Benefit In The Long Term?

I am using SIPs to invest in equity funds. Currently, I have invested Rs 2 lakh in HDFC Midcap Opportunities, Rs 1,42,000 in IDFC Premier Equity Plan and Rs 14,58,000 in a Nifty Index Fund. I plan to stay invested in equities for the next 7 years. Please evaluate my portfolio?

- Pranav Bhondokar

Your portfolio is currently geared towards large-cap funds and allows you to benefit from the higher return potential of small and midcap funds. This simultaneously limits volatility as the bulk of your portfolio is invested in an index fund which is relatively safer because of its focus on large-cap stocks. Your current allocation is shown in the chart below.

As shown in the table, the small & midcap funds in your portfolio (HDFC Mid Cap Opportunities Fund and IDFC Premier Equity) have consistently outperformed the CNX Midcap Index and are amongst the best performers in their category. This is especially true of IDFC Premier Equity as the fund has generated higher returns and is also less volatile than its peers. You should retain your investments in these funds as they have generated high risk-adjusted returns.

However, you may want to consider diversifying your equity portfolio by allocating a portion of your corpus to actively managed large-cap funds. Currently, your large-cap allocation is restricted to a passively managed Nifty index fund.

The Nifty index Fund simply mimics the performance of the Nifty. The fund manager only needs to buy or sell securities when the index constituents change. The fund’s returns and volatility will be in line with the Nifty. In contrast, the fund manager of an actively managed mutual fund seeks to outperform the index by stock-picking and/or sector-picking based on evaluations of companies and industries. An actively managed large-cap fund may not mirror the index and may frequently buy and sell securities in its universe of large-cap stocks.

These funds can outperform the Nifty and passive index funds limit downside risk by having lower allocations to certain stocks or sectors than the index. For example, in recession, defensive stocks such as FMCG and pharmaceutical stocks usually outperform cyclical stocks such as banking and infrastructure stocks. During these periods, actively managed funds (unlike index funds) can restrict losses by reducing the exposure to cyclical stocks and investing in FMCG and pharmaceutical stocks. Similarly, when the economic cycle is on an upswing, actively managed funds can add value for investors by increasing the exposure to cyclical stocks. 

This phenomenon is highlighted in the chart. In 2008 and 2011, the Nifty fell by 52% and 25% respectively but the top actively managed large-cap funds managed to restrict losses and outperform the index. These funds also outperformed the index in bull markets.

Actively managed funds generally have higher expense ratios than passive funds such as Nifty index funds as they typically buy and sell securities more frequently. In spite of this, these funds have outperformed the Nifty and passive index funds over the long-run as shown in the table below. These actively managed large-cap funds are also less volatile as evidenced in their lower standard deviations.

In conclusion, you may want to redeem some of your investments in the Nifty index fund and shift to actively managed large-cap funds such as Axis Equity Fund, Birla Sun Life Frontline Equity Fund, Franklin India Bluechip Fund and ICICI Prudential Focused Bluechip Fund. These funds have generated higher long-run returns than the Nifty and Nifty index funds and are relatively less volatile. Consequently, these schemes should add more value to your portfolio than the Nifty index fund as you appear to be a long-term equity investor. But you can still hold onto some of your investment in the Nifty index fund if you plan to rebalance your portfolio frequently.

You can retain your investments in HDFC Midcap Opportunities Fund and IDFC Premier Equity. As a general rule, you should ensure that the exposure to small and midcap funds does not exceed 20% of your overall equity portfolio, unless you are an aggressive investor.