Ups and downs of leveraging

Ups and downs of leveraging

"...panic unwinding of margin trading positions led to the 1987 crash on Wall Street..."

"...excess leveraging has led to the creation of a bubble in the market...."

"...SEBI imposes higher volatility margins..."

What is leveraging? What is margin trading? How do these exaggerate market movements?

"Give me a place to stand on, and I can move the earth"? Archimedes, the great Greek philosopher, was confident of achieving this because he had realised the power of leverage--the action of a lever. A lever is a simple mechanical device that rests on a pivot and helps lift a heavy load with minimum effort.

What is the connection with finance?

Companies borrow capital (debt) to enhance return on equity. The expectation of companies is that they would be able to get more returns than their cost of debt and hence improve the return on equity.

How does leveraging work in the securities markets?

Just like companies, security market participants believe that if they can earn higher returns than their cost of borrowing, they will be able to boost their returns on capital. Hence, leveraging in the securities market refers to money borrowed to cover part of the cost of purchase of a security. In our context, security stands for stocks.

Did you say part of the cost?

Yes. Remember that companies start with equity capital for their business before borrowing to leverage that equity capital. Similarly, stock market participants have to bear part of the cost that covers their commitment. In stock market language, the upfront money that the participants pay is called “margin”. The balance is borrowed at a certain cost.

How does it help?

Let us take a simple example. Assume you figured out that XYZ would go up by 15% next week. You have Rs110,000 at your disposal. If the closing price of the stock is Rs11,000, you will be able to buy ten shares. In case the stock does move up by 15%, you will end up with stock worth Rs126,500 (Table 1: Case A). 

Now, imagine if somebody offered to finance your purchase on the condition that you pay up 20% of the value as margin and pay him a borrowing cost of 0.25% per week. Taking Rs110,000 as your 20% contribution, the lender would be ready to fund you to the tune of Rs440,000.

Then, you could actually take a position in the stock worth Rs550,000. In other words, you could buy 50 shares of XYZ. Now assume that the stock gained 15%. You sell your shares for Rs632,500. After you repay Rs440,000, the borrowed money, and the interest of Rs1,100, you are left with Rs191,400. Adjust it for the capital that you placed as margin money. Lo! Behold! You have a profit of Rs81,400 or a return of 74% in one week! Look at what leveraging can do for you. (Table 1: Case B).

	15% Price rise		15% Price fall
	Case A	Case B	Case A	Case B
Capital	110,000	110,000	110,000	110,000
Borrowing	0	440,000	0	440,000
XYZ
Purchase value	110,000	550,000	110,000	550,000
Realised value	126,500	632,500	93,500	467,500
Cost of borrowing	0	1,100	0	1,100
Profit	16,500	81,400	-16,500	-83,600
RoI (%)	15.0	74.0	-15.0	-76.0

What if the stock falls?

A good question indeed. Let us rework the profits in the event the price falls by 15% instead of going up 15% in the period under review. The 50 shares of XYZ will be worth Rs467,500. After repaying Rs441,100 to the lender, you would be left with Rs26,500. In other words, a loss of Rs83,500 or minus 76% in one week! It can almost wipe your entire capital. If you had not leveraged, you would have lost only 15%. (Table 1)

So, how does the lender protect himself?

The lender runs a big risk of the borrower defaulting. Hence, he normally increases the “margin” requirement to compensate for the decline in market prices in order to protect his capital.

A double-edged sword

Leveraging is a double-edged sword. You can expect phenomenal returns despite taking on a fixed cost if your instinct is right and the market plays itself out according to your expectations. But if it does not, the results could be catastrophic.

If margin trading is your scene, here are some good stocks you could bet on. Sharekhan’s Stock Ideas presents our best stock picks in the market today. The investment ideas come with a price target and a time frame over which gains can be materialised. Happy investing

The world outside the well

The world outside the well

The trend on trends

You must have heard analysts on CNBC talk about business trends. What is that about and how do they help gauge a company's health? Don't financial ratios determine whether the company is in good financial health and measure all parameters of company efficiency, besides tracking their growth? 

