First Step

Equity funds for market thrills

Wondering which mutual fund scheme to invest in? Equity funds, debt funds, balanced funds, this fund, that fund…the list goes on.

·If you are looking to invest in the stock market but do not have the time to manage your investment, you could hire a professional fund manager by investing in a mutual fund that invests in the stock market, that is in equity funds.

Equity funds pool savings of many investors and invest this sum predominantly in a bunch of stocks, typically 25-30 stocks, across various sectors. A portfolio of the average equity fund might look something like this: Infosys, Wipro, ITC, Reliance, ACC, Bharti, DLF and some more. For an affordable amount, say as little as Rs1,000, one can pick up a stake in all these companies through an equity fund.

·The fund house does everything for the investor, for a fee. Its fund managers and analysts track the market and sift through the universe of stocks, and construct portfolios capable of delivering returns characteristic of equities.

·Equity funds should be considered by investors looking to maximise returns on their investment, and can bear the risk of it eroding temporarily in that pursuit. The universe of equity funds comprises many kinds of schemes, each of which services a specific investment objective. The choice of scheme should match with one’s risk profile and investment objective.

The different types of equity funds include:

·         Diversified equity funds

·         Equity-linked savings schemes (ELSS)

·         Index funds

·         Exchange-traded funds (ETFs)

·         Sector funds

·         Specialty funds

Diversified equity funds

·Of the various kinds of equity schemes, diversified equity funds are the most popular ones among investors. They offer a broad and dynamic exposure to the stock market.  Because they invest in many stocks across many sectors and because they have the freedom to chop and churn their portfolios as they like, diversified equity funds are a good proxy to the stock market. If a general exposure to equities is what you want, they are a good option.

·Diversified equity funds aim to outperform the market, which is represented by stock indices such as the BSE Sensex or the NSE S&P CNX Nifty. In order to achieve this objective, they actively manage their portfolios.

·Diversified equity funds are governed by fewer rules vis-à-vis other types of equity schemes. They can invest in all listed stocks, and even in unlisted stocks. They can invest in whichever sector they like, and in whatever ratio they like. This flexibility is reflected in the performance of actively managed diversified funds, which typically takes on a wide range. So, for instance, even when the Sensex or the Nifty would have gone up by 50%, some diversified schemes would have returned twice that much, while some would have risen just 5%. That’s why it’s important that investors choose their fund house and scheme well.

Equity-linked savings schemes

Equity-linked savings schemes (ELSS) are diversified equity funds that also offer income tax benefits to individuals. ELSS is one of the many Section 80C instruments but offers a pure equity exposure. In fact, an ELSS has to have at least 90% of its corpus invested in equity, at any point in time.

·Under Section 80C, individuals can claim up to Rs1 lakh as deduction from taxable income on making investment in specified instruments. One can invest the entire Rs1 lakh in ELSS in a financial year and claim a deduction of this amount from the total taxable income.

·However, investments in these schemes are subject to a lock-in period of three years. In equity investing, one has to get in, be regular and stay patient. The lock-in clause of ELSS perforce gives an investor a holding period of at least three years--long enough to have a decent shot of making the market work for oneself.

Index funds

·Want to know an easy and an inexpensive way of investing in the Sensex? Invest in an index fund that mirrors the BSE Sensitive Index! An index fund is a diversified equity fund, with a difference--the fund manager has absolutely no say in stock selection. At all times, the portfolio of an index fund mirrors an index (such as the Sensex or the Nifty), both in its choice of stocks and their percentage holding. So an index fund that mirrors the Sensex will invest only in the 30 Sensex stocks and that too in the same proportion as their weightage in the Sensex.

·Because of this, the net asset value (NAV) of an index fund moves virtually in line with the index it tracks. For example, if the Sensex rises 10% in a month, the NAV of a Sensex-linked index fund will also roughly appreciate by 10% over the same period. If the Sensex drops by 10%, so will the NAV of the index fund.

·Although index funds aim to mirror market movement, their returns tend to be marginally lower than the index they track.  This is termed as “tracking error” and occurs due to various costs an index fund has to bear, such as brokerage, marketing expenses and management fees. Obviously, the lower the tracking error, the better the fund.

