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Shopping for funds? Here's a quick guide on the available choices
May 12, 2009

Mutual funds allow you to invest in different asset classes, be it equity, debt or commodity without the hassle of tracking each investment within these asset classes. With this article, we aim to familiarise you with different categories and classes within each category of mutual funds present in the market. This will enable you to diversify your portfolio and grab the opportunities for making handsome profits in the long term.


Author : Dhanashri Rane



Shopping for funds? Here’s a quick guide on the available choices

Equity markets soared to a record high in 2007 with BSE Sensex at an all-time peak of 21,000 in January 2008. A number of equity schemes of mutual funds outperformed the markets then. Thereafter in 2008, equities suffered while income and GILT schemes within the debt category generated double-digit returns (see Table1). The difference in the performance of the different asset classes shows that if the asset allocation in your portfolio is right, your portfolio can be  in good  shape.

EQUITY FUNDS: DIVERSIFY YOUR MARKET EXPOSURE

An equity diversified scheme allows you to invest in a wide range of stocks. Typically, an equity diversified scheme is composed of shares of over twenty companies, with a significant allocation in around ten different sectors. For most of us, investing starts as a way to save from tax payments and make our hard-earned money generate a good return.

If your investment horizon is long term, e.g., you’re willing to hold the investment for at least three years, equity linked saving scheme (ELSS) is a must in your investment portfolio. ELSS is eligible for tax benefit under Income Tax Act Section 80(C), thereby reducing your tax liability by up to Rs. 100,000 per annum. In addition, dividends ensure you get steady returns even during the lock-in period of 3 years.

For more experienced investors with a preference to a particular sector or theme, e.g., technology or small-cap, there are sectoral equity funds. Investing in a sector generally comes with an added risk as the portfolio will be exposed to similar types of stocks or sectors. However, the advantage of investing in mutual funds is that they are managed by professional fund managers. So if you are bullish on a sector/theme, you can pick up a sector/thematic mutual fund instead of buying a couple of stocks with insufficient information about the company’s management and business potential. This way your investments will have fair exposure to a sector or theme of your liking.

Index funds replicate a selected benchmark index and are a good example of ‘passive fund management’. Hence, the expenses and fund management charges are generally lower for index funds as the fund manager is not actively buying or selling stocks.

UNDERSTANDING THE DEBT CATEGORY

If you are averse to investing in equity markets, then debt or fixed income mutual funds may be right for you. Investment in debt can deliver interest income and capital gains to an investor. The movement in a bond’s yield and price can be confusing to investors. Let’s try and understand that first. When banks increase their fixed deposit rates, you choose to move your money into deposits offering higher interest rates. Likewise, a portfolio of high yield bonds will be an attractive investment as it is expected to generate better income for an investor. The yield or the return generated from the bond depends on fluctuations in the price of the bond. There is an inverse relation in the price and yield of a bond. If interest rates go down, then the price of bonds in the market will rise and vice-versa. If the bond has to be sold, the increase in its price will now bring in capital gains to the investor. Capital gains/losses arise due to increase/decrease in the price of the bond.

The flipside of investing in fixed income mutual funds is that you need to consider the interest rate risk and credit risk. If the credit rating of an instrument is low or the instrument is unrated, the risk of default is high. Hence, a debt scheme having a portfolio with superior credit quality of the underlying instruments, e.g., AAA-rated, is less prone to default. The interest rate risk can be assessed using the duration of the portfolio. Duration tells us how sensitive your debt fund is to interest rate changes. Duration is measured in years and will be different for short-term bond funds, medium-term funds and long-term GILT or income funds. Interest rate risk increases as the duration number goes up which is amplified by the tenure of the securities. That’s why long-term securities have bigger duration number (higher interest rate risk) followed by medium-term and thereafter short-term instruments. But high risk can result in high returns, through sale at increased bond prices when the interest rates fall.

We explain to you each class in debt category separately.

Liquid, Cash Management or Money Market funds offer an arrangement to park your short-term money for a day or up to a few months. These plans are composed of treasury bills, money market instruments, MIBOR (Mumbai Inter-Bank Offer Rate) linked instruments and corporate debt. As the name suggests, these plans provide you with liquidity which is almost similar to that of your savings bank account. You can invest for a few days and on redemption, the money will be credited to your bank account. The returns typically surpass those from a bank’s savings account rate. But do bear in mind that their performance depends on the overnight interest rates and liquidity situation prevailing in call money market.

Short-term bond funds can be an interesting investment avenue for investors with an objective to generate income and capital appreciation for a period of less than a year. A short-term fund consists of corporate debt, commercial paper, certificates of deposit and cash. The performance of short-term bond funds depends on the current valuation of the invested securities in the market.

If the credit rating of the instruments is downgraded or there is adverse movement in interest rates in short-term, returns will decline. In comparison to short-term bond funds, liquid mutual funds rank lower in risk, are less volatile and offer liquidity.

In a falling interest rate scenario, an investment in income and GILT funds can add value to an investor’s portfolio. Income funds offer a medium- to long-term investment option by investing in securities issued by the Government of India (GoI) or the state governments, corporate debt, bonds issued by public sector undertakings and money market instruments. GILT funds have larger allocation to GoI securities.

Table 1: One year performance

Fund Name

%*

ICICI Prudential Gilt Fund-Investment-Growth

23.26

DSP BlackRock Government Securities Fund-Plan A-Growth

23.12

Templeton India Govt.Sec. Fund-Composite Plan - Growth

22.32

ICICI Prudential Income Plan-Growth Option

17.63

Birla Sun Life Govt, Securities Long Term Fund-Plan B (Growth)

15.85

Kotak Bond-Regular-Growth

14.42

Source: AMFI, iFAST Compilations, March 2009

BALANCED FUND: MAKING ALLOCATION EASY

If figuring out how to allocate your money between different categories of funds is an uphill task, then a balanced fund is the remedy for you. The proportion of equity and fixed income securities in a balanced fund is split depending on the investment objective of the fund. The fund manager can position the fund based on fluctuations in the capital market and business cycles. Dynamic funds offer the fund manager flexibility to move across equity and debt instruments. The asset allocation can at times be completely into debt if the equity markets have a bleak outlook. However, in the bull run, you may miss out on the performance of the equity or debt markets, because your portfolio is less concentrated compared to an exclusive equity or debt fund.

ARBITRAGE FUNDS: TAKING ADVANTAGE OF VOLATILITY

Arbitrage funds may appeal to investors who have a conservative approach but at the same time are willing to take advantage of volatility in the derivatives segment. The investment goal of arbitrage funds is to generate income through arbitrage opportunities between the cash and derivative markets.

FUND SELECTOR TOOL

Understanding mutual funds is the first step to planning your own portfolio. However the number of schemes and new fund offers can put off the most seasoned investor. It can be a daunting task to scan the various classes of schemes or track how each fund category is performing. The Funds Selector tool on our website has been designed with these requirements in mind. You can use this tool to sift through the various categories and classes of funds, and view their performance in the short term (six months) up to as long as 10 years. Go to ‘Funds Selector’ and experience the world of mutual funds.

Happy investing!

 


iFAST and/or its content and research team’s licensed representatives may own or have positions in the funds of any of the asset management firms or fund houses mentioned or referred to in the article, and may from time to time add or dispose of, or may be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any fund. No investment decision should be taken without first viewing a fund's prospectus. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the fund. The value of funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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