There is an entire gamut of basic ratios that value businesses--book value, EPS, PE, RoE, RoCE-- which are relevant to stock-picking. But while that helps in valuing the financial health of the company, there is still a lot more that goes into buying a good company. There are factors prevailing in the environment that determine profitability and growth. Which is why the study of trends comes in. 

Let us take a look at business environments in the next few paragraphs. Our objective is to suggest which factors to look for while picking a successful business. How not to believe everything you see. Financial ratios follow good business trends, i.e. they happen after the business cycle.

Being alert to and using external trends

"Despite the management's continuing effort to improve efficiency and control cost, and achieving higher throughput, the operating profit before depreciation, interest and tax had gone down by 18%. This was mainly due to the decline in net sales realisation as a result of very competitive conditions prevailing in the market." - Directors Report, ABC Ltd for FY2008. 

What went right? The efficiency of the manufacturing business improved. All internal factors that could result in cost saving were implemented. This ideally should have led to a higher profit margin. Did this happen? No. While the company was cutting its costs, the sale price of the final product came down because of competitive (external) pressures. The business was in a state of oversupply, which was pushing down selling prices and reducing profits.

But does the reverse hold true? Let's look at two companies in the technology sector: XYZ Ltd and PQR Ltd. XYZ Ltd and PQR Ltd are talking in forked tongues, though they operate in practically identical businesses. 

Says the Director's Report, FY2008, of XYZ Ltd: "The Indian software exports industry demonstrated healthy growth during the year. The year saw your company winding down its BFSI-related engagements, in line with its risk management strategy. Your company has successfully managed the transition from being purely BFSI focused to now catering to diversified verticals." 

Goes PQR Ltd's Director's Report for FY2008: "During the same period, due to turmoil in the global financial sector, BFSI services revenue also declined sharply." 

The latter reported a profit of Rs12.12 crore, a fall of 65% over the previous year, while the former reported a 125% growth in profit. How do these two cases correlate? Well, both operate in the same environment and the same industry.

Controllable vs Non-controllable

With ABC Ltd, the downfall in profit was due to external factors, something companies rarely are able to influence, rather than internal factors such as cost saving, which it dutifully took care of to no avail. Meanwhile, the management of XYZ Ltd was farsighted and had implemented a risk management strategy by diversifying its portfolio.  PQR Ltd is a case of how a company can falter by not being alert to trends forming in the industry.

How business environment affects companies

An environment builds the platform on which a company survives and grows; it has to be supportive to the business's growth. Not too many companies can continue to grow when their economic environments are clouding over. The basic economic factors hold true while looking for a business to invest in. Does the demand-supply equation favour the company's operation to be viable and make money? Of course, that is the idealistic scenario, but the viability of the business centres on the broad parameters of demand and supply in the industry.

To learn about the latest trends in the economy, read Sharekhan’s Monthly Economy Review. Sharekhan’s Stock Ideas presents our best stock picks in today’s market. These investment ideas come with a price target and a time frame over which gains can be materialised. Invest in them now to reap the rewards in the long run

Businesses that make good stocks

Businesses that make good stocks

The secret to that lies in the answer to this question: What makes successful businesses? Of course, successful businesses are those that can earn money. The following factors may shed some light on whether the business in question is making money.

Business continuity

First, look at continuity of business. Take the instance of a company in the electronics sector. The Indian government-owned ECTV closed down operations when it failed to take advantage of other business opportunities. It was once the largest seller of television sets in the country. Another example in this industry was Videocon VCR, which was set up as a stand-alone manufacturer of VCRs. The company failed to be alert to technological advancements, which sounded the death knell for the outdated VCR and obviously for the company too!

Adequate capacity

Second, look at capacity. How big is beautiful? Size brings in economies of scale all right—cost is spread over a larger output, bringing down the overall cost. But bigger isn't necessarily better in this case. Companies can grow out of control. Arvind Mills built 10% of the global denim capacity, creating an oversupply situation. When these capacities went on stream, prices of denim dropped and the infrastructure costs just killed the company. Arvind Mills couldn't go close to achieving full capacity in its manufacturing, which it needed to do to be viable. 

