Equity funds for some

Smart Investing

 There are wide ranging options in the equities space - from index funds to aggressive mid-cap funds. In the last two years, there has been a resurgence in mid- and small-cap stock prices. Consequently, most fund managers have also increased their allocation to this segment.

 Market experts feel that the mid and small-cap rally is sustainable this time as it is fundamentals-driven. Accordingly, major mutual fund houses have schemes positioned as aggressive equity funds. In case of an equity boom, these schemes should be able to deliver better returns, but they will be that much more riskier.

 Indexing gains

 For people who are sceptical of the fund manager's ability to select stocks, index funds are a good bet. Index funds mimic a chosen index and therefore deliver market returns. The underlying assumption in index funds is that since the markets are efficient, attempts to beat them are worthless.

 A smarter alternative to the plain vanilla open-end index fund is the exchange traded fund (ETF). These funds, too, track a specific index yet they are different from normal ones in that they are listed and traded on the stock exchanges.

 Unlike a normal fund that comes out with an initial public offer, an ETF creates and redeems units continuously through designated institutions called authorised participants (AP). The AP sells the units in the market and acts as market maker for the fund units.

 The recently launched Unit Trust of India's ETF, called Sunder, tracks the Sensex. "ETFs score over other index-based schemes due to the fact that they have a lower tracking error," says A K Sridhar, president, department of fund management, UTI Mutual. That's because the fund actually accepts only a basket of stocks (Sensex in this case) for creating units and not cash. So the fund does not have to buy stocks from the market, saving on brokerage costs. Similarly, the fund redeems the units also in kind to the APs. For retail investors, the fund allows the flexibility of moving in and out of a scheme at prices prevailing on that date, giving them the flexibility of capturing intra-day prices.

 "The passive nature of the fund and the fact that it does not need to maintain a part of its portfolio in cash reduces tracking error," Sridhar adds.

 Passively active: But in India, experts say the markets are quite inefficient in the sense that there are ample opportunities to beat the benchmark indices. Numbers prove the point: Over the last three years, actively managed equity diversified funds fell 2.46 per cent, the Nifty fell 6.84 per cent and Sensex 8.76 per cent.

 But if you are not very comfortable leaving it all to your fund manager, actively managed index funds may be a good option. As the name suggests, these funds are managed actively by fund managers, within certain limitations based on their chosen index. There are two actively managed index funds currently - Alliance Frontline Equity Fund and HDFC Top 200 Fund.

 The former mimics the Nifty in terms of sector allocation; and within each sector, the fund will invest only in stocks it is most bullish on.

 Why is sector allocation important? For one, it gets you diversification. The underlying idea is that when one sector fails to perform, another may make up for it, ensuring that overall returns are not affected too badly. Even during the tech bubble of 2000 most equity funds had underperformed their benchmark because they had diluted the character of being 'diversified' by allocating an enormously large portion of their portfolio to technology stocks.

 In fact, some of them had allocated as much as 85 per cent of the corpus to the technology sector, even as they continued to call themselves diversified. "With our competencies in stock selection, we think we will be able to deliver better returns," says Samir Arora, head - Asia Pacific, Alliance Capital.

 Another actively managed index fund is the HDFC Top 200. This fund invests in a portfolio of stocks chosen from the BSE-200 index. In fact, this led the fund to lag behind its peers during the tech boom. But it had the last laugh when the tech bubble burst in 2000 and the fund posted lesser losses compared to its peers. Given HDFC Top 200's conservative strategy, it is likely to outperform when the bears take charge of the markets.

 Less than a year old, Alliance Frontline has posted returns of 22.77 per cent in the past three months. HDFC Top 200 has given a return of 37.42 per cent in the last one year.

 All season funds

 Based on the past performance and risk-adjusted returns, the funds that stand out as consistent winners are Franklin Templeton's Bluechip, Prima and Prima Plus, apart from HDFC's India Equity Fund (erstwhile Zurich India). They have not only been able to identify the trends early, but have also been quick to realign their portfolios to make significant gains from market changes. According to a study done by The Smart Investor (Business Standard's weekly investment supplement), these funds haven't fared too badly in the bear markets as well.

