I hope that the first article of profiting from mutual funds was found to be interesting by readers. The purpose of these articles is educational to start with and then in later episodes I will get into evaluating individual schemes and fund houses too.

Now as we talked of the last time that there are two broad categories of mutual funds. Besides this there are some niche categories of funds that are either hybrid or do not fall into these two broad categories. Now the simplest forms of equity mutual fund schemes are the Diversified Equity Schemes. These are schemes where the fund manager has the option of investing into any kind of stock depending on his conviction. These are normally the schemes where the investor should be putting most of his money. The important thing here is that the fund manager should be able to take advantage of the movement in the stock markets in order to re orient the portfolio between different sectors and market segments so as to provide the best returns to investors. The performances of diversified equity schemes vary a lot depending on the portfolio of the schemes. The safest among the equity scheme categories is the large cap fund category. In these schemes the fund manager will invest into blue chip stocks which are very well known and normally will belong to the indices like the NIFTY OR SENSEX. The risk in a large cap scheme is that the fund manager might not be able to move between sectors properly i.e. at any point of time particular sectors will do well. In a high interest rate environment defensive stocks like Consumer Good stocks and Pharmaceutical stocks will do well. At a time when the rupee is weak the exporters will do well which include sectors like Technology and Pharmaceuticals. When interest rates are low or are coming down we see that stocks of sectors like Banking and Capital Goods will do well. As such the job of the fund manager is to foresee what is coming and position the portfolio accordingly. Hence even blue chip equity schemes will have huge variance in performance according to the fund manager’s performance.

The next categories of scheme are multicar schemes which have a mix of large and mid cap stocks, normally in a predefined ratio. Here the large cap part of the portfolio gives stability and the fund manager tries to pick out stocks from his picks of mid cap stocks in order to try to increase the returns of the portfolio. Here the risk lies in the proper allocation across mid and large cap stocks as well as in stock picking as the variance in the performance of mid cap stocks is huge not only across sectors but also within the same sector.

The next category is the mid cap funds category where the return potential as well as the risk is the highest as there the performance of the scheme is largely dependent on the ability of the fund manager to make the right kind of stock picks at the right time. Mid cap scheme can be very volatile and are not suitable for risk adverse investors. If there is one category of scheme where individual fund manager ability comes to the fore it is in the mid cap category. These schemes did very well in the bull run of 2003-2007 but also got hit as the markets reversed. Generally as a rule mid cap companies do better than large cap companies when interest rates are low and the economy is doing well. When interest rates are high and there is a slowdown the hit to mid caps is much more than for established blue chip companies. The last three years have seen a very different performance from mid cap stocks globally versus that in India where because of low interest rates in most of the world economies mid cap and small cap stocks have given much better returns than large cap stocks. The world small cap index is trading at record high levels, however the mid cap index in India is not even at 50% of the peak value seen in 2008. The reason is economic slowdown in India combined with high interest rates.

There is a special category of equity mutual funds that is called the ELSS category. This offers tax benefits under section 80c where investments up to Rs 100000 are tax exempt. Here there is also a lock in of 3 years. Most of the schemes in this category operate as diversified equity schemes.

The other schemes in the equity categories are the thematic funds or sector funds that invest in a single theme or sector. These are the riskiest of schemes and are suitable only for informed investors that can take fast decisions to move from one sector scheme to the other. The performance of various sectors in the stock market tends to be cyclical and normally we have seen that sectors/thematic funds become popular when most of the movement of these sectors has already happened and investors tend to catch the top. Besides this there are schemes that are international funds that invest abroad. This category of schemes has done very well over the last three years as global stock markets and have done much better than India and besides this the rupee has also fallen against most currencies. In an international fund when the rupee falls the returns increase and when the rupee rises returns will fall due to the conversion of the unit value from USD to INR.

International funds are good for diversification but run the risk for the investor of not knowing anything about the companies being invested into and the fund manager who is doing these international investments. The currency risk can work to the favour as well as disadvantage.

Other risky fund categories include gold funds that largely track the price of the underlying category and index funds that track the returns of the index it is following like Nifty, Sensex, Mid cap index etc.

In the next article we will talk about various categories of debt funds and hybrid funds.

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