Investors often make the mistake of investing in mutual funds without fully understanding the implications of the investment. One common area where investors are confused is with regards to aggressively managed equity funds.
They invest in these funds without realising their true nature. The confusion occurs because investors are unable to fathom what gives such funds that 'aggressive edge'. In this note, we analyse the factors that set apart aggressively managed equity funds from other equity funds.
Aggressively managed equity funds can be differentiated by either the style of investing or the nature of the underlying investments. Broadly, equity funds draw their aggressive edge from the following factors:
1. Aggressive stock bets
At Personalfn, we maintain that a diversified equity fund should hold no more than 40 per cent of assets in the top ten stocks. This helps the fund counter stock market volatility more effectively. Aggressively managed funds usually have more than 40 per cent of their assets in the top 10 stocks.
So if you come across an equity fund with a concentrated stock portfolio that has more than say 60 per cent of assets in the top 10 stocks, you can be sure it is managed aggressively.
Even within the top 10 stock holdings, you are likely to observe that the first few stocks account for a substantial chunk. Finally, such an investment pattern is likely to be the norm, rather than an exception.
2. Aggressive sectoral/thematic bets
Sometimes an equity fund may have around 40 per cent of its assets in the top 10 stocks and this could mislead the investor into believing that it is conservatively managed. If the investor reaches this conclusion without evaluating the fund's sectoral portfolio then this would be a mistake.
For instance, an equity fund could have more than a fourth of its assets (i.e. 25 per cent of assets) in a single sector. Or it could be heavily invested in just 2-3 themes, which collectively account for a large chunk of its portfolio.
And all along the fund could be well-diversified in its stock allocations, leading investors to conclude that it is managed conservatively. While the truth is, it's an aggressively managed fund by virtue of its sectoral/thematic allocations.
3. Aggressive portfolio churning
Then there are equity funds that have reasonably diversified stock and sectoral portfolios, but are managed aggressively.
This can be attributed to their investment strategy, which involves churning their portfolios aggressively to benefit from the hottest market trends.
Given that these funds could have well-diversified stock/sectoral allocations, how can investors identify such funds? The secret lies in evaluating the funds on the risk parameter. Such funds usually perform adversely on Standard Deviation i.e. they will have a higher Standard Deviation, which implies increased volatility.
Also, studying their portfolios over a period of time will reveal their penchant for frequently churning the portfolio.
4. Underlying investments
Finally, you may see an equity fund that is well-diversified across stocks and sectors and pursues a relatively steady investment style (i.e. low portfolio churn), but is still classified as aggressive. The reason for this classification is its underlying investment, which is inherently risky. Within equities various investments have varying risk levels.
For instance, large cap companies are relatively more stable because they have established track records (in sales and revenues among other parameters) and are more liquid. On the other hand, mid cap companies tend to be riskier because they are under-researched (compared to large caps) and their systems are evolving; moreover, mid caps can also be relatively illiquid.
Therefore, mid cap stocks and mid cap funds are riskier investment propositions than large caps/large cap funds, for instance. Then there are investments in emerging sectors which don't have an established track record as yet; also, information about such sectors isn't freely available, thereby accentuating the risk profile of the investments.
The above list isn't a comprehensive one and there could be several other factors that can contribute to making a fund, an aggressively managed one. From an investor's perspective, the key lies in accurately understanding a fund's nature and being unambiguously aware of the risk involved before making an investment decision.
Your family's future depends on this. Read now
More from rediff