Something similar happened to Core Healthcare. The company scaled up its capacities to 60% of India's IV fluids capacity. The market just could not absorb this capacity and its quality was found wanting in the international market. The obvious happened: losses mounted and the company completely eroded its net worth. 

Big could also mean small, but dominant in its area. Small companies in niche segments which nevertheless rule their sectors. Like Himatsingka Siede, a designer house that made it big in the international silk furnishing business, catering to a select market and never going in for the overkill.

Capacity as much as the market needs, 

not how much the company can make

Survival ability

Competition kills and this is one major cause of failure. Hindustan Unilever has over the years taken the competition to its rivals and expanded its portfolio. When growth from its bread and butter business of detergents and soap was plateauing, the company found new outlets to grow. In the last three decades, this survival skill transformed the company into an FMCG conglomerate with powerful cash flows. The survival factors here are more to do with the ability of the management to see future trends in their business.

Subsidies and barriers to entry

In numerous cases, to encourage the development of a business or of society, governments resort to subsidising services and equipment in order to make it viable for manufacturers to develop infrastructure. But such sops-dependent businesses may not make for wise long-term investments. Once such benefits are withdrawn, as they must eventually be, companies are exposed to the cold chill of ruthless competition, which may squeeze margins and reduce cash flows. Monopolies also bring with them inefficiencies that are hard to scale back in a free regime. 

Talking about subsidised businesses, Renewable Energy Systems and NEPC Micon are two companies that actually thrived on subsidies to grow their profits. That's all they did. In a crunch, when subsidies were withdrawn, they found themselves uneconomical and unviable because their products weren't as efficient as alternatives available in the market. The markets have recognised these factors at the earlier stages and valued these companies at a meagre ten times their earnings.

Monopolies and subsidised business come with a disclaimer: Though cash flows are strong, returns will exist only as long as the happy situation does

Minor points to watch, from the company's viewpoint

Appropriate infrastructure: The infrastructure should complement the market where it sells its product or where it procures its raw material. You can't have a cement plant in Karnataka and try to service the Delhi market. It would be far more expensive just to transport goods that far, thus spiralling costs.

Watch competition

New capacity creations: Most capacities in any business come in at the peak of the business cycle. This generally leads to a drop in selling prices as new capacities mean more supply. And a demand drop would hurt the players in that field.

Increase in capacities usually comes at the crest of the product cycle

Cost management: The company should have a suitable cost structure for the business. Lower costs enable the company to survive in a down phase well. In an upward business cycle, good cost management implies higher profitability.

Efficient companies go the distance. In an industry revival, these are the first to rebound

Products with stamina: Look out for opportunistic businesses. There have been small niche players who have tried to identify and milk insubstantial opportunities. For instance, a small company, India Food Fermentations, tried to market the concept of dosas as fast food through a vending machine, Dosa King. This company went bankrupt.

Novelties don't make lasting businesses

The above factors were about as comprehensive as we could cover them. These are, broadly, the most common factors one encounters as an analyst in the process of sieving out companies eligible for investment. Sharekhan’s Stock Ideas are well-researched companies with sound fundamentals. In order to get healthy returns on your portfolio over a longer term, invest in Sharekhan’s Stock Ideas, which presents our best stock picks in today’s market

Traders swing both ways

Traders swing both ways

15:35 Minutes | Uploaded on 13 Jan 2009

Traders swing both ways

If there is one brahmastra in the trader's arsenal, it is his ability to go short. Taking that analogy further, a stance to only go long and not short would be like going to war leaving half your weapons home. Certainly not something that is advisable, unless of course you are looking to be a martyr. 

You must agree with the adage that the trend is your friend. If you suffer from an allergy to going short, then you must be specialist at wringing your hands in dismay. What else can you do when the market swings downwards, as it so often does?

What is Short Selling?

“Buy low, sell high” is the goal of both short selling and long buying in shares. A short sale reverses the order of a typical stock purchase: The stock is sold first and bought   

Just as a buyer buys in anticipation of prices going up so he may sell at a profit, a short seller sells in anticipation of prices going down so he may buy the shares back at a lower price. The difference is his profit. If you look closely, in both the cases the shares have been bought low and sold high. The only difference being that in short selling, you reverse the order of the transactions.

Why sell short?

