If you’re someone who has been investing in the markets, you may have often thought about what matters most as an investor – ‘timing the market’ or ‘time in the market’. While there is no right or wrong answer to that question, we believe that both are necessary for you as an investor to make investing worth your while. A longer time horizon helps diffuse the risk in returns, but getting the timing right can be more rewarding.
As a retail investor timing the market is relatively crucial which means that you have to buy low and sell at peaks. Undoubtedly, this is a daunting task. Therefore, investing in equity Mutual Funds offers the right solution. Equity Mutual Funds are run by professionals who call the shots on your behalf as they are in a better position to gauge the volatile markets.
Additional Reading: Introduction To Equity Mutual Funds
On the other hand, Debt Funds which carry relatively lower risk than Equity Funds offer a whole lot of other categories and strategies that are far more complex. The numerous jargons used in these type of funds can put off a fairly new investor.
Additional Reading: All About Risks In Debt Funds
And that’s why it’s important to classify Mutual Funds. Let’s begin by sorting them out under various asset classes that they get invested in for example stocks and bonds. Mutual Funds can be divided into three broad categories – equity, hybrid and debt. Each of these are further divided by fund houses based on style, objective, and strategy.
We can really go on and on as there’s an endless list to this categorisation. But, what matters most to you as an investor is how well you can construct a fund portfolio based on your risk tolerance, investment objective and time horizon.
We have categorised various funds with objective mapping to an investors risk profile.
Equity Funds For Building Long Term Wealth
If you’re someone who is looking to build a portfolio for the long term, in the hope to beat inflation, then Equity Funds are for you. These funds invest at least 65 percent of their assets (with a maximum of 100 percent) into stocks. For young investors who are in their twenties and thirties this is a great opportunity to benefit from the power of compounding.
Additional Reading: How Should A 22-Year-Old In India Invest Money?
To put things into perspective, if you were to invest Rs. 1 lakh in a top performing Equity Fund, say about 20 years ago, your fund would be worth Rs. 16 lakhs as of today at an annual compounded growth rate of 15 percent. How cool is that? So, if you are still thinking, it’s time for you to get the ball rolling.
Moderate Risk Taker
Equity diversified funds are further classified as large-cap, mid-cap, small-cap and multi-cap funds. Most large-cap funds have a mandate of investing 80 percent into larger stocks (above Rs. 10,000 crore). Top performing funds in this category have delivered 13 to 16 percent return over a period of 5 to 10 years.
Whereas, mid-cap and small-cap funds invest predominantly in smaller stocks (less than Rs. 10,000 crore). While these funds carry a relatively higher risk than large-cap funds, they are rather rewarding.
Top performing funds in the past have delivered neat returns of 30 to 31 percent over a five-year period. If you’re someone who prefers stability of returns and have a moderate risk appetite, large-cap funds are your best bet. And while these funds are great to beat inflation in the long run, they also tend to cap losses well when markets are volatile.
For the slightly adventurous investors out there, who are game for a little 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 the drawback is that they also tend to fall more than large-cap funds. In the 2011 bear market, for instance, these funds lost 26 per cent.
A few funds within the equity funds carry higher risk than diversified funds by pegging up their exposure to a particular theme or sector. Thematic funds invest in FMCG, technology, banking and pharma. These type of funds carry concentrated risks 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 a few pharma funds over the past year. These funds managed to deliver just about 1 per cent return. Also, IT funds have incurred losses of 6 per cent over the past year.
But these very funds can deliver spectacular returns when the tide turns. Some banking funds 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.
And if you’re in the mood to go all out, you can try investing in global funds that have exposure in other geographies. These funds are riskier than other diversified funds.
Debt Funds For Income Generation
Debt Funds generate returns in a slightly different manner than Equity Funds. Most of us are of the opinion that Debt Funds cannot erode in value similar to Fixed Deposits. Now, that is a misconception. 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.
Additional Reading: Introduction To Debt Funds
The Net Asset Value (NAV) on Debt Fund can thus rise or fall along with the underlying bond prices. And if you’re wondering what impacts bond prices? Here’s the answer – interest rate movements in the economy can impact bond prices. If interest rates move up, bond prices fall and vice versa.
And this is when the concept of ‘duration’ comes into the picture. Longer-duration bonds are more sensitive to interest rates. Hence, more often than not, debt fund managers will increase the duration to cash in on the rally in bonds if a falling rate scenario is noticed.
Debt Funds are prone to incurring 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. Understood?
So, one could ask, 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 follow a strict ‘duration’ or ‘credit’ call or blend the two to come out with different strategies.
Additional Reading: What To Remember While Choosing The Right Debt Funds
Now, for those of you who are looking for alternatives to a Savings Bank Account and Fixed Deposits, Liquid Funds and ultra-short-term Debt Funds are catered especially for you. And while these funds are riskier than bank FDs, they carry the lowest risk amongst Debt Funds.
Liquid Funds prove to be the safest in the entire category because they only invest in debt securities with a residual maturity of less than or equal to 91 days. With a short maturity period this fund has minimal interest rate risk and credit risk (default risk).
On an average, Liquid Funds have delivered 7-9 percent 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 on this are higher though. On an average, over the past five years, returns from this category have been around 7.5-9.5 percent which make these funds desirable to conservative investors who don’t want the burden of high risk.
If you’re looking to invest in Debt Funds for a period of less than three years, the returns will be taxed at the income tax slab rates. Interest on savings accounts is exempt up to Rs. 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 percent that most banks offer.
In comparison to bank FDs for less than a year, liquid or ultra-short debt funds may provide competitive returns. But with a bank FD, you’ll be charged a penalty should you withdraw the money before maturity. That’s not the case with Liquid Funds, because it allows you to exit investments without any penalties.
Moderate Risk Taker
If you’re an investor and are willing to take slightly higher risk and have a longer time horizon of, say, 2-3 years, Debt Funds, which generate returns both from accruals and duration calls (only moderately), are a great idea. 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.
High Risk Investor
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. Let’s explain all these terms for you.
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 mainly invest in long-term government securities and 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 percent in favourable markets (when rates fall sharply), but also pinch investors more, when rates move up sharply.
Hybrid or Balanced funds allocate their assets both to equity and debt, this way you get the best of both worlds. 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.
Additional Reading: An Introduction To Balanced Funds
Equity-oriented balanced funds invest more than 65 per cent in equity and the rest in debt. The higher allocation of equity helps deliver superior returns while also offering the tax benefit available to the equity diversified category.
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 are treated as short-term capital gains.
Investing in Mutual Funds aren’t all that tricky after all. When you’re narrowing down on the type of investment, you should keep your eye on the funds’ performance. But, you can also boost your returns by opting for funds which have a relatively lower expense ratio too.
Fund managers charge a fee to manage investor’s money. This along with other expenses is called the expense ratio or total expense ratio (TER). The NAV of each fund is calculated each day and is borne by the investor.
A relatively higher expense ratio can eat into your 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.
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