Diversified Funds vs. Index Funds vs. Thematic Funds
When it comes to choosing a mutual fund most people have three common types of funds in mind – Diversified funds, Index funds and Thematic funds. Each category of fund has its own features, advantages and drawbacks. Lets try to decode understand each of them.
I’m hoping that most readers would be aware of the basic features of a mutual fund. In case you want to get some basic right I recommend you to check out the links below:-
Why choose a diversified fund? How does it work?
A diversified fund in simple terms is a fund which invests across a diverse range of companies and sectors (banking, mining, telecom, infrastructure, etc. in order to ensure that the portfolio is protected from dramatic movements in one or two sectors.
Examples of Diversified Funds
1. HDFC Growth Fund
2. DSP-BR Equity Fund
3. Franklin Flexi Cap Fund
The nature of diversification would depend on the fund philosophy and objectives. A flexi cap fund may investing companies of varying sizes, consisting of a mix of large cap, mid cap and small cap. Some funds may have a preference for a set of sectors, market capitalization (value of shares traded), etc.
For conservative investors a diversified fund with more exposure to blue chips (large caps) may be a good choice. Investors looking for extra kick in their returns may looking at diversified funds with mid cap and/or small cap exposure.
Advantages of Diversified funds
- Moderate to High Risk
- Returns can be moderate to high depending on market conditions. (High returns i.e greater than 20% p.a. are generally common in bull markets). Returns should be higher than benchmark (index) returns. i.e. if Nifty generates 15% p.a. your fund should return more 15%. Otherwise you are better off investing in a low-cost index fund, which we will discuss next.
- Diversified Portfolio reduces stock/sector specific risk or volatility
- Suited for most people looking for diversification
- Professional fund management
Drawbacks of Diversified funds
- You cannot capitalize on growth or momentum in one sector which is outperforming the market
- Returns could be poor or moderate if the net performance of sectors within the portfolio are not good
- Costs can be high because of the cost and time involved in stock selection, research and other operations.
- There is a higher dependence on the skill of the fund manager
- A few other draw backs may emerge when you compare with other funds/options.
Diversification does not mean just investing in more number of stocks. It aims to make sure that you invest in stocks in different businesses or sectors so that the portfolio is not affected dramatically by varying business cycles favoring some sectors while negatively impacting other sectors.
The second form of diversification is based on the size of companies based on market capitalization (value of shares traded in the market). The fund could invest in a mix of large cap and mid caps stocks or even include a bit of small cap in its portfolio.
Large cap stocks or companies would be reputed players which are leaders in a sector with solid brands, products and expertise in their respective markets. For instance Hindustan Unilever (HUL) is a leader in FMCG sector with brands such as Rin, Surf, Hamam, etc. Like HUL there would be a number of leaders in different sectors which diversified funds can look at.
Mid cap and small cap stocks are medium and small sized companies or players. By investing in a mix of large cap and mid/small cap you get exposure to stable large companies as well as fast growing smaller companies. The large players provide a safety factor, stability, etc while the mid/small players provide you the potential for superior growth.
Why choose a Index Fund? How does it work?
An index fund is a fund that invests its money in index stocks, in such a way that its portfolio is more or less a replica of the index or the benchmark that it tracks.
Examples of Index Funds
1. For instance ICICI Pru Index Fund is a fund that aims to closely track the performance of S&P CNX Nifty Index by investing the respective index stocks in the same composition or weightage as in the index. So this fund basically invests in the 50 stocks that are part of Nifty in the same ratio as prescribed in the index.
Advantages of Index Funds
- Simplicity: Index based investing is easier to track and manage. Even the benchmark (Nifty/Sensex) is closely tracked, so you can easily see how the fund is performing vis-à-vis the index and take appropriate decisions.
- Low Cost: The entry and exit loads for an index fund are relatively lower than diversified funds.
- Lower Fund Expenses: This tells you the cost of management of the fund including its internal operations. This would be lower because the fund is passive in nature since it mimics the index. So the fund manager in this case does not have to spend time on stock selection, research, sector allocation, etc. because he is simply going to make a portfolio which replicates the Nifty index.
- Transaction costs for the fund: A diversified fund may churn its portfolio often to find better opportunities to take new bets. But an index fund has to stick to its mandate of simply tracking the index. Changes to the index are quite rare and may happen only 4-5 times a year or less, so frequent churning and transaction costs are minimized.
