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Continued from previous issue
We discussed about equity funds at large and then the passive
funds that intend to offer average returns. Let us now move on
to the actively managed funds where the fund managers take a
certain position in order to outperform the market averages. Let
me begin with a popular myth that prevails in the market. The
popular belief is that the presence of an expert fund manager
means that the fund should be able to beat the market averages.
Whereas this sounds very logical, as we had seen in the last
article, there are certain cost handicaps that the fund manager
has to counter. However, there is still a whole industry that
thrives on the attempts to beat the market averages (we have
been referring to the market index as the market average). While
the public at large attributes the occasional out performance by
a fund manager to their skill, most fund managers know that they
can do so only by taking certain high risks. These risks are
related to concentration, size, credit or liquidity. In one of
the earlier articles, we learnt about the benefits of
diversification. The possibility of all the components of the
portfolio losing out simultaneously is low – that is the
principle behind diversification. However, the flip side is that
the possibility of all the components gaining at the same time
is also low and that at all times, there will be some components
that will under perform the others in the portfolio. This is
exactly where a fund manager would attempt to segregate winners
and losers from among the listed stocks. He will buy the winners
and stay away from the losers thus outperforming the market.
However, this reduces the amount of diversification that one
would have otherwise got. This concentration has the potential
to generate superior returns, but at the same time it carries
the risk of the fund manager's decision being wrong. |
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One
of the concentration strategies is "stock selection" or to select
stocks based on research as explained above to pick up those
stocks, which are likely to do well in the future. The portfolio
manager would then construct a portfolio of a number of stocks. He
may buy as few as 20 stocks and as many as 200 stocks or any
number in between. There are various different approaches to the
stock selection process:
Some conduct fundamental analysis, which is the study of the
balance sheet and profit & loss account of the company. The
analysts study the business soundness,
cash flows and profit margins to arrive at a proper price to buy
or sell the stock. In the analyst language, this is called
fundamental analysis.
Some look at the historical price patterns and volume of
trading in the stock. They give a low priority to the fundamental
analysis as mentioned above. Instead they try to predict the near
term price movement or price target based on how the price and
volume have behaved. This is also known as technical analysis. |
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 The other form of concentration is to segregate the market as per
the size of the companies - so you have funds investing in stocks
of large companies or mid-sized
companies or small companies. Another approach is to invest in a
single industry or few industries. Based on the above classifications, we have the following types
of funds:
Large cap funds: These invest in the stocks of some of the largest
companies, e.g. State Bank of India. The large companies generally
have a better business model and hence are expected to give stable stock performance with lower
risk.
Mid-cap funds: These invest in the stocks of some of the
mid-sized companies. These companies carry higher risk compared to the large companies.
However, at the same time, these companies also have the potential
to become large companies some time in the future thus multiplying the investor wealth.
Sector funds: Some investors may feel that at the time of
investing, a certain industry or a group of industries may be more
promising than the broader market. They may want to ignore the principle of
"Do not put all your eggs in
one basket" and instead follow the principle of "Put all your eggs
in one basket and then watch the basket carefully". This is a risky approach.
All these approaches may result in superior performance. However,
the sector or stock performance is quite cyclical, which leads to
the various strategies rewarding
the investors at different points in time. Having looked at the
equity funds, we will start looking at the fixed income funds. |
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To be continued
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Amit Trivedi
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The author runs Karmayog
Knowledge Academy. The views expressed are his personal opinions.
He can be reached at karmayog.
knowledge@gmail.com |
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