Mutual fund for dummies: Part 2

2 September, 2007

If Ranjit Pillai is interested taking the help of mutual funds, he needs some more education. He should know that there are different varieties of mutual funds out there. The key is find right one that matches his risk profile and objective.

Equity funds: They invest only in stocks, and hence the are riskiest among mutual fund schemes. However, these funds have historically outperformed all asset classes. At present, there are four types of equity funds available in the market.

1. Index funds: These funds track a key stock market index, like the Bombay Stock Exchange Sensex or the National Stock Exchange S&P CNX Nifty. They invest only in stocks that form the market index as per the individual stock weightages. The idea is to replicate the performance of the benchmarked index to near accuracy. Index funds are considered a passive investment vehicle, as the performance of the fund will be almost the same as the index concerned, except for few minor points.

2. Diversified funds: These funds are expected to have a diversified portfolio spread across industries and companies. However, the investment decision is entirely the prerogative of the fund manager. This will allow a fund manager to pick stocks that will help him beat the market benchmarks. However, if her errs, the fund can suffer, too. That is why a fund manager is a key figure in diversified funds.

3. Tax-saving funds or equity-linked savings schemes: These funds are mainly used to claim tax rebate under section 88. They are like diversified funds, except that investment in ELSS have a lock-in period of three years. The lock-in period gives them an edge over diversified funds has they can benefit a lot from their stock picks. Redemption compulsions can prevent diversified funds from enjoying the full benefits of their stock picks.

4. Sector funds: They are the riskiest among equity funds, as they invest only in specific sectors or industry. The performance of sector funds are married to the fortunes of the specific sector or industry. This can work both ways for the sector funds. One way to maximize your returns from sector funds is to get into the sector when it is expected to zoom and get out before it falls. However, it is easier said than done.

Since you have managed a nodding aquaintance with various equity funds, how do you choose the right one for you? First, identify the category of equity fund you want to invest. The next step is to evaluate the performance record of the fund. Find out how it has performed over the years compared to its competitors. Also, check out the reputation, transparency in operations, etc.

Make sure your fund has a diversified portfolio. Avoid funds that have exposure to few sectors or stocks as the performance of the fund will be tied to the performance of only these stocks and not to the entire market performance. Also make sure that the fund has a diversified investor base. A fund with a few large investors will be forced to take orders from them, which may not be in your interest.

Debt funds: These funds invest in fixed-income securities like bonds, government of India securities, debentures, commercial paper, call money, etc. There are three types of debt funds. One, income funds. They are like diversified funds. They can invest in any debt instruments. They invest heavily into corporate bonds and debentures for higher returns. This makes them risky as there is risk of a company failing to fulfill its debt obligations. Two, gilt funds. They are a notch lower on the risk ladder as they invest only in government securities and T-bills, where the interest and repayment is guaranteed by the government. However, the flip side is they give comparatively lower returns than income funds. Third category is called liquid funds, which invest in money market instruments like treasury bills, call money, debentures, etc. Liquid funds are ideal for people looking to park their money only for a short term.

We all know debt funds are less risky. However, that doesn’t mean that they are risk-free. Debt funds have three of risk: credit risk, interest rate risk, and liquidity risk. Interest rate risk is because of the inverse relationship between interest rates and prices of debt instruments. Credit risk is associated with instruments such as debentures and commercial paper from private companies. There is always a chance that these companies can default on their commitments.

Now, how would you pick a debt fund? Try to match the time horizon of the fund. For example, if you are investing the money for less than a year, go for a liquid fund as they invest in securities with one-year maturities. You can opt for income funds if you are looking to invest for more than one year. Also, look at the portfolio to find out whether the income fund is compromising on credit ratings to enhance returns. A lot of low quality paper increases credit risk. The next three steps are similar to equity fund: performance record, diversified portfolio, and diversified investor base.

Balanced funds: They invest in both equity and debt. They are ideal tool for investors who want to take very little risk. The exposure to equity can enhance returns. Those with a little bit risk appetite can opt for monthly income plans, which invest up to 25% of their corpus in equity. Pure balanced funds can invest more in equity, hence they are more risky. If you are conservative investor settle for a fund where equity exposure is capped at 60%. The most crucial factor while choosing a balanced fund is the ratio of equity and debt the fund has. Also, follow the procedure we followed in equity and debt fund selection.