Equity Mutual Funds

The Path to Wealth Creation

‘We spoke about the fact that Equity funds have the highest risk but can also provide the highest returns over the medium-to-long-term horizon. Hence they can be the ideal vehicle for wealth creation for patient long-term investors.

Let’s start with the simplest funds first. And those would be Index Funds and ETFs.’ Siddharth started.

Index Funds and ETFs

‘Warren Buffett, the famous investor, has said  - A low-cost index fund is the most sensible equity investment for the great majority of investors. By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals.

Now that’s especially true in developed markets like the USA where the equity markets have matured and fund managers find it difficult to perform better than the overall market. But it may not hold in emerging markets like India where the equity markets are still inefficient and fund managers still have a chance to beat the market performance.’

‘But what exactly are index funds?’

‘Index funds are just a basket of stocks that represent a broad market. In the case of a Nifty 50 index fund, you're buying a small piece of the 50 largest publicly traded companies in India.’

‘What is the advantage of buying an index fund?’

‘It results in automatic diversification, which minimizes your overall risk. Importantly, there's no market timing or individual stock picking involved — the fund simply tracks the performance of the stock index. So, it is ideal for investors to invest small amounts slowly over a long period of time. This is known as dollar-cost averaging and it’s a sound strategy for most long-term investors.’

‘I’ve heard that they have lower fees than other Mutual Funds. Is that correct?’

‘Yes, you are right. Investors save on fees. Here, we are referring to a fund's expense ratio, or the fee you pay the fund house to manage your investments, expressed as a percentage of your total funds being managed. For example, if you invest in an index fund with a 0.5% expense ratio, the expense will take Rs 5 for every Rs 1,000 of your total assets annually. This is typically lower than what other mutual funds charge.’

‘How is it possible for index funds to charge lower fees?’

‘They are designed to be passive, i.e. just replicate the index, so they don't require much attention from fund managers. Hence, they can charge lower fees and make investing financially accessible to the masses.

However, as I mentioned earlier, investing only in index funds may not be the best idea in India. Do you know why?’ asked Siddharth.

‘Because we still have good investment opportunities in companies that are not in the index,’ a young man volunteered.

‘Excellent. That’s one of the key reasons. India has a long runway for growth. So, fund managers can invest in companies which have good growth prospects but are not in the index yet. There’s a good chance that such companies will perform well and may get included in the index one day. So returns can be higher.

Another reason is that Indian markets are still inefficient. What that means is that valuations of companies may not always reflect their intrinsic value. So, it’s possible that the companies in the index may be overvalued at some point in time while the rest of the companies may be undervalued. Hence it may be better to invest in the non-index companies rather than in the index as returns can be higher.

The chart below summarizes the pros and cons of Index Funds:

‘We’ve also heard of ETFs. What are they?’

‘ETFs are Exchange Traded Funds. Basically, they are based on an underlying index like the Nifty 50 index. Their advantage is that can be traded any time like stocks and their expenses are much lower than the corresponding Index funds. So, you can invest in the Nifty 50 ETF instead of the Nifty 50 Index Fund.

‘Are there any disadvantages of ETFs?’

‘Yes, keep in mind that ETFs are still at a nascent stage in India currently and may not be very liquid. So, you may end up paying more in terms of transaction costs.’

‘Next, let’s look at Largecap Funds.’

Largecap Funds

‘Let’s do an exercise right now,’ Siddharth told the audience, ‘Name some household products you all use every day.’

‘Colgate toothpaste, Dove soap, Pantene shampoo, Fortune oil, Parachute, Harpic, Lyzol, Rin, Ariel, Fevicol, Asian Paints’ the audience rattled out such names.

‘Excellent. Do you know which companies manufacture these products?’

‘Hindustan Unilever, ITC, Colgate, Dabur, Godrej, Asian Paints, Pidilite,’ the audience members yelled out.

‘Great. Now which are some of the IT companies whose names you know?’

‘TCS, Infosys, Wipro.’

‘And what about banks and Financial Services companies?’

‘HDFC Bank, ICICI Bank, Bajaj Finance.’

‘I am impressed to see that you all are well aware of these names. As you know, these are some of the largest companies in India. They are highly reputed companies with the best corporate governance practices. They have an excellent track record of generating wealth for their investors over long periods. I am sure all of us have heard of folks who have made a fortune by investing in Infosys and TCS in the 1990s or in HDFC Bank in the last decade.’

‘Yes, my neighbour bought his flat with the profits he made from his Infosys stock,’ one of the attendees said.

‘Great. Don’t you wish you also had a small ownership in these bluechip companies which have lower risk but which give steady returns. Largecap mutual funds serve this purpose. They are equity funds which invest a bigger proportion of their total assets in such large companies which fall in the top 100 companies according to market capitalization (market value of the company’s outstanding shares). Hence, largecap funds are able to better withstand a slowdown in the markets, generate regular dividends, and provide steady compounding of wealth. They carry a lower risk as compared to other types of funds and are known to generate steadier returns.

In the long-term (around five to seven years), large-cap funds tend to offer good capital appreciation, even though the returns may be lower compared to mid-cap or small-cap funds. Hence, they are a good option for investors with relatively lower risk appetite and a long-term investment horizon.

‘Next, let’s look at Midcap and Smallcap Funds….’