sectoral funds outperformed diversified funds

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1

UNIVERSITY OF MUMBAI

A

PROJECT REPORT ON

ON

SECTORAL FUNDS OUTPERFORMED DIVERSIFIED FUNDS

Submitted by:

Hitesh Jain

Under the guidance of:

Prof. Viraj Sadekar

MASTERS OF MANAGEMENT STUDIES

VIVEKANAND EDUCATION SOCIETYS

INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH

BATCH: 2008 2010


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DECLARATION

I, Hitesh Jain, student MMS (Finance) of Vivekanand Education Societys Institute of Management

Studies & Research, Chembur, Mumbai, hereby declare that, I have completed a research project on

Sectoral Funds outperformed Equity Diversified Funds during the academic year 2009-10. The

information submitted is true and original to the best of my knowledge.

Hitesh Jain

M.M.S (Finance)

Academic Year 2008-10


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ACKNOWLEDGEMENT

I take this opportunity to express my deep gratitude and thankfulness for those who have given their

invaluable time, support and cooperation in the project work, without their advice and help; I could not

have accomplished the task.

In preparing this progress report I have been fortunate to receive valuable assistance, suggestions

and support from numerous teachers of VESIMSR, who taught over the past two years, and

friends who have been able critics of my action and work.

I am deeply indebted to my project guide, Prof. Viraj Sadekar, for giving valuable advices and

help, both technical and other, throughout the duration of the development of this project.


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INDEX

Sr.No.

Contents Page No.

1 Executive Summary 5

3 Introduction 6

4 Literature Review 10

5 Objective 14

6 Research Design 15

7 Data Analysis 17

9 Limitations of the Study 19

10 Conclusion 20

11. References 21


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Executive Summary

The purpose behind this research is to examine the superiority between Diversified Equity Funds

and Sectoral Funds. 5 funds which are active in the market from past 7 years from the respective

investment category would be selected for the purpose of the study. In Pharma Sector, only 3

funds are selected as only 3 funds are currently active in the market in the 7 year category. The

period of study taken was 2004-2010. The data was taken from valuereserachonline.com. The

Performance analysis was done on the basis of Sharpe ratio as well as on the average returns of

past 7 years. As per the analysis Equity Diversified Funds has outperformed Technology Sector.

However nothing can be concluded in the Equity Diversified Fund v/s Pharma Sector category.

It is also been found out that since the total risk of the portfolio its standard deviation is used in

the Sharpe ratio, diversification does not play any role in performance analysis. The Sharpe ratio

is useful measure for an investor, which puts all his money in one fund.


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Introduction

The Purpose of this study is to understand what type of mutual fund is most preferred by the

existing customer because performance of these funds is the criteria for customer selection

and which Fund has outperformed between Sectoral and Equity Diversified Funds.

There has been a longstanding discussion of which fund between sectoral and diversified fund

gives better returns. On the one hand theres a Equity Diversified fund who has a very good long

term record in delivering great returns with low to average risk. The risk involved in this type of

fund is moderately low.

On the other hand theres a Sectoral Equity Fund, which invests in only a particular sector. Of

late, a lot of investors are showing keen interest in sectoral funds. Sectoral funds are high risk/

return funds and cannot form a base for your portfolio. When a sector is performing well, these

funds tend to outperform the diversified funds. It may not be the case in the long run.( especially

in cases like a sector taking a sudden downturn).

Sectoral Equity Funds

There are funds that invest in a specified sector of economy and they specialize in the said sector.

However, they run the risk of not being able to diversify. Sector based funds are aggressive

growth funds which make investments on the basis of assessed bright future for a particular

sector. The specialty of sector funds rather oddly lies in the fact that they go against the very

grain of mutual fund investing i.e. holding a diversified portfolio. That is why you will find some

Asset Management Companies that swear against sector funds! Sector funds are launched with

the intention of capitalizing on opportunities in a single sector, for example the pharmaceutical

industry, the software industry among others. The fund invests in various stocks from the same

industry thereby making it a high risk-high return investment proposition.


