For long, market gurus have been at loggerheads over which matters more to investors — ‘timing the market’ or ‘time in the market’. An indisputable answer to this would be that both are necessary to make investments worth the while. While a longer time horizon can help diffuse the risk in returns, getting the market timing right can be even more rewarding.
But for retail investors, timing the market — which would essentially mean buying low and selling at peaks — could be a daunting task.
Investing in equity mutual funds offers just the solution. These funds, run by professionals who call the shots on your behalf, are in a better position to gauge over-heated or undervalued markets.
Sample this: Over a 20-year period, while the Sensex delivered a compounded annual return of 11 per cent, top performing diversified equity funds raked in a tidy 23 per cent return for investors.
But with 42 fund houses offering over 300 equity-oriented schemes, investors are often intimidated by the plethora of choices. And these are just one category of funds.
Debt funds,which carry relatively lower risk than equity funds, feature a whole gamut of fund categories and strategies that are even more complex. The jargon often used to describe these funds can easily put the investor off.
The simplest way to classify mutual funds is by way of the various asset classes — stocks and bonds — that they invest in. The three broad categories — equity, hybrid and debt — are further divided by fund houses based on style, objective and strategy.
While the differentiation is endless, what matters to you, as an investor, is how well you can construct a fund portfolio based on your risk tolerance, investment objective and time horizon.
Here are various categories of funds with the objectives mapped with investors’ risk profile:
Equity funds for building long-term wealth
If you are looking to build a portfolio for the long term, one that beats inflation, then equity funds are the way to go. Equity funds invest at least 65 per cent of their assets (maximum up to 100 per cent) into stocks. If are in your twenties or thirties, an early start can help you benefit from the power of compounding.
An investment of ₹1 lakh in a top performing equity fund, say, 20 years back, would be worth ₹16 lakh today at an annual compounded growth rate of 15 per cent!
For the moderate risk-taker
Equity diversified funds are further classified as large-cap, mid-cap, small-cap and multi-cap. Most large-cap funds have a mandate of investing 80 per cent into large-caps (above ₹10,000 crore). Top performing funds in this category have delivered 16 and 13 per cent return over five and 10-year periods, respectively.
Mid- and small-cap funds, on the other hand, invest predominantly in smaller stocks (with market cap of less than ₹10,000 crore). These funds carry higher risk than large-cap funds, but also reward investors in market rallies.
Top performing funds such as Reliance Small Cap, Mirae Asset Emerging Bluechip and DSPBR Micro-Cap Fund have delivered tidy returns of 31, 30 and 31 per cent over a five-year period. Multi-cap funds invest across the market capitalisation spectrum, though most have a large-cap bias.
For those who prefer stability of returns and have a moderate risk appetite, large-cap funds are a good bet. While these funds deliver inflation-beating returns over the long run, they tend to cap losses well, in volatile markets.
For instance, ICICI Pru Focused Bluechip Equity Fund, one of the top performing large-cap funds, fell by 16 per cent in the 2011 bear phase, while the Sensex lost a higher 23 per cent.
For those who are game for more risk, mid- and small-cap funds are good options. The top performing funds delivered stellar returns of 92 per cent in the market rallies of 2014 (while large-cap funds delivered 52 per cent).
But they also tend to fall more than large-cap funds. In the 2011 bear market, for instance, these funds lost 26 per cent.
For the aggressive investor
Within equity funds, there are some funds that carry far higher risk than diversified funds, by pegging up their exposure to a particular theme or sector.
Thematic funds such as Franklin Build India Fund (infrastructure), Birla SL MNC fund (MNC), Taurus Ethical Fund (Shariah) and Tata Dividend Yield Fund (dividend yield) and contra funds (Invesco India Contra Fund) and sector funds such as those under categories like FMCG, technology, banking, pharma.etc., fall under this category.
These funds carry concentrated bets and their performance is prone to cyclical swings. For instance, concerns over regulatory action against Indian drug makers by the US Food and Drug Administration have led to the under-performance of pharma funds over the past year. These funds managed to deliver just 1 per cent return. With the software sector facing headwinds, IT funds have incurred losses of 6 per cent over the past year.
But these funds can deliver spectacular returns when the tide turns. ICICI Pru Banking and Financial Services Fund, for instance, delivered chart-topping returns of 60 per cent over the past year, as banking stocks gained handsomely on hopes of a revival in the economy.
Investors wishing an exposure to other geographies can invest in global funds. These funds are riskier than other diversified funds.
Debt funds for income generation
Most of us understand how equity funds work. But how do debt funds generate returns?
First, it is important to dispel a common misconception with debts funds — that they cannot erode in value, just like fixed deposits. While debt funds are not as risky as equity funds, a part of your initial investment can erode, nonetheless. This is because these funds invest in various fixed income instruments such as government bonds, corporate bonds and other money market and short-term debt instruments. The NAV on the debt fund can thus rise or fall along with the underlying bond prices.
And what impacts bond prices?
For one, interest rate movements in the economy can impact bond prices. If interest rates move up, bond prices fall and vice versa.
This is where the concept of ‘duration’ comes into play. As longer-duration bonds are more sensitive to interest rates, the fund manager of a debt fund will increase duration to cash in on the rally in bonds in a falling rate scenario.
