Numbers say it better than words: five years ago, Rs 21,000 crore was invested in stocks through mutual funds; today, this has risen to Rs 1,45,000 crore. Clearly, Indians have seen that funds are the best way of investing in stocks. But choosing the right fund is becoming more complex.
In 2002, there were just about 70 or 80 equity funds—today there are well over 500. It’s not just the number that has increased but also the variety. Fund houses are busy inventing reasons to prove that their latest fund has a completely new investment approach.
It’s impossible for any investor, let alone a first timer to make sense of all this. The right way to start is to reduce the funds to a few basic categories and then choose which type of fund is suitable.
BALANCED FUNDS: Stress on stability
The first steps set the trend for the future. If his first venture into stocks dip into the red, an investor may review his decision to invest at all. That is why first-time investors in equities should opt for balanced funds. These are less volatile than equity funds because they invest in equities as well as in debt.
But, their returns are lower compared to equity funds. In the past five years, diversified equity funds have given average annual returns of 48% while balanced funds have given around 30%.
ELSS FUNDS: Plan taxes, create wealth
This tax planning and wealth creation tool is especially suited to the young investor with a long-term view. First-time investors may find equitylinked saving schemes (ELSS) attractive because of the low minimum investment (Rs 500). ELSS are diversified equity funds by another name. They offer tax benefits under Section 80C but lock up your money for three years.
EQUITY FUNDS: Diversifying risks
It pays to take a little risk in the stock markets, especially if that risk means greater rewards. A profitable investment in balanced funds would whet an investor’s appetite for risk. Just the right time to move on to equity index funds. Index funds are mildly volatile because their portfolios consist of index-based shares in the same proportion as their weightage in the index.
They usually mirror the returns of the stock index they are based on. Investors who have become comfortable with a little more risk could move to diversified equity funds that invest in stocks across different sectors and company sizes.
Good diversified equity funds usually outperform the market by a comfortable margin. In the one month ending 5 October, index funds gave an average return of 15%.
That’s good but it pales before the 22% return of the best performing diversified equity fund during the period.
FoF, SECTOR FUNDS: Adding complexity
Fund of funds do not directly buy stocks but invest in other funds chosen by the fund manager. Nothing wrong with them but current tax laws leave them handicapped. Sector funds offer focused diversification but have a high risk-reward ratio.
Stay away unless you can take a 25% loss in a quarter. Understanding these categories would help make the choice easier for the new entrant.
By Dhirendra Kumar, CEO, Value Research