The two primary reasons for selling short are opportunism and portfolio protection. Occasionally we see a stock that we believe has gone up too high too fast. Or we may see a stock struggling to get past a strong resistance. Taking a short position is the only way we can profit from both these situations.

Short sales are also used to protect a portfolio against a market downturn. Short sellers rake in the moolah when stock prices fall. So when we think prices are going to fall, we diversify a predominantly long portfolio by adding some short positions. This way the portfolio will have positions that make money both when prices rise and when they fall.

We then use the profits from the short sales to help offset losses in the long positions. This reduces the volatility in the portfolio's returns and helps protect the value of the portfolio when prices are falling.

In defence of the short

Oh! We can almost hear long-termers hiss and boo at the suggestion that short-selling is a nifty portfolio management tool. Don't listen to them. In the long term we are all dead, remember.

They'll tell you that there is no need to short. They'll tell you not to worry about short-term fluctuations in the market. But the point is that most bear markets start with a tiny innocuous intra-day blip that grows and balloons. And before you know it the bears are on the rampage, tearing your portfolio to shreds. 

Why sit through a correction where your portfolio has the potential of losing, say, 10% of its value when you could possibly generate a positive return during the same period? Then, when the market turns up, you can get back to the long side and participate in the next leg of the bull market. It does sound like a smart thing to do, doesn't it?

Acting and reacting

But does that mean we react to every intra-day blip that pushes down prices. God! No. That's a sure-fire, time-tested, quality-checked, guaranteed method of committing financial hara-kiri. As is the case with every trade, even a short call is put out only if the risk-to-reward ratio makes sense. 

That brings us to the other thing that the long-termers would make noises of disapproval over. The risk in a short trade.

A short could turn into a long sad story

Short-selling stock is an extremely high-risk transaction. The potential gains are limited while the potential losses are unlimited. That's right. Losses tend to infinity!

How? The potential gains are limited to the size of the short sale. The lowest a stock can fall to is Rs0.50 (normally even the rottenest of shares manage to find a stray quote at Rs0.50). So it costs next to nothing to buy back the shares and close out the short sale. In this case, the profits almost equal the outlay on the original short sale, excluding transaction costs.

The potential losses however are unlimited because a stock can keep going up in price indefinitely. Imagine if you had gone short on 100 shares of Infosys Technologies in the IT bull run or say BHEL in the last bull run. Now that you have imagined what that would feel like, it's best you put it out of your memory. That is the kind of stuff nightmares and horror films are made of.

Down on an up

The other risk with taking short positions is that stock prices tend to rise over time. Betting whether a stock's price will go up or down is not like flipping a coin. (Thank God! Or we would be out of a job.) The odds are not even. Over the long term, stock prices on average do tend to trend up. 

Also, the reason most people buy shares of a company is because they expect the company to make profitable investments that will make the value of their stock go up. (We do know of a few who buy stocks so that they can use the loss as a tax hedge. Guess there is no better place for that kind of service than the stock market.) Betting that a stock will fall in price is betting against the trend. It does happen but the odds are against it.

So to keep a long story short, short selling can be a very profitable strategy to play the downside, it comes with so much risk that the losses could wipe you out of home and hearth if not handled with discipline and the right kind of tools. Like stop losses. But that is a story that has already been told over and over again.

For now, to find some profitable short selling calls, turn to Sharekhan’s Smart Charts that presents the best positional trading calls in the market on today’s date. Each call is introduced along with a recommendation (Go Long/Go Short), a price target, a stop loss and a chart depicting the trend in the stock. Log in to your trading account with Sharekhan now and start trading. Check the monthly performance of Smart Charts here

Seasoned Investor

Meet the 'Mind Traps'

17:03 Minutes | Uploaded on 13 Jan 2009

Meet the 'Mind Traps'

Here is a quick test to determine your Investment Quotient (IQ).

Stock A at Rs100 has a 7% chance of dropping below Rs100 in the next five years.

Stock B at Rs200 has a 93% chance of gaining from this price level in the next five years.

Which is a safer investment bet--Stock A or Stock B?

In case you picked Stock A, you are being very smart or foolishly brave.

