How to achieve the right diversification in Mutual Funds?
The efficient market hypothesis (EMH) was developed by Eugene Fama who argued that stocks always trade at their fair value, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. So it is better to buy and hold broad index fund rather than picking individual stocks. Fama believed that returns earned above the index are an outcome of pure luck. However, research indicated that there are sources of Alpha (excess returns over benchmark) in plain sight because of behavioural biases of market participants, or structural/liquidity issues of the market. These factors are acknowledged by Eugene Fama who went on to publish 5 factor model. Andrew L. Berkin and Larry E. Swedroe have highlighted following strategies as primary source of Alpha over long term in their book “Your Complete Guide to Factor-Based Investing”.
Every fund manager follows a process and has a natural inclination to some of the following Process/Factors that leads to outperformance. We study what are these Processes and why they work in long term.
Value
What is value investing?
Value investing buys stocks that are under-valued with the expectation of prices rising to fair value. Investors in the market focus on short term performance and chase performing ideas irrespective of valuation. If a company is undergoing a downturn, however temporary that is, it’s stock would fall hard as investors sell them exaggerating short term pain. This leads to the stock price falling below its fair value. Empirical evidence suggests that historically buying undervalued stocks leads to higher than market return over long term.
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