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Diversified Equity Funds

Typically, a diversified equity fund invests in a number of equity/ equity related instruments

from various sectors thereby enabling investors to benefit from diversification. Equity

Diversified fund has a very good long term record in delivering great returns with low to average

risk. The risk involved in this type of fund is moderately low. HDFC Equity Fund and Sundaram

Growth Fund can be classified as conventional diversified equity funds.


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Mutual Fund Industry in India:-

The Indian mutual fund industry's average assets under management (AAUM) grew for the third

month in succession and stood at Rs. 5.02 trillion in February 2009 as compared to Rs. 4.62

trillion in January 2009. The AAUM crossed the Rs. 5 trillion milestone in February 2009 for the

first time after it dipped below this level in October 2008.

Indexing has flourished because it is compatible with both theoretical findings and practical

needs. On the theoretical side, the philosophy of passive fund management emanates from the

efficient market hypothesis. If the markets are difficult to beat, then there is no point in spending

money to devise methods and strategies to outperform the market. Instead of the high return

high cost approach it is better to focus on market return low cost approach. This kind of

differentiated product has an appeal to treasury managers and high networth individuals and has

resulted in huge inflows from institutions, corporations and high networth individuals. These

investors are in a position to demand and expect pre-defined performance from the investment

managers. They not only look at the overall performance but also investigate the factors that

contribute to the overall performance. The fund management company has to respond to this

situation. Therefore, it is of paramount significance that we find a method to attribute the overall

index fund performance to causal factors of relevance.

In the last ten years (November 1998 to November 2008), the Indian market has grown by an

average 12 per cent annually, the boom years and the earlier sluggish period all told. During the

same period, fund managers have generated a return of 18-20 per cent for diversified equity

funds, a good proxy for the broad market. But thats just half the story. Things have been

changing over the last five years. Beating the market isnt a cakewalk these days. And the out-

performance of a fund relative to its benchmark - also known as alpha - has been falling

gradually.

Overall, fund managers have given a return of 15.33 per cent over the last five years while the

markets returned 13.5 per cent. Here, if we add a 2 per cent dividend redistribution that an index

fund investor can benefit from, then the returns from the market will be 15.5 per cent on par with

any active fund manager.


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But then averages can sometimes be misleading - especially since a clutch of fund houses and

their star fund managers have done far better than the average.


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Literature Review

Performance evaluation of mutual funds is one of the preferred areas of research where a good

amount of study has been carried out. The area of research provides diverse views of the same.

Richard Kjetsaa, Journal of the Academy of Business and Economics Study ( 2005 ) says that

The rationale underlying investing in sector funds is the observation that exceptional investment

performance often occurs with specialized or focused portfolios. In fact, sector funds regularly

appear at the top of the list of best-performing funds--but the lack of diverse industry holdings

also induces some sector funds to populate the bottom of the relative annual performance scale.

Sector funds can play a role in a diversified portfolio; however, a portfolio exclusively

constructed with sector funds would be highly volatile with erratic performance, and high

expenses, portfolio turnover and manager turnover.

Marcin Kacperczyk, (2004 )Study has investigated using U.S. mutual fund data from 1984 to

1999, we find that mutual funds differ substantially in their industry concentration, and that

concentrated funds tend to follow distinct investment styles. In particular, managers of moreconcentrated funds overweigh growth and small stocks, whereas managers of more diversified

funds hold portfolios that closely resemble the total market portfolio.

We find that funds with concentrated portfolios perform better than funds with diversified

portfolios. This finding is robust to various risk-adjusted performance measures, including the

four-factor model of Carhart (1997), the conditional factor model of Ferson and Schadt (1996),

and the holding-based performance measures of Daniel, Grinblatt, Titman, and Wermers (1997).

Analyzing the buy and sell decisions of mutual funds, we find evidence that the trades of

concentrated portfolios add more value than the trades of diversified portfolios.


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In summary, this paper finds that investment ability is more evident among managers who hold

portfolios concentrated in a few industries. The evidence lends support to the value of active

fund management.

