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Monday, April 2, 2007

Advantages of Diversification

We all know that it pays to diversify. Thereby making the portfolio less volatile and therefore less risky. I wanted to do an analytical exercise to prove the benefits of diversification but was having trouble finding data.

Then after reading my article at seekingalpha Ayush Jain (ayush.jain at gmail.com) sent me an e-mail providing data and analysis for HDFC Prudence fund

HDFC Prudence funds suits our purpose as it has been around since 1994. It is a hybrid fund with equity allocation up to 75%. The fund has done exceedingly well earning 22.66% annualized return since inception. The comparison of the fund with Sensex reveals some interesting insights.

Rs. 10,000 is assumed to be invested on 1st of every month. No money is ever taken out of the funds. The following definitions will help understand the results:
  • Period: is the number of years for which money is invested starting in 1991 (for sensex) and 1994 (for HDFC Prudence)
  • Minimum Amount: is the Amount after investing for the time period
  • Minimum Return: is the return is the annualized return
  • % Period of losses: is the number of periods in which you would have sustained losses i.e. for 184 1-year (starting 1991) periods you would have lost money in 71 periods (or 38.59%).
  • Total Num of Period: For Sensex it will be 184 1-year period, 172 2-year period etc
Sensex Results:

Period (in
Years)

Minimum

Maximum

Average

% Period
of Losses

Total Num
Of Period

Amount

Return

Amount

Return

Amount

Return

1

93,558

-22.036

298,673

100.01

131,277

9.398

38.59%

184

2

165,516

-22.355

418,580

43.343

276,184

9.735

36.05%

172

3

258,896

-15.601

732,196

39.975

443,826

10.838

31.25%

160

4

356,750

-11.524

1,195,186

40.069

612,856

10.017

31.08%

148

5

451,378

-9.341

1,640,058

35.637

796,161

9.582

29.41%

136

6

551,081

-7.595

2,125,649

32.031

987,335

9.097

28.23%

124

7

647,285

-6.519

2,510,623

27.702

1,185,699

8.627

28.57%

112

8

737,201

-5.902

2,906,050

24.468

1,423,349

8.705

26.00%

100

9

874,010

-4.265

3,426,969

22.624

1,677,642

8.704

25.00%

88

10

1,000,028

-3.343

3,878,810

20.641

1,918,410

8.381

27.63%

76

11

1,138,946

-2.481

4,378,743

19.132

2,280,117

8.883

20.31%

64

12

1,317,794

-1.372

4,899,592

17.866

2,787,753

9.819

5.77%

52

13

2,220,463

4.931

5,319,094

16.493

3,505,464

11.054

0.00%

40

14

3,051,960

7.654

5,966,176

15.776

4,395,231

12.115

0.00%

28

15

4,822,602

11.572

6,528,314

14.936

5,718,946

13.472

0.00%

16

16

6,921,864

13.922

7,659,560

14.961

7,447,629

14.673

0.00%

4



HDFC Prudence:

Period (in
Years)

Minimum

Maximum

Average

% Period
of Losses

Total Num
Of Period

Amount

Return

Amount

Return

Amount

Return

1

101,887

-15.095

213,411

77.842

132,742

10.618

28.26%

138

2

195,750

-12.841

460,299

52.134

303,572

16.726

12.70%

126

3

344,006

-2.255

754,025

41.836

527,947

20.407

4.39%

114

4

505,967

2.118

1,204,367

40.437

818,505

22.533

0.00%

102

5

663,846

3.389

1,825,694

39.723

1,187,117

23.681

0.00%

90

6

1,018,150

9.992

2,424,878

36.125

1,612,614

23.605

0.00%

78

7

1,199,131

8.911

3,210,332

34.117

2,174,600

23.999

0.00%

66

8

1,656,080

12.039

4,265,264

33.073

2,999,177

25.171

0.00%

54

9

2,468,701

16.238

5,464,728

31.774

4,142,943

26.331

0.00%

42

10

3,829,918

20.421

6,832,374

30.475

5,442,166

26.513

0.00%

30

11

5,854,311

23.651

8,330,101

29.144

7,180,273

26.827

0.00%

18

12

8,164,429

25.058

9,537,348

27.245

8,681,955

25.922

0.00%

6


I believe it would be best to ignore data for periods that will be most impacted by the current bull rally (2003 - present). As those returns are unlikely to be replicated, at least in the near future. Therefore, I would ignore the results where the Total Number of Period is less than 75 (nothing under 60 in any case).

Looking at the data, HDFC Prudence has consistently averaged around 23%. This is an excellent return considering Sensex has just averaged between 8-9 %. HDFC Prudence price has gone up by 11 times (from 10 to 110) whereas assuming Sensex at 3865.44 (Sensex Jan 23, 1994 close) has only gone up by approx 3 times in 13.25 years.

This analysis does not take into account dividends declared by the Sensex. Whether Index returns would become comparable to HDFC Prudence taking dividends into account is open to debate until I get that data.

I think there are 2 aspects HDFC Prudence performance. 1st fund manager's skills in picking the right stocks and 2nd the mix of Prudence portfolio (contains stocks and bonds). Assuming that market timing is difficult, I would think that some of the returns can be explained by diversification offered by multiple asset classes in HDFC Prudence.

3 comments:

  1. I don’t think that the analysis here does rational justice to the subject. It only takes into consideration returns and no risks.
    Sensex consists of 30 largest and most actively traded stocks, representative of various sectors, on the Bombay Stock Exchange.

    HDFC prudence, not being an index fund, would be investing in much more risky stocks. (Stocks other than 30 mentioned in Sensex)
    It is quite possible that some of these 'diverse' stocks would have given remarkable results. (With remarkable Risks).
    But one must take into consideration the Risk involved in the so called 'diversification'.
    HDFC prudence has given better results by taking Higher Risks. I don’t think there is any thing novel in that. It is almost a Tautology.

    "Diversification', as you define in this article’, seems to be inconsistent with 'Diversification' that the investing world generally believes in i.e. picking up funds to minimize risks and not maximize profits.

    Personally I believe it is impossible to beat the Sensex (market) in the long run without taking substantially more risk than the level implicit in the market.

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