How to diversify your equity portfolio: IPOs, cash market, derivatives, mutual funds

Date : 18/10/2021
Read: 6 mins

Based on risk analysis and returns, equity portfolio diversification can include IPOs, cash market, derivatives, equity mutual funds, etc.

We have all grown up hearing the famous saying: ‘Don’t put all your eggs in one basket.’ The same holds true for your equity portfolio as well. In this article, we will try and answer the all-important question: How can one diversify their equity portfolio?

An investor can diversify their equity portfolio at various levels:

The broad diversification at the first level can be between direct equity and equity mutual funds.
At the second level, direct equity (domestic and international) can be further diversified into IPOs, cash market, and derivatives.
At the third level, mutual funds can be further diversified into a core portfolio (investments in various equity schemes across market capitalisation) and satellite portfolio (investments in sectoral/thematic funds and international mutual funds).

Equity portfolio diversification

An investor can diversify their equity portfolio as shown in the above image. Let us discuss each of these portfolio components.

Direct equity

As the title suggests, it involves an investor investing directly in equity shares through their trading and demat account. Direct equity investment carries higher risk, so an investor should allocate a small portion (say 20%) of their overall equity portfolio to it. You should allocate the remaining portion (80% in this case) of the equity portfolio to mutual funds.

Direct equity investments can be further diversified as follows:

a) Initial Public Offerings (IPOs): You can allocate some portion of your direct equity portfolio to IPOs. Many IPOs have given reasonably good returns this year (2021) and last year. Many more companies are expected to come out with their IPOs in the remaining part of 2021 and in the years to come.

b) Cash market: Apart from IPOs, you can invest in already listed companies in the secondary market. For long-term investing, you should do a fundamental analysis of the companies you plan to invest in. From a risk and return analysis point of view, fundamental analysis has two important aspects: Qualitative risk analysis and quantitative risk analysis.

Quantitative risk analysis: It focuses on the financials of the company and involves analysing the balance sheet, income statement, and cash flow statement of the company. The balance sheet tells us what the company owns (assets) and what it owes (liabilities). It helps us arrive at the net worth of the company. The income statement tells us about the company’s sales, profits, margins, etc. Cash flow tells us about the company’s liquidity position (cash inflows and cash outflows).
Qualitative risk analysis: While quantitative risk analysis focuses on the company's financials, qualitative risk analysis focuses on the other aspects. It involves analysing the company’s market position in terms of its products/services and the economic moats that the company enjoys. It also analyses the company’s promoters, management, corporate governance standards, etc.

The fundamental analysis helps you to identify a company for investment in the long term. You can enjoy the benefits of compounding in the long term and create wealth. Once you invest in the company’s shares, you should review its fundamentals every 6-12 months. Companies release financial statements on a quarterly, half-yearly, and yearly basis.

c) Derivatives: Apart from long-term investing in the cash market, you can do short-term trades in the derivatives market. You can trade in futures and options in the derivatives markets based on technical analysis. These days, most broking firms provide customers with access to charts along with trade recommendations. Be cautious about derivative trades as they can lead to big losses if the trade goes in the opposite direction.

Mutual funds

For mutual fund investments, you can adopt the core and satellite portfolio approach. Allocate a major portion (say 75-80%) of your mutual fund allocation to your core portfolio. The remaining small portion (20-25%) of your mutual fund allocation can go to your satellite portfolio. This approach can help you make high-return investments (satellite portfolio) by offsetting possible risks through more stable alternatives (core portfolio).

Core portfolio

You can diversify your core portfolio by making investments in mutual fund schemes across market capitalisation as follows:

Large-cap mutual fund schemes: These funds invest in the top 100 companies ranked by market capitalisation. These are large companies with good market share, sales, and profits. They have already created wealth for their shareholders and have the potential to continue doing the same in the future also. These companies are also referred to as blue chips.
Mid-cap mutual fund schemes: These funds invest in the next 150 companies (101–250 rank) as per market capitalisation. These are medium-sized companies that have proved themselves to some extent in terms of shareholder wealth creation but still have the potential to continue creating wealth. Many of these companies have the potential to become tomorrow’s large-cap companies.
Small-cap mutual fund schemes: These funds invest in the 251st company and up in terms of market capitalisation. These companies are still at a nascent stage. They have the potential to multiply investor wealth if things go as planned. Many of them have the potential to become tomorrow’s mid-caps and large-caps in the distant future.

Depending on your risk appetite, you can decide the allocation between large, mid, and small-cap funds. For example, a young investor with a high risk appetite can allocate a greater proportion to small-cap funds and lower allocation to mid-cap and large-cap funds. On the other hand, a middle-aged or senior investor can allocate a higher proportion to large-cap funds and less to mid-cap and small-cap funds.

Satellite portfolio

A small portion of your equity mutual fund portfolio can be invested in your satellite portfolio. Based on market opportunities, you can make this investment in sectoral/thematic mutual fund schemes. For example, during 2020-21, the following sectors/themes did well.

Information Technology (IT): Due to COVID-19 lockdowns, the demand for digital services went up. It resulted in IT companies winning big deals and having a robust order pipeline for the future. All this has led to IT mutual fund schemes delivering very good returns to investors.
Healthcare: As the pandemic affected millions of people, the demand for healthcare went through the roof. As a result, the share prices of listed hospital companies, diagnostic companies, and pharma companies did well. Overall, the healthcare theme did well in terms of investor returns.
Commodities: Once the lockdowns eased and the pace of vaccinations accelerated, the demand for goods and services picked up once again. As a result, the demand for various commodities went up, and commodities as a theme did well.

Last words

As an investor you can lower your overall risk with proper diversification of your equity portfolio. You can also earn optimum returns on your equity portfolio. Your direct equity portfolio can benefit from your own investment decisions in the short term. On the other hand, for your mutual funds portfolio, you should let a qualified and experienced fund manager generate long-term wealth for you with the magic of compounding.