In the Indian context, Amanulla (2001) tested the portfolio efficiency of mutual funds of Unit

Trust of India (UTI) by employing traditional performance measures such as Jensen, Treynor and

Sharpe's methodology. Employing Granger Causality and Co-integration tests, the paper also

investigated the performance evaluation of mutual funds. Average weekly net asset values of 16

mutual funds of UTI and two stock market price indices i.e. Bombay Stock Exchange (BSE)

sensitive index as well as S & P CNX Nifty index for the period June, 1992 to July, 2000 were

used in the study. The results from traditional measures provided a mixed evidence of

performance evaluation while the evidence from Granger causality suggested the existence of

uni-directional causality in BSE sensitive index and bi-directional causality in Nifty index. The

market index and mutual funds were also found to be co-integrated, indicating a long-run

relationship.

Brands, Brown and Gallagher [2005]conducted a study of active Australian equity managers

and found a positive relationship between portfolio concentration and fund performance at the

stock, industry and sector levels. They defined portfolio concentration as the extent to which the

portfolio weights held in stocks, industries and sectors deviate from the underlying index or

market portfolio.

Ivkovich, Sialm and Weisbenner [2006]found that stock investments made by households that

choose to concentrate their brokerage accounts in a few stocks outperform those made byhouseholds with more diversified accounts (especially among those with large portfolios). They

found that when controlling for households average investment abilities, their trades and

holdings perform better when their portfolios include fewer stocks. Ivkovich et al. use the term

concentrated to refer to investors who hold only one or two stocks in their brokerage accounts,


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and use the term diversified to refer to investors who are not as highly focused with their

portfolio (i.e., hold three or more stocks).

AlphaProfit.coms research suggests that By allocating assets across a group of sector funds,

investors can effectively create a diversified mutual fund portfolio using sector funds. This

approach gives the investor flexibility to over-weight or under-weight certain sectors versus

broadly diversified indexes such as the S&P 500. To implement this active approach to money

management, it helps to have a diverse group of sector funds to choose from. Fidelity

Investments manages 41 sector funds under the Fidelity Select Portfolios umbrella which

makes this family of sector funds well-suited for this purpose. By dividing assets across, say, 8

sector funds in the Fidelity Select Portfolios, e.g., Fidelity Select Biotechnology (NDQ: FBIOX),

Fidelity Select Computers (NDQ: FDCPX), Fidelity Select Energy Service (NDQ: FSESX),

Fidelity Select Home Finance (NDQ: FSVLX), Fidelity Select Medical Delivery (NDQ:

FSHCX), Fidelity Select Multimedia (NDQ: FBMPX), Fidelity Select Retailing (NDQ: FSRPX),

and Fidelity Select Wireless (NDQ: FWRLX), one can build a customized diversified portfolio.

With each of the sector fund managers actively scouting for the best investment ideas within

their sectors, this cluster of Fidelity Select Portfolios packs a lot of power into your diversified

portfolio.

Wachter, Jessica A. and Wurgler, Jeffrey A. (2007), studied trading skills of the fund manager

associated with the ability to buy stocks that are about to enjoy high returns upon their upcoming

quarterly earnings announcement and to sell stocks that are about to suffer low returns around

the next earnings announcement. The results yield new evidence of trading skill by mutual fund

managers. The future earnings announcement returns on stocks that funds buy are, on average,

higher than the future returns on stocks that they sell. The stocks that funds buy perform

significantly better at future earnings announcements than stocks with similar characteristics,

while the stocks that funds sell perform significantly worse than such stocks. Fund trades predict

not just earnings announcement returns but EPS surprises as well.


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Cohen, Randolph B., Coval, Joshua D. and Pastor, Lubos, (2003) had developed a

performance evaluation approach in which a fund manager's skill is judged by the extent to

which his investment decisions resemble the decisions of managers with distinguished

performance records. They proposed new performance measures that exploit the information

contained in the similarity of a manager's holdings (or changes in holdings) to those of managers

who have performed well, and in their distinctiveness from those of managers who have

performed poorly. These performance measures use historical returns and holdings of many

funds to evaluate the performance of a single fund. As a result, these measures are typically more

precise than the traditional return-based measures.

Shukla and Singh ( 1994 ) tested proposition whether portfolio managers advance professional

education resulted in superior performance, and found that euity mutual funds managed by

professionally qualified managers were riskier but better diversified than the others. It also

pointed that these fund managers outperformed others as a group, although performance

difference was not considered statistically significant.