 Says Franklin's fund manager Siva Subramanian: "In all market conditions, the key parameters that drive our investment decisions are fundamentals and valuations."

 Investment in quality stocks, timely exits and attempts to stay diversified at all times have helped Franklin India Bluechip to turn in a consistent performance in different market conditions, say fund analysts.

 The other fund that has done well on a consistent basis is HDFC India Equity Fund. Notably, this was the first to exit technology stocks and hence saved its investors a lot of heartburn. The fund has been a consistent performer in bull markets, and identifying trends early is one of its strengths.

 Says Prashant Jain, head of equities, Zurich India Equity: "We follow a more disciplined approach when it comes to investing. We do not believe in making calls on the market. We have a sense of the real value of companies and stay invested in a company till the unlocking of value happens."

 Another plan that has done exceptionally well is UTI's Master Value Fund. Originally launched as a closed-end fund, it was converted into an open-ended fund a couple of months ago. Over the last three years, this fund has delivered an annualised return of 10.41 per cent with a 35.51 per cent return in the year ended June 2003.

 Grab the opportunity

 Opportunity funds are the new buzzwords on Fund Street. There is the DSP Merrill Lynch Opportunities Fund, the Tata Opportunities Fund and many more that do not really call themselves opportunity funds, but have positioned themselves as aggressive plans to make best use of emerging market opportunities. The idea is really to take aggressive positions in the rising sectors or stocks which look most promising. Says Anup Maheshwari, fund manager at DSP Merrill Lynch, "Our opportunities fund focusses on sectors which look most promising."

 In recent times, most fund houses have added to their menu aggressive growth funds. These funds normally take bets in the stocks and sectors they are bullish on to be able to give high powered returns. Obviously, in a rising market these funds will tend to outperform the regular diversified funds by a wide margin. "However, investors should buy them only if they can stomach the risks associated with these funds," says Paras Adenwala, fund manager, Birla Sunlife Mutual Fund.

 Other funds in the league include, ICICI Power - which returned a neat 31 per cent last year; and Alliance Basic Industries Fund which returned 48 per cent. Besides, the two open-end funds from the Reliance Mutual stable - Reliance Vision and Reliance Growth - have done exceptionally well over the last three years with returns of 19.72 per cent and 10.52 per cent, respectively.

 Should you invest in the leader of the last bull run?

 Conventional wisdom suggests that stocks or funds that beat the market in bullish times fall as sharply when the market plummets. This is because such funds invariably assume higher risks by loading up their portfolios with high-beta stocks (which move faster than the index) when the market is heating up. So when the market mood changes and stocks begin to fall, they are unable to churn portfolios fast enough to guard asset values from sinking.

 On the contrary, funds that are cautious in their approach neither provide sensational returns in boom time, nor end up collapsing when the market takes a U-turn. But should you invest in a fund because it outperformed the markets in the last bull run? Experts say it may be a bad idea, unless the fund has shown consistent outperformance over many bull phases.

 Investing in a fund only because it did well in a particular bull run may be foolish, because the future may be vastly different from the past. For instance, a fund manager who predicted the tech rally early may or may not be able to predict the next big wave, and hence may or may not top the charts in the next bull run. On the contrary, some unheard of fund manager may actually crop up as the top performer if he is able to spot an emerging trend ahead of the market.

 Another important point is that funds that have outperformed in the past may not have done so by consciously maintaining a high-beta portfolio in a bull market and by carrying defensive elements in a bear phase. The idea of holding a high-beta portfolio in bullish times and a low-beta portfolio in bearish times may sound good on paper, but is not as easy to implement.

 A consistent approach, irrespective of market conditions, can be rewarding in the long haul and investing in funds with such an approach is a safer option. Betting on aggressive funds can be more rewarding, but that is much more risky.