What's the right MF for you? Here's the answer

If you are planning to invest your money in equity funds, there are plenty of options for you. Broadly the equity funds can be categorised into index funds, diversified funds and sectoral or thematic funds.

Your friend could have told you index funds are safe and cost effective. Your colleague could have told you, infrastructure is going to be the next big theme. So invest in infra funds.

As an investor you are confused with the information overload and would like to choose the right type of fund for you. I will unveil this for you today.

Ramalingam K, an MBA (Finance) and certified financial planner, is founder & director of Holistic Investment Planners (P) Ltd (http://holisticinvestment.in).

Index funds vs diversified funds

Index funds are just index trackers. They aim to replicate the movements of an index. Index funds will hold all of the securities in the index in the same proportion as the index. There is no research and analysis on which stock to invest. There is no human input.

They just track and replicate the index. There is no active management and there is no fund manager. So they enjoy the low cost advantage.

On the other hand, diversified equity funds will invest in non-index stocks also. The fund manager and his team will do an in-depth research before investing in each and every share. The aim of the fund manager is to outperform the index. Most of the diversified funds have outperformed the index with a huge margin. You can see this below.

As these funds are actively managed, the expense ratio of these funds is relatively higher. But you are well compensated for the extra fees you pay. The returns you see in the above table are the net returns after adjusting all the expenses.

If that is so, then how come the concept of the index fund is so popular and accepted?

In the developed countries, matured markets, grown up economy it is REALLY difficult to beat the index. So the extra expense on the active management will reduce the return. So index funds are better and popular there.

But in a country like India, where the economy is growing fast, market is still not matured and the country is in the transition phase of moving from a developing country to a developed country there are lot of better opportunities with the non-index stocks. That is why in all emerging markets including India, it is possible for the fund managers to outperform the index.

So, diversified equity funds in the long run (5 years and above) will outperform the index funds in all the emerging markets like India. That is why you need to choose diversified equity funds when compared to index funds.

Sectoral fund invests in a particular sector. There could be a 'Pharma Fund' which invests only in the pharmaceuticals sector. You can also see the funds like banking fund, IT sector fund, FMCG fund. The performances of these funds are restricted to the opportunities available in those particular sectors.

Thematic fund invests based on a particular theme. There could be an infrastructure fund which invests only in infrastructure based stocks. There are thematic funds available in the other themes like capex opportunities, energy opportunities, rural India, PSU opportunities. The performances of these funds are based on the success of those themes. Thematic funds can invest only in those sectors favoured by its theme.

On the other hand, the diversified equity funds can invest across various sectors and they can follow many themes. There is no restriction. The fund manager can invest a sizeable portion in any particular sector or any theme if he thinks that sector/theme can do better in the future. Also he can move from one sector to the other sector and change theme intermittently based on the changes in the market outlook.

This flexibility of moving from one sector/theme to the other sector/theme is not available with sectoral/thematic funds.

Even if the fund manager of the sectoral/thematic fund thinks that, this particular sector/theme will not do well for the next couple of years, he is forced to remain invested in the same sector/theme. Whereas the diversified fund manager can change to another sector/theme if the outlook for a sector/theme changes.

Most often, the market creates hype on a particular sector or theme. Then investors get a feeling that this is going to be the next big sector/theme which is going to drive the market. This is only an illusion.

Technology is the next big sector

This was the hype created by the market in the year 1999. Everyone around you could have talked about technology stocks. Mutual funds have launched so many technology sector funds like ecom funds, internet opportunities funds. Most of the investors believed this illusion as real and invested their hard earned money in these funds.

Technology sector as a whole crashed during the year 2000 and all the technology funds took years to recover from their losses. But the diversified equity funds which had sizeable exposure in technology stocks have revived faster than the standalone technology funds.

Infrastructure is the next big theme

This was the hype created in the market in the year 2007. Everyone around you could have talked about infrastructure stocks. Most of the mutual fund houses launched schemes based on the infrastructure theme. Market crashed in 2008 and infrastructure stocks were the worst affected. Investors learned that, the prospect which they have perceived for infrastructure in 2007 was only an illusion.

Sectoral/thematic funds have potential to deliver superior returns, but it is almost impossible to predict when they will do so. Also there is an inherent danger of getting inferior returns. But market will play with your greed and make you believe the illusion as real and take action. Beware.

So it is better to leave the choice to the fund manager regarding in which sector/theme to invest. He knows when to invest in a particular sector /theme and when to move out of a particular sector or theme.

Therefore, east or west the diversified funds are safe and best.