Grubber ( 1996 ) attempted to resolve the puzzle relating to fast growth of mutual funds inspite

of inferior performance of actively managed portfolios. The study reported that average mutual

fund had negative performance compared to the market and provided evidence to support the

persistence of performance. It resolved the puzzle that sophisticated clientele withdrew money

from mutual funds in the event of poor performance, whereas these mutual funds found money

from disadvantaged clientele under such circumstances.

Gupta and Sehgal ( 1998 ) evaluated investment performance of 80 mutual funds schemes for

the Indian market over a four year period 1992-1996. It tested propositions relating to fund

diversification, consistency of performance, parameter of performance and objective stationarity

in addition to examining risk return relationship in general. The empirical results reported in the

study indicated that mutual fund industry has performed reasonably well for the Indian market. Itnoticed lack of adequate portfolio diversification. The study produced evidence to support

consistency of performance and its non-stationarity over-time was noted in relation to risk-return

parameters. Finally , a significant and positive risk-return relationship was documented by the

study when standard deviation was used as a risk measure.


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Objective

Objective:-

The present study has been undertaken with the object of examining, analyzing and inferring the

performance of the mutual funds, which addresses the following issues:

To understand what type of mutual fund is most preferred by the existing customer

because performance of these funds is the criteria for customer selection.

Which mutual fund is the best in its category?

Which Fund has outperformed between Sectoral and Equity Diversified Funds.

Hypothesis:-

Ho = Equity Diversified Funds outperforms Sectoral Funds.

H1 = Sectoral Funds outperforms Equity Diversified Funds.


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Research Design

A. Methodology

The empirical technique used here is the Sharpes Ratio. Sharpes measure also known as return

to variability ratio, is used to evaluate investment performance of managed portfolio by excess

returns in terms of variability of the realized returns. The excess return is the differential return

of ex-post portfolio return and the riskless return. The ratio may be positive or negative. This

measure is often used to investigate the investment performance of managed portfolios as well as

to rank the portfolios in terms of performance.

Sharpes ratio = (Ex post or realized return on portfolio Risk free rate of return)/ Standard

Deviation (variability or risk ) of the portfolio return.

S = Rp Rf

------------

Interpretation of Sharpes Ratio

The Sharpe ratio indicates the excess return per unit of risk associated with the excess

return.

The Sharpe ratio does not refer to the market portfolio or any other benchmark. Actually,

the implicit benchmark is the risk free rate of return

Its higher value indicates superior portfolio performance, while the lower value implies

inadequate investment performance.


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B. Data and sample description

This study groups the funds into 2 investment categories:

Diversified Funds

Sectoral Funds

Pharma Sector

Technology Sector

5 funds which are active in the market from past 7 years from the respective investment category

would be selected for the purpose of the study. In Pharma Sector, only 3 funds are selected as

only 3 funds are currently active in the market in the 7 year category. The period of study would

be from 2004-2010. The data would be taken from valuereserachonline.com.

Details of the sample

Investment categories

Diversified Equity Funds Sector Equity Funds

Pharma Technology

Birla Sun Life Mid Cap Plan A Franklin Pharma DSPBR

Technology.com Reg

Reliance Growth UTI Pharma &

Healthcare

Franklin Infotech

Hdfc Top 200 Magnum Pharma ICICI Prudential

Technology

DSPBR Equity Birla Sun Life New

Millennium

Templeton India Growth Magnum IT


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Data Analysis

Summary descriptive statistics for investment categories across 5 mutual

funds in each category.

