The riskiest among equity funds, sector funds invest only in stocks of a specific industry, say IT or FMCG. A sector fund’s NAV will zoom if the sector performs well; however, if the sector languishes, the scheme’s NAV too will stay depressed.
Barring a few defensive, evergreen sectors like FMCG and pharma, most other industries alternate between periods of strong growth and bouts of slowdowns.
The way to make money from sector funds is to catch these cycles–get in when the sector is poised for an upswing and exit before it slips back. Therefore, unless you understand a sector well enough to make such calls, and get them right, avoid sector funds.
b) Income / Debt Oriented Scheme
The aim of income funds is to provide regular and steady income to investors. Such schemes generally invest in fixed income securities such as bonds, corporate debentures, Government securities and money market instruments. Such funds are less risky compared to equity schemes. These funds are not affected because of fluctuations in equity markets.
However, opportunities of capital appreciation are also limited in such funds. The NAVs of such funds are affected because of change in interest rates in the country. If the interest rates fall, NAVs of such funds are likely to increase in the short run and vice versa. However, long term investors may not bother about these fluctuations.
Such funds attempt to generate a steady income while preserving investors’ capital. Therefore, they invest exclusively in fixed-income instruments securities like bonds, debentures, Government of India securities, and money market instruments such as certificates of deposit (CD), commercial paper (CP) and call money. There are basically three types of debt funds.
Income funds
By definition, such funds can invest in the entire gamut of debt instruments. Most income funds park a major part of their corpus in corporate bonds and debentures, as the returns there are the higher than those available on government-backed paper. But there is also the risk of default–a company could fail to service its debt obligations.
Gilt funds
They invest only in government securities and T-bills–instruments on which repayment of principal and periodic payment of interest is assured by the government. So, unlike income funds, they don’t face the spectre of default on their investments. This element of safety is why, in normal market conditions, gilt funds tend to give marginally lower returns than income funds.
Liquid funds
They invest in money market instruments (duration of up to one year) such as treasury bills, call money, CPs and CDs. Among debt funds, liquid funds are the least volatile. They are ideal for investors seeking low-risk investment avenues to park their short-term surpluses.
The ‘risk’ in debt funds
Although debt funds invest in fixed-income instruments, it doesn’t follow that they are risk-free. Sure, debt funds are insulated from the vagaries of the stock market, and so don’t show the same degree of volatility in their performance as equity funds. Still, they face some inherent risk, namely credit risk, interest rate risk and liquidity risk.
3 Interest rate risk: This is common to all three types of debt funds, and is the prime reason why the NAVs of debt funds don’t show a steady, consistent rise. Interest rate risk arises as a result of the inverse relationship between interest rates and prices of debt securities. Prices of debt securities react to changes in investor perceptions on interest rates in the economy and on the prevelant demand and supply for debt paper.
If interest rates rise, prices of existing debt securities fall to realign themselves with the new market yield. This, in turn, brings down the NAV of a debt fund. On the other hand, if interest rates fall, existing debt securities become more precious, and rise in value, in line with the new market yield. This pushes up the NAVs of debt funds.
4 Credit risk: This throws light on the quality of debt instruments a fund holds. In the case of debt instruments, safety of principal and timely payment of interest is paramount. There is no credit risk attached with government paper, but that is not the case with debt securities issued by companies. The ability of a company to meet its obligations on the debt securities issued by it is determined by the credit rating given to its debt paper.
The higher the credit rating of the instrument, the lower is the chance of the issuer defaulting on the underlying commitments, and vice-versa. A higher-rated debt paper is also normally much more liquid than lower-rated paper. Credit risk is not an issue with gilt funds and liquid funds. Gilt funds invest only in government paper, which are safe. Liquid funds too make a bulk of their investments in avenues that promise a high degree of safety. For income funds, however, credit risk is real, as they invest primarily in corporate paper.
5 Liquidity risk: This refers to the ease with which a security can be sold in the market. While there is brisk trading in government securities and money market instruments, corporate securities aren’t actively traded. More so, when you go down the rating scale–there is little demand for low-rated debt paper. As with credit risk, gilt funds and liquid risk don’t face any liquidity risk. That’s not the case with income funds, though. An income fund that has a big exposure to low-rated debt instruments could find it difficult to raise money when faced with large redemptions.
c) Balanced Fund
The aim of balanced funds is to provide both growth and regular income as such schemes invest both in equities and fixed income securities in the proportion indicated in their offer documents. These are appropriate for investors looking for moderate growth. They generally invest 40-60% in equity and debt instruments. These funds are also affected because of fluctuations in share prices in the stock markets. However, NAVs of such funds are likely to be less volatile compared to pure equity funds.
As the name suggests, balanced funds have an exposure to both equity and debt instruments. They invest in a pre-determined proportion in equity and debt–normally 60:40 in favour of equity. On the risk ladder, they fall somewhere between equity and debt funds, depending on the fund’s debt-equity spilt–the higher the equity holding, the higher the risk. Therefore, they are a good option for investors who would like greater returns than from pure debt, and are willing to take on a little more risk in the process.
d) Money Market or Liquid Fund
These funds are also income funds and their aim is to provide easy liquidity, preservation of capital and moderate income. These schemes invest exclusively in safer short-term instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank call money, government securities, etc. Returns on these schemes fluctuate much less compared to other funds. These funds are appropriate for corporate and individual investors as a means to park their surplus funds for short periods.
