Diversified equity mutual funds are mutual fund schemes which invest in equity or equity related securities across different sectors and market capitalization segments. Diversification across sectors reduces the risk of the investment. Individual stocks are exposed to three types of risk – company risk, sector risk and market risk. By investing in a large number of companies, diversified equity mutual funds diversify the company specific risks. By investing across different industry sectors (banks, automobiles, oil and gas, cement, capital goods, pharmaceuticals, fast moving consumer goods, Information Technology, metals, chemicals, telecommunications etc.), diversified equity mutual funds diversify the sector risks.
Diversified equity mutual funds also diversify across different market capitalization segments. This can help these mutual funds perform better than large cap equity mutual funds which are focused on particular segments across different market cycles or conditions. The universe of stocks can be broadly divided into three segments based on their market capitalization. Market capitalization of a company (stock) is the share price of the company times the number of its shares outstanding.
Companies whose market capitalizations exceed Rs 10,000 Crores are known as large cap companies. These are well known companies with a fairly long history. These companies command a high percentage of the market share in their respective industry sectors. Given their large size, investors believe that these companies are better placed to survive downturns in the economy compared to smaller companies; as a result these companies are perceived to be less risky and investors are ready to pay a premium for their shares.
Companies whose market capitalizations range between Rs 2,000 Crores to Rs 10,000 are known as midcap companies. These companies have the potential to grow faster than large cap companies and therefore, midcap stocks can give better returns than large stocks in the long term. However, these companies are thought to be more risky than large cap companies. Companies whose market capitalizations are less than Rs 2,000 Crores are known as small cap companies. Small cap stocks can grow faster than midcap stocks but are riskier (more volatile) than midcap stocks.
Small and midcap stocks tend to be under-researched and therefore, their valuations tend to be lower than large cap companies. By buying high potential mid and small stocks and holding them for a long period of time, investors can create a lot of wealth not only through faster earnings growth but also through valuation re-rating (upgrade). However, these stocks tend to suffer more than large cap stocks in bear markets. It takes a lot of expertise in identifying good midcap and small cap stocks.
Large cap stocks tend to outperform small and midcap stocks in bear markets, while small and midcap stocks tend to outperform in bull markets.
Diversified equity mutual funds which invest in large cap, midcap and small cap stocks tend to perform better (on a relative basis) in bull markets and bear markets. Diversified equity mutual funds tend to outperform large cap funds in bull markets, but suffer less than midcap funds in bear markets. As such, diversified equity mutual funds are ideal investment choices for long term investments.