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All about investing in equity mutual funds

Last updated on: April 13, 2010 08:23 IST

All about investing in equity mutual funds


Kunnath Santhosh

2009 was a great year for equity mutual funds. An average diversified equity fund delivered 84 per cent -- the highest calendar year return in the last 5 years. The performance of technology funds and pharma funds were even better (up 116 per cent and 96 per cent respectively). Index funds gained 81 per cent. These numbers are really tempting especially if you missed out on last year's bull-run. And if you are a new or first-time investor, there is an even greater tendency to get misled by these numbers!

Choosing funds based on last year's performance irrespective of the fund's objective may not be the right investing strategy. To help you make better investment decisions, we have tried to put together a brief tablet on various types of equity funds based on their investment objective.

1. Diversified equity funds

These are vanilla equity funds that invest in various company stocks. They have the basic objective of generating regular long-term capital growth from a diversified and actively managed portfolio of equity and equity related securities. These funds can be further classified as large-cap or mid-cap funds.

A large cap fund limits its investment to big company stocks like Reliance, Infosys, ONGC, Tata Steel, SBI, etc. On the other hand, mid-cap funds invest in small or medium sized company stocks like Nagarjuna Fertilisers, Madras Cements, Punj Lyod, etc.

Since small companies are usually less stable than large firms, we can expect higher volatility in case of mid-cap funds as compared to large-cap funds. Hence, before making an investment in a diversified equity fund, one should read the investment objective very carefully. If you don't have the appetite to take higher risk, ignore mid-cap funds. Instead, choose among large-cap funds.



The author is co-founder and director of Bangalore-based Perfios Software Solutions Private Limited. is a personal finance software solution that provides a 360-degree view of your personal finance, with very little manual intervention.

Photographs: Rediff Archives

2. Tax saving funds (ELSS)

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Tax-saving mutual funds, also known as equity linked savings schemes (ELSS), are essentially diversified equity funds. The fund manager of an ELSS too invests 100 per cent of the money in equity markets and hence returns are based on the performance of the stock market. The only difference here is that a tax-saving fund also provides tax benefit.

As per Section 80CC of the Income Tax Act, you are eligible to get tax rebate on an investment of up to Rs 1 lakh in any of the available tax-saving options including ELSS. However, there is a catch -- a minimum lock-in of three years. You can't sell your fund before completion of 3 years.

3. Sector funds

These funds invest in a particular sector like pharma, FMCG, banks, PSU, technology, etc. And due to this sector restriction, these funds lack diversification. Though they invest in various stocks, the universe is limited to a particular sector. Currently, there are many sector-oriented funds in India like technology funds, banking funds, pharma funds, FMCG funds and PSU funds.

We recommend sector funds to only those investors who have some knowledge or background about the respective sector or keep a disciplined track of the sector in question.

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4. Index funds

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Index funds aim to replicate the performance of a particular index (BSE Sensex, NSE Nifty, etc). They invest in same set of stocks that comprises an index and in the same proportion. Hence, an index fund's return for any time period will be similar to that of the benchmark index.

Since index funds work on autopilot, the fund manager's role is very minimal. These passively managed funds are usually recommended for conservative investors who are fine with average market returns.

5. Fund-of-funds (FoF)

Unlike usual mutual funds that invest in stocks, fund-of-funds (FoF) invest in other mutual fund schemes. This is a new concept in India and many fund houses have started launching such funds. It provides additional diversification and is usually less volatile -- a decent combination for first time investors.

Additional guidance

Even if we are clear on the fund's objective we have an inbuilt tendency to buy funds having good track record. But it should not be the only criteria driving your investment decision. Past performance is no guarantee for future returns. And mutual funds are no exception to it.

Also, one should first decide on his / her investment objective before analysing the fund's objective. What's my overall goal? How much can I contribute towards investing? How much risk can I bear? Answers to these basic questions will guide you on where to put your money. Post self-evaluation, you may end up acknowledging that equity funds are not meant for you. Then these tempting numbers and reading through funds' objective does not make sense.

Equity funds have usually delivered better returns over long-term when compared to any other asset class. A 5-year annualised return of over 20 per cent is a testimony to this. Hence, we recommend investors to enter equity markets or buy equity funds only if you are a long-term player. Investing in equity funds for shorter duration or for speculative purpose is strictly not advisable.

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