Barring a few defensive, evergreen sectors like FMCG and pharma, most other industries alternate between periods of strong growth and bouts of slowdowns.
The way to make money from sector funds is to catch these cycles–get in when the sector is poised for an upswing and exit before it slips back. Therefore, unless you understand a sector well enough to make such calls, and get them right, avoid sector funds.
b) Income / Debt Oriented Scheme
The aim of income funds is to provide regular and steady income to investors. Such schemes generally invest in fixed income securities such as bonds, corporate debentures, Government securities and money market instruments. Such funds are less risky compared to equity schemes. These funds are not affected because of fluctuations in equity markets.
However, opportunities of capital appreciation are also limited in such funds. The NAVs of such funds are affected because of change in interest rates in the country. If the interest rates fall, NAVs of such funds are likely to increase in the short run and vice versa. However, long term investors may not bother about these fluctuations.
Such funds attempt to generate a steady income while preserving investors’ capital. Therefore, they invest exclusively in fixed-income instruments securities like bonds, debentures, Government of India securities, and money market instruments such as certificates of deposit (CD), commercial paper (CP) and call money. There are basically three types of debt funds.
Income funds
By definition, such funds can invest in the entire gamut of debt instruments. Most income funds park a major part of their corpus in corporate bonds and debentures, as the returns there are the higher than those available on government-backed paper. But there is also the risk of default–a company could fail to service its debt obligations.
Gilt funds
They invest only in government securities and T-bills–instruments on which repayment of principal and periodic payment of interest is assured by the government. So, unlike income funds, they don’t face the spectre of default on their investments. This element of safety is why, in normal market conditions, gilt funds tend to give marginally lower returns than income funds.
Liquid funds
They invest in money market instruments (duration of up to one year) such as treasury bills, call money, CPs and CDs. Among debt funds, liquid funds are the least volatile. They are ideal for investors seeking low-risk investment avenues to park their short-term surpluses.
The ‘risk’ in debt funds
Although debt funds invest in fixed-income instruments, it doesn’t follow that they are risk-free. Sure, debt funds are insulated from the vagaries of the stock market, and so don’t show the same degree of volatility in their performance as equity funds. Still, they face some inherent risk, namely credit risk, interest rate risk and liquidity risk.
3 Interest rate risk: This is common to all three types of debt funds, and is the prime reason why the NAVs of debt funds don’t show a steady, consistent rise. Interest rate risk arises as a result of the inverse relationship between interest rates and prices of debt securities. Prices of debt securities react to changes in investor perceptions on interest rates in the economy and on the prevelant demand and supply for debt paper.
If interest rates rise, prices of existing debt securities fall to realign themselves with the new market yield. This, in turn, brings down the NAV of a debt fund. On the other hand, if interest rates fall, existing debt securities become more precious, and rise in value, in line with the new market yield. This pushes up the NAVs of debt funds.
4 Credit risk: This throws light on the quality of debt instruments a fund holds. In the case of debt instruments, safety of principal and timely payment of interest is paramount. There is no credit risk attached with government paper, but that is not the case with debt securities issued by companies. The ability of a company to meet its obligations on the debt securities issued by it is determined by the credit rating given to its debt paper.
The higher the credit rating of the instrument, the lower is the chance of the issuer defaulting on the underlying commitments, and vice-versa. A higher-rated debt paper is also normally much more liquid than lower-rated paper. Credit risk is not an issue with gilt funds and liquid funds. Gilt funds invest only in government paper, which are safe. Liquid funds too make a bulk of their investments in avenues that promise a high degree of safety. For income funds, however, credit risk is real, as they invest primarily in corporate paper.
5 Liquidity risk: This refers to the ease with which a security can be sold in the market. While there is brisk trading in government securities and money market instruments, corporate securities aren’t actively traded. More so, when you go down the rating scale–there is little demand for low-rated debt paper. As with credit risk, gilt funds and liquid risk don’t face any liquidity risk. That’s not the case with income funds, though. An income fund that has a big exposure to low-rated debt instruments could find it difficult to raise money when faced with large redemptions.
c) Balanced Fund
The aim of balanced funds is to provide both growth and regular income as such schemes invest both in equities and fixed income securities in the proportion indicated in their offer documents. These are appropriate for investors looking for moderate growth. They generally invest 40-60% in equity and debt instruments. These funds are also affected because of fluctuations in share prices in the stock markets. However, NAVs of such funds are likely to be less volatile compared to pure equity funds.
As the name suggests, balanced funds have an exposure to both equity and debt instruments. They invest in a pre-determined proportion in equity and debt–normally 60:40 in favour of equity. On the risk ladder, they fall somewhere between equity and debt funds, depending on the fund’s debt-equity spilt–the higher the equity holding, the higher the risk. Therefore, they are a good option for investors who would like greater returns than from pure debt, and are willing to take on a little more risk in the process.
d) Money Market or Liquid Fund
These funds are also income funds and their aim is to provide easy liquidity, preservation of capital and moderate income. These schemes invest exclusively in safer short-term instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank call money, government securities, etc. Returns on these schemes fluctuate much less compared to other funds. These funds are appropriate for corporate and individual investors as a means to park their surplus funds for short periods.