Why diversified equity funds are outperforming

The outperformance of the vast majority of diversified equity (DE) funds compared to their benchmark indices has been a puzzle. In the last five years for instance, 86 per cent of active DE funds, and as much as 90 per cent of the total corpus of DE funds, have beaten the Sensex/Nifty.

One possible reason may be the Nifty/Sensex are not constructed in a way that gives a truly representative picture of market movements. Or, this may happen because India is not a strongly-efficient market. Rather than being disseminated at the same time to everybody, information leaks at different speeds, to different people.

It is interesting to take a look at the weightages of fund allocations versus the weights of the indices. The sector weightage of DE funds obviously indicates the investment focus of fund managers. Apart from looking at individual funds, it is useful to look at the sector weights in aggregate, since the overwhelming majority of DE funds outperform. The aggregate allocations indicate consensus opinions. One caveat is that, given the buying power funds possess, some outperformance may be caused by fund buying.

As of March 2018, aggregated fund data (taken from Value Research) showed that DE funds were clearly overweight in four sectors compared to the Sensex. The funds seemed to be betting more heavily on construction, healthcare, metals and chemicals.

Construction companies have a weight of 8.32 per cent in fund portfolios whereas the Sensex weight was 4.8 per cent. Larsen & Toubro is the only construction company in the Sensex. Healthcare has a 2.53 per cent weight in the Sensex whereas healthcare stocks consist of 5.9 per cent of DE fund corpus. The two pharma majors, Sun Pharma and Dr Reddy's are part of the index.

Metals represent 1.55 per cent of the Sensex. The only company is Tata Steel. Funds have an exposure of 3.68 per cent to the metals sector. This would include large holdings in non-ferrous metals as well. Chemicals represent 1.5 per cent in the Sensex, while funds have allocated 4.4 per cent to the sector.

There is another interesting data set from Value Research, which tracks changes in asset allocations of DE funds over the past year. Interestingly, construction has seen a steady increase in allocations. Between February 2017 and February 2018, assets invested in construction increased from 7.41 per cent to 9.92 per cent. Metals also increased, to 4.81 per cent from 4.03 per cent. However, there was a decline in healthcare allocation, which dropped from 5.9 per cent to 4.8 per cent. Chemicals also saw allocations down to 5.37 per cent from 5.7 per cent.

What does this tell us? Construction obviously seems to be a big bet and this should feed into infrastructure creation, and real estate, since those are the two sectors that contribute the largest number of projects to construction. It is a fragmented industry, and many companies have gone through painful deleveraging after taking on far too much debt in the past. Construction is the most interesting bet, because of the value-chain extension in multiple directions.

Activity here drives both steel and cement offtake. If construction does well, it is likely cement and steel will also see growth. Steel has benefited from tariff barriers that prevent it being swamped by cheap Chinese imports. Apart from iron and steel, other non-ferrous industrial metals have benefited from the hardening of international prices.

Healthcare appears to be a somewhat contrarian bet. While the pharma industry has not done well for several years, it could see a boost from the weaker rupee. Healthcare stocks such as Fortis have also seen speculative activity based on merger possibilities. Chemicals could run into rocky ground if crude prices keep rising since that would push up input costs.

One possible reason may be the Nifty, Sensex are not constructed in a way that gives a truly representative picture of market movements