·A broad-based stock index is the barometer of the stock market and, indirectly, of the corporate sector and the economy. If one is content with market returns, index funds are the best option. An index fund offers a lot of convenience as well. While it continues to track the market all along, one does not have to track the fund.

·The passive nature of index funds also makes them less risky than actively managed equity funds. The profile ensures that many tenets of fund management, like adequate portfolio diversification, are adhered to at all times.

Exchange-traded funds

Like index funds, exchange traded funds (better known as ETFs) too mirror an index. For example, the Nifty Benchmark Exchange Traded Scheme (Nifty BeES), tracks the Nifty. However, unlike an index fund, which can be transacted through the fund house at the end-of-day NAV or the following day’s NAV, an ETF is listed on the stock exchanges, and can be bought and sold from the market at real time prices, through a broker. One can, thus, invest in the market at real time index values.

·For example, each unit of the Nifty BeES roughly equals one-tenth of the Nifty value. So, if the Nifty is trading at 5700 at a given time, the NAV of a Nifty BeES unit will be about Rs570, and the buy and sell quotes will be based on this price.

·ETFs also tend to show a lower tracking error than index funds. The unique operational mechanism of ETFs means they don’t have to buy or sell securities, which means they don’t have to pay brokerage. This translates into lower expenses. In May 2007, there were just six equity ETFs in India. However, given their obvious superiority in passive fund management, they are very popular globally. To invest in an ETF, hit this button.

Sector funds

·Sector funds invest in stocks from only one sector, or a handful of sectors. The objective is to capitalise on the story of the sector and offer investors a window to profit from such opportunities.

·Because of their narrow focus, sector funds are considered amongst the riskiest of all equity funds. In a diversified fund, even if one sector performs badly, others can cover up. But if the chosen sector of a sector fund performs badly, its entire portfolio suffers.

·Hence, sector funds are recommended for only those who understand the working of the sector they are investing in.

·There are a number of sector funds dedicated to sectors such as information technology, pharma, fast moving consumer goods (FMCG), infrastructure, banking and so on.  Sector funds, thus, offer a diverse choice ranging from “defensive” sectors, such as pharma and FMCG, to “cyclicals” like infrastructure and commodities.

Specialty funds

·Specialty funds include mid-cap funds, blue-chip funds, small-cap funds and so on.

Blue-chip or Large-cap funds

·Blue-chip funds typically invest in equity of the big, established companies, that is the blue-chips, such as Reliance, Infosys, ITC, Tata Steel and so on.  Market players also refer to them as “large-cap” companies, with size in this context being benchmarked to the company’s market capitalisation. A typical large-cap stock would have a market capitalisation of over Rs5,000 crore.

·These funds have a lower risk vis-à-vis mid-cap or small-cap funds, because of the quality of companies they invest in.  Also, the growth forecasts are relatively more predictable and easier to make, and investment is relatively easy. Returns are expected to be moderate because the big companies have already grown to a point where they can grow only so much.

Mid-cap funds

·Mid-cap funds are diversified equity funds that target “mid-sized” companies on the fast-growth trajectory, with a reasonable level of risk. Market players refer to them as “mid-cap” stocks, with the companies having a market capitalisation of typically between Rs1,000 to Rs5,000 crore.

·Mid-sized companies have more scope to expand than their larger counterparts, who have already walked the growth path.  Companies such as Infosys, Dr. Reddy’s Laboratories and Hero Honda were mid-sized companies in the early nineties. Those who invested in them early enough would have seen their money grow many times over. These are the kinds of big moves that mid-cap funds aim to capitalise on.

·The danger, of course, is that for every Hero Honda there are more than a few Hindustan Motors and PAL-Peugeots, companies that stagnated or withered away. That’s the risk mid-cap funds face.

Small-cap funds

·These are diversified equity funds that target “small-sized” companies. These are typically companies that are at an infant stage but where the potential of growth is very high. Market players refer to them as “small-cap” stocks, with the companies having a market capitalisation of typically less than Rs1,000 crore. Small-cap funds venture into the relative unknown, where both risk and reward are greater.

That is about the size of it as far as equity funds are concerned, there are other types of funds too. To invest in an equity fund, click here. To know the top mutual fund picks of this month, hit this button. If you wish to experience the thrills, spills and chills of the stock market firsthand, invest in our Stock Ideas, which are well researched companies with strong fundamentals.