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.