Equity Diversified Funds V/S Pharma Sector

Fund Name

3 year

Return

5 year

Return

7 year

Return Fund Name2

3 year

Return

5 year

Return

7 year

Return

Birla Sun Life

Mid Cap Plan A 21.63 26.22 39.81

Franklin

Pharma 23.66 21.12 30.09

Reliance Growth 20.3 28.95 47.7

UTI Pharma &

Healthcare 16.45 14.11 23.87

Hdfc Top 200 22.06 27.68 40.56Magnum

Pharma 3.59 10.29 27.73

DSPBR Equity 20.65 28.3 41.72

Templeton India

Growth 23.03 24.7 36.88

Equity Diversified Funds V/S Technology Sector

Fund Name

3 year

Return

5 year

Return

7 year

Return Fund Name2

3 year

Return

5 year

Return

7 year

Return

Birla Sun Life

Mid Cap Plan

A 21.63 26.22 39.81

DSPBR

Technology.com

Reg 8.11 23.36 33.15

Reliance

Growth 20.3 28.95 47.7

Franklin

Infotech 1.73 14.96 23.61

Hdfc Top 200 22.06 27.68 40.56

ICICI

Prudential

Technology -0.67 15.92 26.82

DSPBR

Equity 20.65 28.3 41.72

Birla Sun Life

New

Millennium -1.44 14.62 26.4

Templeton

India Growth 23.03 24.7 36.88 Magnum IT -5.13 16.24 23.73


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Sharpes ratio

Investment categories

Diversified Equity Funds Sector Equity FundsSharpes

Ratio

Pharma Sharpes

ratio

Technology Sharpes

ratio

Birla Sun Life Mid Cap

Plan A

0.46 Franklin

Pharma

0.66 DSPBR

Technology.com

Reg

0.24

Reliance Growth 0.46 UTI Pharma &

Healthcare 0.46

Franklin Infotech 0.06

Hdfc Top 200 0.54 MagnumPharma

0.10 ICICI PrudentialTechnology

-0.04

DSPBR Equity 0.39 Birla Sun Life New

Millennium -0.06

Templeton India Growth 0.53 Magnum IT -0.12

Interpretation of Sharpes ratio

Sharpes measure also known as return to variability ratio, is used to evaluate investment

performance of managed portfolio by excess returns in terms of variability of the realized

returns. The excess return is the differential return of ex-post portfolio return and the riskless

return. As can be seen from the above calculations, sharpes ratio has been the highest for the

Franklin Pharma Sector Fund and has been negative for the Technology Sector Fund.


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Limitations of the Study

Data has been analyzed for only 7 years January 2004- December 2009 which may not be

sufficient for arriving at a conclusion.

There may be a difference of opinion regarding the appropriateness of the

statistical tools used for analysis.

This study also does not take into account fluctuations in the fund returns due to change

in the state of the economy like recession, inflation etc.

Due to lack of availability of data in Sectoral Funds, data is limited to Pharma and

Technology Sector.


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Conclusion

This papers primary contribution is in providing more conclusive evidence on the debate

Whether the Sectoral funds has outperformed Diversified Equity Funds. It is found that, Equity

Diversified has got better returns than technology sector in each of the 3 year, 5 year and 7 year

category. The Sharpe ratio of the equity diversified funds was also better than the technology

sector. However, nothing can be concluded in pharma sector category as there is no correlation

between the returns and the sharpe ratio.

It is also been found out that since the total risk of the portfolio its standard deviation is used in

the Sharpe ratio, diversification does not play any role in performance analysis. The Sharpe ratio

is useful measure for an investor, which puts all his money in one fund.


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References

Cohen, Randolph B., Coval, Joshua D. and Pastor, Lubos, 2003, Judging Fund Managers

by the Company They Keep, Journal of Finance, American Finance Association, vol.

60(3), pp 1057-1096

Gruber, M.J., 1996, Another Puzzle: The Growth in Actively Managed Mutual Funds,

Journal of Finance, vol51, pp.783-810.

Richard Kjetsaa( 2005 ), The performance of sector mutual funds relative to benchmarks,

Journal of the Academy of Business and Economics Study

Marcin Kacperczyk, (2004 ), On the Industry Concentration of Actively Managed EquityMutual Funds, Social Science Research Network

Gajendra Sidana, Debashis Acharya( 2007 ), Classifying mutual funds in India: some

results from clustering, Indian Journal of Economics and Business

David Blanchett (2009 ), Portfolio Concentration And Mutual Fund Performance, Index

Universe.

Sam Subramanian, Using Sector Funds to Construct Diversified Mutual Fund Portfolios,

Buzzle.com.

Baker, Malcolm P., Litov, Lubomir P., Wachter, Jessica A. and Wurgler, Jeffrey A.,

2007, Can Mutual Fund Managers Pick Stocks? Evidence from Their Trades Prior to

Earnings Announcements

Ramesh Chander, Performance Appraisal of Mutual Funds in india

www.valueresearchonline.com

sectoral funds outperformed diversified funds

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