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Knowledge Corner

Mutual Fund Investing-II

MUTUAL FUND PRODUCTS AND FEATURES
EQUITY FUNDS
A variety of schemes are offered by mutual funds. It is critical for investors to know the features of these products, before money is invested in them. Let us first understand what Open Ended and Close Ended funds are.
WHAT ARE OPEN-ENDED AND CLOSE-ENDED FUNDS?
Funds (or any Mutual Fund scheme for that matter) can either be open ended or close ended. An open ended scheme allows the investor to enter and exit at his convenience, anytime (except under certain conditions) whereas a close ended scheme restricts the freedom of entry and exit. Whenever a new fund is launched by an AMC, it is known as New Fund Offer (NFO). Units are offered to investors at the par value of Rs. 10/ unit. In case of open ended schemes, investors can buy the units even after the NFO period is over. Thus, when the fund sells units, the investor buys the units from the fund and when the investor wishes to redeem the units, the fund repurchases the units from the investor. This can be done even after the NFO has closed. The buy / sell of units take place at the Net Asset Value (NAV) declared by the fund. The freedom to invest after the NFO period is over is not there in close ended schemes. Investors have to invest only during the NFO period; i.e. as long as the NFO is on or the scheme is open for subscription. Once the NFO closes, new investors cannot enter, nor can existing investors exit, till the term of the scheme comes to an end.
However, in order to provide entry and exit option, close ended mutual funds list their schemes on stock exchanges. This provides an opportunity for investors to buy and sell the units from each other. This is just like buying / selling shares on the stock exchange. This is done through a stock broker. The outstanding units of the fund do not increase in this case since the fund is itself not selling any units. Sometimes, close ended funds also offer ‘buy-back of fund shares / units”, thus offering another avenue for investors to exit the fund. Therefore, regulations drafted in India permit Investors in close ended funds to exit even before the term is over.
EQUITY FUNDS
Salient Features
These are by far the most widely known category of funds though they account for broadly 40% of the industry’s assets, while the remaining 60% is contributed by debt oriented funds. Equity funds essentially invest the investor’s money in equity shares of companies. Fund managers try and identify companies with good future prospects and invest in the shares of such companies. They generally are considered as having the highest levels of risks (equity share prices can fluctuate a lot), and hence, they also offer the probability of maximum returns. However, High Risk, High Return should not be understood as “If I take high risk I will get high returns”. Nobody is guaranteeing higher returns if one takes high risk by investing in equity funds, hence it must be understood that “If I take high risk, I may get high returns or I may also incur losses”. This concept of Higher the Risk, Higher the Returns must be clearly understood before investing in Equity Funds, as it is one of the important characteristic’s of Equity fund investing.
Equity Fund Definition
Equity Funds are defined as those funds which have at least 65% of their Average Weekly Net Assets invested in Indian Equities. This is important from taxation point of view, as funds investing 100% in international equities are also equity funds from the investors’ asset allocation point of view, but the tax laws do not recognize these funds as Equity Funds and hence investors have to pay tax on the Long Term Capital Gains made from such investments (Which they do not have to in case of equity funds which have at least 65% of their Average Weekly Net Assets invested in Indian Equities). Equity Funds come in various flavors and the industry keeps innovating to make products available for all types of investors.
Relatively safer types of Equity Funds include Index Funds and diversified Large Cap Funds, while the riskier varieties are the Sector Funds. However, since equities as an asset class are risky, there are no guaranteeing returns for any type of fund. International Funds, Gold Funds (not to be confused with Gold ETF) and Fund of Funds are some of the different types of funds, which are designed for different types of investor preferences. These funds are explained later.
Equity Funds can be classified on the basis of market capitalization of the stocks they invest in – namely Large Cap Funds, Mid Cap Funds or Small Cap Funds – or on the basis of investment strategy the scheme intends to have like Index Funds, Infrastructure Fund, Power Sector Fund, Quant Fund, Arbitrage Fund, Natural Resources Fund, etc. These funds are explained later.
INDEX FUND
Equity Schemes come in many variants and thus can be segregated according to their risk levels. At the lowest end of the equity funds risk – return matrix come the index funds while at the highest end come the sectoral schemes or specialty schemes. These schemes are the riskiest amongst all types’ schemes as well. However, since equities as an asset class are risky, there are no guaranteeing returns for any type of fund. Index Funds invest in stocks comprising indices, such as the Nifty 50, which is a broad based index comprising 50 stocks. There can be funds on other indices which have a large number of stocks such as the CNX Midcap 100 or S&P CNX 500. Here the investment is spread across a large number of stocks. In India today we find many index funds based on the Nifty 50 index, which comprises large, liquid and blue chip 50 stocks.
The objective of a typical Index Fund states – ‘This Fund will invest in stocks comprising the Nifty and in the same proportion as in the index’. The fund manager will not indulge in research and stock selection, but passively invest in the Nifty 50 scrips only, i.e. 50 stocks which form part of Nifty 50, in proportion to their market capitalization. Due to this, index funds are known as passively managed funds. Such passive approach also translates into lower costs as well as returns which closely tracks the benchmark index return (i.e. Nifty 50 for an index fund based on Nifty 50). Index funds never attempt to beat the index returns, their objective is always to mirror the index returns as closely as possible. The difference between the returns generated by the benchmark index and the Index Fund is known as tracking error. By definition, Tracking Error is the variance between the daily returns of the underlying index and the NAV of the scheme over any given period.
