Is your equity mutual fund scheme's index bias hiking your risk exposure?

India’ s bellwether stock market indices— typically represented by a diverse set of companies—are in unfamiliar territory right now. The influence of the financial sector on leading indices is at its highest today.

The sector now accounts for 40%, or two-fifth of the Sensex. The Nifty 50 reflects a similar tilt in favour of financials at nearly 36%, with broader indices also taking a slant to this basket. Here is why investors should take notice.

Lopsided fund portfolios
With banking and finance firms muscling their way into the indices, several sectors have been left marginalised. Pharma firms, for instance, are being eased out of mainstream indices. Their representation in the Sensex is today at a 7-year low of 2.6%. Similarly, weights of capital goods and telecom firms are also at an all-time low, while cement firms no longer find a place in the leading index.


Why does this matter for investors? Equity funds, which invest in a diversified basket of companies, typically tend to align their portfolio with the benchmark index at the sector level. While many are comfortable taking large active positions in individuals stocks relative to the index, most do not deviate substantially from the index at the sector level.

Consequently, portfolios of most equity funds are heavily tilted towards banking and financial services firms. The largest fund in the large-cap segment, Aditya Birla Frontline Equity Fund, currently in-vests 36.57% of its portfolio in these companies. In the mid-cap space, HDFC Mid Cap Opportunities takes 27.81% exposure to this basket while Franklin India Prima Plus from the multi-cap category has put 30% of its assets in this segment. Over the past few years, this bias has worked in favour of investors as the funds have benefited from the rapid growth of private sector banks and NBFCs.

But there is high risk involved in being skewed towards a certain segment. Besides, investors could also miss out on returns from under-represented sectors in the coming years. Harsha Upadhyaya, CIO-Equity, Kotak Mutual Fund, says, “Currently, frontline indices do not completely represent our economy or market. If any portfolio is constructed purely on a sector-neutral strategy against such narrow benchmarks, then there is a risk of missing out on many emerging sectors or themes.” Kaustubh Belapurkar, Director-Fund Research, Morningstar Investment Adviser India says most managers will avoid taking outsized bets on sectors.

He adds that the flexibility to take overweight or underweight positions allows them to take non-benchmark names and overweight sectors they may have a positive view on. Actively managed diversified funds will be in a better position to realign the portfolio unlike index funds and ETFs which mirror the index.

Insulate yourself
What can investors do in this scenario? Vidya Bala, Head-Mutual Fund Research, FundsIndia, reckons investors can insulate themselves by adopting varying strategies—value and growth, focused and diversified, and so on. “A growth fund may largely reflect sector weights on the broad market but a value fund will often include the under-represented sectors. Then there are focused funds which go totally bottom up and pick stocks and are not too worried about deviation from the benchmark,” Bala says. Portfolios of focused funds like ICICI Prudential Select Large Cap and Axis Multi Cap and value conscious funds like Aditya Birla Pure Value and ICICI Prudential Value Discovery are light on financials.

Several schemes do not favour financials
Several value driven and focused funds provide a way to avoid index bias.

Source: Value Research. Data as on 30 November

While most funds that have deviated substantially from the benchmark index are focused or value-oriented, there are several that take a pure bottom-up approach to stock selection. These do not allow the index to guide portfolio construction, while retaining a diversified approach.

For instance, Franklin India Prima has 19.17% exposure to banking & financial services, even as these form 30.75% of its benchmark index. ICICI Prudential Multicap has invested 21% in this space which makes up 32.17% of its index. “Funds that take active sector and/or stock bets are expected to perform better if those bets materialise, as they will be capturing investment ideas not represented by frontline indices,” says Upadhyaya.

However, some experts say investors should stay away from funds taking aggressive sector bets. Says Belapurkar, “Investors are better off holding more diversified funds, as funds taking outsized sector bets are more volatile and the risk of one sector call going wrong can affect returns.” Several funds have taken even higher exposure to the financial space than the weightage in their respective index. Finally, with funds taking a heavy position in financials, there is little merit for having a dedicated fund for the sector. “Most diversified funds offer sufficient exposure to the banking space. Unless an investor has a value-oriented portfolio and requires a fullfledged cyclical exposure, there is no need to hold a banking fund separately,” says Bala.