- Higher Safety: Since stocks in the index are the ones with good volumes, track record, etc it provides a good safety to investors who don’t want to risk their investments in stocks/sectors which don’t have a reliable track record.
Disadvantages of Index Funds
- No outperformance: These funds cannot outperform the broad index like Nifty/Sensex because of their inherent structure
- Stock picking not possible: The fund manager cannot proactively pick stocks or sectors outside the index. So opportunities outside the index consisting of thousands of stocks cannot be tapped in this case. But diversified funds have this advantage.
- Mundane/Boring Portfolio: Compared to a diversified fund the portfolio may not see any changes. New stock addition or deletions or changes to the composition of the portfolio will be minimal. People who want to see more action will hate this. Let me tell you a secret that from a purely investment point of view index investing or passive investing might be advantageous. We will also have a special section on “Taking the boring route to successful investing” which shows you how simple boring investment vehicles actually help you build wealth overtime.
Why choose a Thematic Fund ? How does it work?
These are funds which have a mandate to invest in a specific sector or sectors or a theme. Some funds invest in one or two core sectors, while other would have a broad theme, which might encompass multiple sectors.
Examples of Thematic Funds
1. For instance “Franklin Infotech Fund” invests in high quality, fast growing companies in the information technology sector.
2. Another example would be “JM Basic fund” which invests in in sectors categorized under “basic industry” which includes energy, petrochemicals, oil & gas, power generation & distribution and electrical equipment suppliers, metals and building material. In the case of JM Basic fund the coverage is across various industry, so ‘basic industry’ can be seen as a theme or philosophy.
3. “DSPBR T.I.G.E.R fund” is another example of a theme based fund. This fund is managed by DSP BlackRock Investment Managers Pvt. Ltd. and the name T.I.G.E.R is an acronym which refers to ‘’The Infrastructure Growth and Economic Reforms’. The fund aims to invest in corporate, which benefit from economic or policy reforms.
Advantages Thematic Funds
- You have the opportunity to bet on a particular sector instead of invest in a single stock.
- Possibility of higher returns on a focused/concentrated portfolio
- Thematic funds also provide some variety or potential for extra returns despite a higher risk.
- The fund manager or fund house which has clarity of theme can actually tap unique opportunities in several sectors across thousands of companies in India.
- Some themes or philosophies like TIGER, basic industry, etc are broad providing diversification across sectors and market capitalizations.
Disadvantages Thematic Funds
- High risk because you are dependent on the performance of one sector/theme which may not fetch good returns in all market cycles or periods.
- Returns can be poor or pathetic if a sector (s) undergoes a bad phase for long periods.
- Fund Manger cannot change the theme or philosophy. Diversification to other sectors is not possible as in case of diversified funds.
- Past performance is not reliable because if a particular sector undergoes an extreme situation it cannot be handled or mitigated.
When to choose between a Diversified, Index and Thematic funds ?
The core portfolio of an individual depends on his income, savings, risk appetite, return expectations, etc. In addition to pure investment parameters we have to identify financial goals/objectives that one wants to achieve. The key question revolves around safety, tenure of investment, returns and liquidity.
1. Assuming a higher weightage or priority to safety, I would first prefer index funds followed by diversified funds.
2. Thematic funds are better avoided if you are looking for safety. Secondly looking at investment tenure and returns, thematic funds are not superb because in a bad year thematic funds’ Net Asset Value can drop and can sink the returns earned in the past.
3. On the other hand diversified funds and index funds can provide moderate to high returns overtime.
All though all three categories are reasonably liquid, the index funds score better in liquidity because of their lower exit loads.
To make life simple for a mutual fund investor my vote goes for diversified funds and index funds. I’m still not saying diversified funds are better than index fund, or vice versa because each one has its own advantages and drawbacks.
However, since thematic funds are little toxic or risky its better to avoid unless you have the knack to handle nasty surprises posed by volatility.
As far as index funds are concerned they provide moderate returns with moderate risk which are in-tune with the market, while diversified funds can outperform the market but come with higher risk attached. So if you are conservative you can invest more in index funds, but if you are moderate or aggressive you can invest more in diversified funds.
For the right mix of funds you can consult a professional financial advisor. Build wealth through mutual funds is simple – you only need to invest systematically every month in 3-4 good funds with high ratings. Don’t wait for the New Year’s to come up with a resolution – start saving and investing now.