In case you picked Stock B, you are one among the many investors who fall for a very common mental illusion caused by "Framing" according to behavioural scientists. 

In simple words, "Framing" stands for human fallibility to decide based on the way information is presented. 

Let us revisit the IQ test 

Both the stocks have an equal chance of falling by 7% from their current levels. After all a 93% chance of Stock B going up means it has a 7% (100-93%) chance of falling. 

In case you chose Stock B, you are not very different from the average man on the street who prefers Stock B to Stock A just because it is presented in a manner that makes it appear more appealing.

As humans, we always make approximations in our decision making process. No wonder, we are all on the lookout for easy ways to make money. One of the approximations we do is to figure out departures from a base case described rather than calculate what is the eventual outcome. 

So in this case, the description of Stock A's 7% chances of falling turns out to be the base case and the second option is evaluated against this. So a 93% chance ofrising looks good for Stock B. The mind does not grasp the implications of a 7% fall and 93% rise in the first sweep!

In case you managed to get the above test right in one sweep, great show! But be sure to stay away from the many more that abound. 

Experience comprises illusions lost, rather than wisdom gained.

                                                                                - A French Parish Priest 

Welcome to the world of psychology of investing 

The recent past has seen the development of a new field in investing that blends economic decision making with psychology in order to understand individual as well as collective financial behaviour. 

Investors and traders alike get lost in myriad illusions created by the mind that is a big stumbling block for making wise investing or trading decisions. 

Here is another way "framing" impedes decisions that we seldom recognise. 

Investors are not as much "risk averse" as they are "loss averse". 

Here is a desi version of classic example that the founding fathers of this discipline, Daniel Kahneman and Amos Tversky, presented to two groups of people. 

Group I choice set

You have Rs1,000 in your pocket and need to choose between one of these two investing options

Option 1: A sure shot gain of Rs500 

Option 2: A 50% chance to double the money and a 50% chance of making no profits

What would you choose?

Group II choice set

You have Rs1,000 in your pocket and need to choose between one of these two investing options

Option 1: A sure shot loss of Rs500

Option 2: A 50% chance of losing the Rs1,000 capital and a 50% chance of losing nothing!

Hmm! In their experiments they found that 84% in Group I chose option 1 whereas in Group II, a good 69% chose option 2!! 

Know why the groups chose those options the way they did? It had to do with the way the options were posed to them. Group II participants had a sure shot loss staring at them as one option whereas the other option presented them an opportunity though half a chance to walk away with losing nothing. 

Of course, the knowledgeable among you would have figured out that there is nothing to choose between the two options, as they are the same. 

Hence, as long as the Sensex is climbing 400 points every month, a bullish trader will stomach a 100-point fall during a week and see it as a money-making opportunity. But when the Sensex is in a downtrend, even a 100-point rally during a week does not enthuse the traders enough! 

In fact, empirical studies done in the USA prove the following: "Positive emotional value of a gain is only one-half to one-third of the negative emotional value of an dollar equivalent loss. For example, a $100 loss causes emotional pain two to three times the emotional pleasure of a $100 gain." This theory is called "Prospect Theory"? 

Most people feel more pain for losing Rs100 than they feel happiness when they make Rs100. 

Which portfolio would you prefer?

Portfolio A has Rs1,000 worth of one stock that appreciates by 10% and Rs1,000 worth of another stock that declines by 15%.

Or

Portfolio B has Rs1,000 worth of one stock that stays flat and Rs1,000 worth of another stock that declines by 5%.

There are similar studies done that demonstrate people prefer portfolio B to portfolio A. 

Why? 

Portfolio A has one stock that declines by 15% whereas the maximum decline of stock in Portfolio B is 5%. The mind ignores the fact that the other stock in Portfolio A appreciates by 10%.  

Hence, most people prefer Portfolio B to Portfolio A though both the portfolios lose the same.

Has your curiosity been tickled enough? Keen to fight and take control over your own illusions? To make sound investments, buy into Sharekhan’s Stock Ideas, which presents our best stock picks. The investment ideas come with a price target and a time frame over which gains can be materialised. Log on to your trading account now and let the game begin. To learn our view on the market, read our latest Market Outlook report.

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.