Diversified equity fund
Also written Diversified equity scheme · Diversified equity schemes · Diversified equity mutual fund · Diversified fund
An equity scheme that invests across a wide spectrum of companies drawn from several industries, so that no single company and no single industry can sink the portfolio.
In plain language
Buy one company's shares and you carry that one company's fate. If the business fails, the loss can be the whole amount you put in.
A diversified equity fund spreads the money instead. It buys shares across a wide range of companies, drawn from several industries. One bad company then costs you a slice, not the lot. One bad industry costs you a bigger slice, but still not the lot.
Equity is worth the trouble because it has the potential to beat inflation over long periods. When returns beat inflation, the buying power of your money grows.
The workbook pairs the fund with one habit. Stay invested for the long term, through the ups and downs. A SIP makes that easier, because it keeps adding small amounts without asking you to judge the market.
How it works
The workbook's definition. A diversified equity fund is a simple type of mutual fund that invests across a wide spectrum of companies representing a number of industrial sectors. That single design answers two separate risks: the risk of owning one company's share, and the risk of owning shares of companies from one industry.
What it cannot do. Diversification works on company-specific and sector-specific risk. Chapter 7 is blunt that systematic risks, such as inflation, affect the entire economy and cannot be mitigated by diversification — they are non-diversifiable. A fund manager can cut unsystematic risk by diversifying across companies, and no further.
The distributor's job before recommending one. Check the segment of the market the fund actually buys in — large companies, mid-sized companies, small companies, or a combination. The workbook's guidance: large companies are generally less risky than their smaller counterparts, while the small companies offer higher return potential. Two funds can both be diversified equity funds and sit at very different risk levels.
Where the return comes from. Chapter 4's summary of drivers is short: a diversified equity fund derives its return from the returns generated by the portfolio of stocks the scheme has invested in — not from a yield, the way a liquid fund or an FMP does.
The one figure attached to this product. Section 4.4 itself gives no percentage, no minimum holding and no cap. The figure that does apply comes from Chapter 4's opening: as one of the five simple and performing schemes a new cadre distributor may sell, a diversified equity scheme must have returns equal to or better than its benchmark in each of the last three years.
A measurement note. Chapter 7 adds that because Beta is more relevant for diversified equity schemes, comparisons using the Treynor Ratio should ideally be restricted to such schemes.
A worked example
Sunita, a nurse in Kolhapur, starts a Rs 3,000 monthly SIP in a diversified equity fund. The portfolio below is illustrative; the reasoning is the workbook's.
The scheme holds 48 companies across 11 industrial sectors. No single holding is more than 4.5 per cent of the portfolio, and the largest sector, banking, is 19 per cent.
What a single failure costs her. After two years she has Rs 72,000 invested, worth Rs 84,000. One holding — a mid-sized auto ancillary at 2.1 per cent of the portfolio — collapses and goes to zero.
Loss to the scheme = 2.1 per cent of Rs 84,000 = Rs 1,764.
Had she instead put the whole Rs 72,000 into that one company's shares, she would have lost Rs 72,000. That gap is what the word diversified is buying her.
What it does not buy her. In the following year inflation and a rate shock pull the whole market down 14 per cent. All 48 holdings fall together. Her Rs 84,000 becomes about Rs 72,240. No amount of spreading across companies would have prevented this, because the cause was economy-wide.
Why the segment matters. A second fund is also called a diversified equity fund but holds mostly small companies. In the same fall it drops 22 per cent. Both funds are diversified; they are not equally risky, which is exactly the check the workbook asks the distributor to make.
Why NISM asks about it
Chapter 4 (Mutual Fund Products for the New Cadre of Distributors), section 4.4, in a chapter carrying 6 per cent of the marks; Chapter 7 then supplies the diversifiable-versus-non-diversifiable risk split and the Treynor Ratio caveat. The classic question is Chapter 4's own sample question on which of the listed products is close-ended — FMPs, with diversified equity schemes among the open-ended distractors. Expect also a question on what diversification across sectors does and does not remove.