Debt funds can also incur losses if they make wrong credit calls. Some debt funds capitalise on interest receipts. Thus they invest in bonds with lower credit ratings, betting on the credit risk to earn higher interest.
So, how can these funds suffer losses? If the company that has issued the bond defaults on its interest or principal repayment, then the debt fund’s portfolio, to that extent, is written off. This will impact the NAV of the debt fund.
Hence, debt funds can follow a strict ‘duration’ or ‘credit’ call or blend the two to come out with different strategies.
For the conservative investor
For those looking for alternatives to bank savings and fixed deposits, liquid funds and ultra short-term debt funds fit the bill. While these funds are riskier than bank FDs, they carry the lowest risk amongst debt funds.
Liquid funds are the safest in the category, investing only in debt securities with a residual maturity of less than or equal to 91 days. With the maturity period this short, both interest rate risk and credit risk (default risk) are minimal. Liquid funds, on an average, have delivered 7-9 per cent returns annually over the last five years. Compared to liquid funds, ultra short-term debt funds carry slightly higher risk, given that these funds invest in debt securities with residual maturity up to one year. The returns, though, can be higher. Over the past five years, returns from this category have averaged 7.5-9.5 per cent.
For investors looking at debt funds for a period of less than three years, their returns will be taxed at the income tax slab rates. Interest on savings accounts is exempt up to ₹10,000 under Section 80TTA of the Income Tax Act. But even assuming 7 per cent return on liquid funds, post-tax returns work out higher than the 4 per cent that most banks offer.
Also, for large sums of surplus, liquid or ultra-short term funds still offer better returns.
While bank FDs for less than a year may offer returns comparable to those from liquid or ultra-short debt funds, should you need the money before maturity, you will be charged a penalty. Liquid funds allow you to exit investments without such penalties.
For the moderate risk-taker
For investors with a slightly higher risk appetite and longer time horizon of, say, 2-3 years, debt funds, which generate returns both from accruals and duration calls (only moderately), may be considered. Short-term income funds and Banking and PSU Debt Funds fall under this category.
Short-term income funds invest in debt securities that mature up to 3-4 years. Their portfolios usually have a small allocation to long-term gilts and higher allocation to AAA-rated, medium-tenure, corporate bonds. Banking and PSU Debt Funds offer stable returns and minimise risk by investing in good-quality debt instruments, mainly issued by banks and public sector undertakings.
For the high-risk taker
Investors willing to bet aggressively on either credit or interest rate movements can consider credit opportunities funds, regular income funds, dynamic income funds and long-term gilt funds.
Credit opportunities funds invest a relatively higher portion in lower-rated bonds. Hence they carry higher credit risk, while duration is maintained at 2-4 years, minimising rate risk. Regular income funds carry higher rate risk but lower credit risk. Dynamic bond funds essentially ride on rate movements and alter the duration of the fund portfolio depending on the expectation of rate movements.
Gilt funds, which mainly invest in long-term government securities, carry negligible credit risk. But as they carry a relatively higher duration of 7-10 years, they are more prone to rate risk. They can generate returns of 16-18 per cent in favourable markets (when rates fall sharply), but also pinch investors more, when rates move up sharply.
Hybrid/balanced funds — best of both worlds
Hybrid or Balanced funds allocate their assets both to equity and debt. While the debt portion performs the task of protecting the downside, the equity portion boosts returns. Risks vary depending on the extent of allocation to debt or equity.
For the aggressive investor
Equity-oriented balanced funds invest more than 65 per cent in equity and the rest in debt. The higher allocation o equity helps deliver superior returns while also offering the tax benefit available to the equity diversified category (no long-term capital gains tax on investments held over one year).
For the conservative investor
Debt-oriented schemes allocate up to 40 per cent and Monthly Income Plans (MIP) 10-30 per cent of their corpus into equity, thus pegging the risk lower. However, returns are also lower than those of equity-oriented balanced funds. Moreover, as they fall under the category of debt funds, capital gains within three years is treated as short-term capital gains.
Adding punch to returns
When zeroing in on your funds, performance is a key parameter to watch, no doubt. But you can boost your returns by opting for funds with relatively lower expense ratio too.
Mutual funds charge a fee to manage investors’ money. This, along with other expenses, is called the expense ratio or total expense ratio (TER). The NAV of each day is actually calculated after accounting for such expenses and hence borne by the investors.
A relatively higher expense ratio can eat into returns. Hence, aside from comparing returns, do look at the fund’s expense ratio. You can make higher returns by opting for the direct route too. The commission paid to intermediaries is excluded from the expenses, hence returns are higher under the ‘direct’ plans.
A study of the performance of equity, debt and hybrid schemes (632 schemes), since January 2013suggests that, on an average, the difference in expense ratio between regular and direct plans for funds with a large corpus in equity-oriented funds, stood close to 80 bps.
The difference in the expense ratio between regular and direct plans is lower in the case of debt funds — income and gilt long-term funds (71 bps and 60 bps, respectively) and liquid funds (12 bps). However, the difference in returns is significant for debt funds where returns tend to be relatively lower.
(The article first appeared in The Hindu BusinessLine.)