DIVERSIFIED LARGE CAP FUNDS
Another category of equity funds is the diversified large cap funds. These are funds which restrict their stock selection to the large cap stocks – typically the top 100 or 200 stocks with highest market capitalization and liquidity. It is generally perceived that large cap stocks are those which have sound businesses, strong management, globally competitive products and are quick to respond to market dynamics. Therefore, diversified large cap funds are considered as stable and safe. However, since equities as an asset class are risky, there are no guaranteeing returns for any type of fund. These funds are actively managed funds unlike the index funds which are passively managed, in an actively managed fund the fund manager pores over data and information, researches the company, the economy, analyses market trends, takes into account government policies on different sectors and then selects the stock to invest. This is called as active management.
A point to be noted here is that anything other than an index funds are actively managed funds and they generally have higher expenses as compared to index funds. In this case, the fund manager has the choice to invest in stocks beyond the index. Thus, active decision making comes in. Any scheme which is involved in active decision making is incurring higher expenses and may also be assuming higher risks. This is mainly because as the stock selection universe increases from index stocks to large caps to midcaps and finally to small caps, the risk levels associated with each category increases above the previous category. The logical conclusion from this is that actively managed funds should also deliver higher returns than the index, as investors must be compensated for higher risks. But this is not always so. Studies have shown that a majority of actively managed funds are unable to beat the index returns on a consistent basis year after year. Secondly, there is no guaranteeing which actively managed fund will beat the index in a given year. Index funds therefore have grown exponentially in some countries due to the inconsistency of returns of actively managed funds.
MIDCAP FUNDS
After large cap funds come the midcap funds, which invest in stocks belonging to the mid cap segment of the market. Many of these midcaps are said to be the ‘emerging blue chips’ or ‘tomorrow’s large caps’. There can be actively managed or passively managed mid cap funds. There are indices such as the CNX Midcap index which h tracks the midcap segment of the markets and there are some passively managed index funds investing in the CNX Midcap companies.
SECTORAL FUNDS
Funds that invest in stocks from a single sector or related sectors are called Sectoral funds. Examples of such funds are IT Funds, Pharma Funds, Infrastructure Funds, etc. Regulations do not permit funds to invest over 10% of their Net Asset Value in a single company. This is to ensure that schemes are diversified enough and investors are not subjected to undue risk. This regulation is relaxed for sectoral funds and index funds. There are many other types of schemes available in our country, and there are still many products and variants that have yet to enter our markets. While it is beyond the scope of this curriculum to discuss all types in detail, there is one emerging type of scheme, namely Exchange Traded Funds or ETFs, which is discussed in detail in the next section.
OTHER EQUITY SCHEMES
Arbitrage Funds
These invest simultaneously in the cash and the derivatives market and take advantage of the price differential of a stock and derivatives by taking opposite positions in the two markets (for e.g. stock and stock futures). Multicap Funds: These funds can, theoretically, have a small cap portfolio today and a large cap portfolio tomorrow. The fund manager has total freedom to invest in any stock from any sector.
Quant Funds
A typical description of this type of scheme is that ‘The system is the fund manager’, i.e. there are some predefined conditions based upon rigorous back testing entered into the system and as and when the system throws ‘buy’ and ‘sell’ calls, the scheme enters, and/ or exits those stocks. P/ E Ratio Fund: A fund which invests in stocks based upon their P/E ratios. Thus when a stock is trading at a historically low P/E multiple, the fund will buy the stock, and when the P/E ratio is at the upper end of the band, the scheme will sell.
International Equities Fund
This is a type of fund which invests in stocks of companies outside India. This can be a Fund of Fund, whereby, we invest in one fund, which acts as a ‘feeder’ fund for some other fund(s), i.e invests in other mutual funds, or it can be a fund which directly invests in overseas equities. These may be further designed as ‘International Commodities Securities Fund’ or ‘World Real Estate and Bank Fund’ etc.
Growth Schemes
Growth schemes invest in those stocks of those companies whose profits are expected to grow at a higher than average rate. For example, telecom sector is a growth sector because many people in India still do not own a phone – so as they buy more and more cell phones, the profits of telecom companies will increase. Similarly, infrastructure; we do not have well connected roads all over the country, neither do we have best of ports or airports. For our country to move forward, this infrastructure has to be of world class. Hence companies in these sectors may potentially grow at a relatively faster pace. Growth schemes will invest in stocks of such companies.
ELSS
Equity Linked Savings Schemes (ELSS) are equity schemes, where investors get tax benefit up to Rs. 1 Lakh under section 80C of the Income Tax Act. These are open ended schemes but have a lock in period of 3 years. These schemes serve the dual purpose of equity investing as well as tax planning for the investor; however it must be noted that investors cannot, under any circumstances, get their money back before 3 years are over from the date of investment.
Fund of Funds
These are funds which do not directly invest in stocks and shares but invest in units of other mutual funds which they feel will perform well and give high returns. In fact such funds are relying on the judgment of other fund managers. Let us now look at the internal workings of an equity fund and what must an investor know to make an informed decision.
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