Common exam traps
- "Diversified equity fund" is Chapter 4's descriptive label, not one of SEBI's named scheme categories. Chapter 2's SEBI list names Multi Cap, Flexi Cap, Large Cap, Mid Cap and the rest. A question asking you to pick the SEBI category will not offer this phrase.
- Diversified equity schemes are open-ended. The close-ended product on Chapter 4's list is the Fixed Maturity Plan.
- Diversification removes unsystematic risk only. Inflation and other economy-wide shocks are non-diversifiable, however many stocks the scheme holds.
- Two diversified equity funds can differ sharply in risk depending on whether they buy large, mid or small companies. Checking that segment is the distributor's duty, not the fund's promise.
- Small companies carry higher risk and higher return potential — the workbook states both halves, so an option claiming only one is incomplete.
- Treynor Ratio comparisons belong to this category, because Beta is the risk measure that suits a diversified portfolio.
Check yourself
1.What must a distributor particularly check before recommending a diversified equity fund?
- a)Whether the fund is close-ended
- b)The segment of the market it invests in — large, mid-sized, small companies or a combination — since large companies are generally less risky while small ones offer higher return potential
- c)Whether it tracks an index
- d)Whether the scheme has a graded exit load
Show the answer
Answer: (b) The segment of the market it invests in — large, mid-sized, small companies or a combination — since large companies are generally less risky while small ones offer higher return potential
Care must be taken by the distributor to see the segment of the market that such a fund is investing in – is it investing in stocks of large companies, or mid-sized companies, or small companies, or a combination of these?
The large companies are generally less risky in comparison to their smaller counterparts. At the same time, these small companies also offer higher return potential. Care must be taken to understand this while selecting the schemes for the investors.
"Diversified equity" is a category, not a risk level. Two funds can both be diversified and yet be quite different propositions.
What diversification does address: a diversified equity fund is a simple type of mutual fund that invests across a wide spectrum of companies representing a number of industrial sectors. Such diversification reduces the risk of owning one company's share or the risk of owning shares of companies from one industry.
Two risks, both reduced by diversification — single company and single industry.
But there is a second risk that diversification does not touch: equity is a risky asset in that the share prices fluctuate a lot. Due to such fluctuations, there is a high possibility that one may end up buying at high prices or selling at low prices or both.
That one is answered differently: the risks can be mitigated through two things: by investing in a diversified portfolio made up of stocks of good quality companies in sound businesses, and by staying invested for long term through ups and downs of the markets.
And for the second, one tool helps: for a large number of investors, SIP (Systematic Investment Plan) helps here.
Why equity at all: equity as an asset class has the potential to generate returns higher than inflation. When that happens, the purchasing power of one's money grows.
Where this is taught
Free preparation for NISM Series V-BRelated terms
- Treynor ratioRisk premium per unit of market risk — the return a scheme earned above the risk-free rate, divided by its beta rather than by its standard deviation.
- Unsystematic riskThe part of an investment's risk that belongs to one company or one issuer — a strike, a fraud, a downgrade — and which diversification can remove, unlike market-wide systematic risk.
- Systematic Investment PlanA facility to invest a constant amount into a scheme at regular intervals, which buys more units when the NAV is low and fewer when it is high and so averages the cost of acquisition down.
- DiversificationSpreading an exposure across holdings that do not move together, so that total risk falls by more than total return does — minimising risk per unit of return.
- Actively managed fundA scheme whose fund manager chooses the portfolio within the broad limits of the investment objective, aiming to beat its benchmark — at a higher running cost than a passive fund.
- Flexi Cap FundAn open-ended equity scheme that must keep at least 65 percent in equity and may move that money freely across large, mid and small cap stocks, with no fixed split.
- Multi Cap FundAn open-ended equity scheme investing across large, mid and small caps, with at least 75% of total assets in equity and at least 25% each in large-cap, mid-cap and small-cap companies.
- New cadre of distributorsA limited class of mutual fund distributors SEBI allowed from 2012 — postal agents and retired government or bank officers among them — who may sell only five kinds of simple and performing schemes.