Mutual funds, demystified

Part I: What are mutual funds? Where do they invest?

We have seen the basic types of assets into which a mutual fund might invest: equity and debt, and how this choice impacts the risk and return characteristics of the funds.

However, you would have noticed funds which have now evolved and try to provide you with more fine-tuned products in a specialised niche. Equity funds, in particular, like to identify newer or better avenues of investment and hence they create products around those new avenues.

Style of a mutual fund:

Equity

An equity fund can invest in a large-cap, mid-cap or a small-cap stock. You might have heard these words being thrown around rather liberally by all the new funds on offer. 'Cap' refers to market capitalisation (M-cap) of a stock. M-cap is defined as the total market value of the equity of a company.

For example, if a company has 1,000 shares outstanding and the price of each share is Rs 20, the market value of the total equity of the company is Rs 20,000 (1,000*20). To exemplify, the market capitalisation of Reliance is approx Rs 200,000 crore (Rs 2,000 billion), while that of Hero Honda is around Rs 15,000 crore (Rs 150 billion).

Large cap, hence, refers to companies which have a large market capitalisation (usually above Rs 5,000 crore). Mid-cap refers to companies whose market value lies between Rs 1,000 crore to Rs 5,000 crore.

Any company with market capitalisation of less than Rs 1,000 crore is called a small cap company. Now different fund houses have different definitions of where a 'cap' ends and where the other begins but these are rough bench-marks. One of the biggest selling points currently of the new fund offers is that the small cap companies of today will increase in value so much that they will become the next mid-cap or large-cap companies.

Looking at managing equities differently, we say that the fund manager may pick a growth or a value stock. Growth companies are typically ones which are witnessing high amount of growth in their profits (due to growth in underlying demand, increase in prices, new technology, etc).

These firms command a valuation which is superior to firms with a lower growth potential. Value companies, on the other hand, are in mature industries where they offer more stable cash flows and a reasonable valuation to buy them. Note that in a market downturn, a growth stock can become a value stock if it is available cheap!

A fund manager may decide to invest exclusively in growth or value stocks or in a combination of both.

Based on whichever style is chosen, the fund can be 'boxed' into the 3*3 matrix below:

Debt

Debt funds can similarly be classified in to long, medium and short tenor funds. While the definitions are flexible again, long funds typically invest in instruments with maturity greater than 5 years, while short-term funds invest in instruments with less than one year of maturity; medium-term funds invest in the 1-year to 5-year range.

Note that the longer the duration (roughly average maturity) of the investments, the more sensitive it is to interest rate movements. Also remember that the price of bonds varies inversely with interest rates.

On the other axis, a debt fund can invest in high quality instruments like government of India bonds, bonds issued by healthy PSUs, top-notch corporates, etc. It can progressively lower its investment quality by investing in not-so-stable corporates or in fixed deposits of co-operative banks. The advantage of lowering credit quality is higher expected returns (with the increased risk of default).

Based on whichever style is chosen, the fund can be 'boxed' into the 3*3 matrix above.

Theme of a mutual fund:

A mutual fund can create an investment philosophy around which it wants to invest. In India, this is typically seen around equity funds. A theme serves both the parties: it provides the investor with a specific or new opportunity while providing a new 'buzz' to the asset management company. Some of the themes are as follows:

• Sector-specific investments: investment in companies of a particular sector, like pharma or banks or IT
• Investments in a specific segment of the market: large-cap, mid-cap or small-cap
• Investment in a specific asset type: real estate mutual funds will invest in property
• Specific opportunity: The India Growth and Economic Reforms (TIGER) fund of DSPML plays on this opportunity where they bet on companies that will benefit from either India's growth or general economic reforms or both.
• Tax-related investments: investment with a specified lock in and investing in equities to take advantage of tax incentives.

Styles and themes have their own risk-return profile which is more fine-tuned than the broad asset class. You need to be careful when you choose the style or theme: ensure that these meet your risk-return requirement.

In the next article, we will look at the benefits of investing through a mutual fund.

• See tomorrow: 6 BIG advantages of investing in a mutual fund

The author is Director, PARK Financial Advisors Pvt. Ltd., Mumbai. He is an IIM-Ahmedabad alumnus. He can be contacted at tilotia.akhilesh@parkfa.com