The year 2002 was exceptionally good for mutual funds. Most of them performed well during the year both in absolute and relative terms.

Diversified equity funds, on an average, gave 18 per cent returns, while debt funds gave about 15 per cent.

You would have been really unlucky to have lost money in mutuals last year.

Equity fund performance was outstanding and more than 90 per cent of funds outperformed the benchmark index.

So it didn't really matter which fund you invested in. Thanks to the fantastic run last year, fund marketers are tom-tomming the virtues of fund investing.

But hang on, mutual funds are definitely not a sure-shot get-rich strategy. If anything, the going may only get tougher for mutual funds in 2003.

Last year, equity funds managers could beat the index because of a short-term rally in specific quarters of the market.

In the early part of the year, it was PSU stocks, then it was the mid-cap rally. And towards the end of the year, tech and bank stocks were in the limelight. There were also enough opportunities to trade in the market to make profits.

All this, coupled with the fact that the index itself did not make any headway, was one reason why fund managers could give worthwhile returns.

This year analysts expect the index to perform better. So it may not be as easy to better market averages.

On the debt side again, there are already noises that the party may be over soon. The yield on 10-year government paper is already down to less than 6 per cent.

Though the soft bias towards soft rates still continues, fund managers are cautiously optimistic. With every downtick in yields, there is more scepticism.

There are concerns over the fiscal deficit and inflation. If the tension between US and Iraq continues and oil prices rise, the possibility of a spike in interest rates cannot be ruled out.

Moreover, the yield curve is flattening. Simply put, the spread between longer papers and those with short maturity is shrinking.

This means that the ability of a fund manager to perk up returns by loading the portfolio with longer issues will be limited. Again, the spread between corporate paper and gilts is diminishing. All this only spells bad news for debt funds.

So if you are a diehard fund investor, where should you put your money?

By conventional logic, financial advisors will tell you that your investments should be based on your age and financial goals.

Agreed. But that does not mean that you can afford to ignore market conditions completely. Whether it be allocating across various categories of funds or choosing a fund from a particular genre, there is no way you can do without being active, if you  want to  maximise returns.

Says Rajat Jain, chief investment officer, IDBI Principal Mutual: "It is important to revamp your portfolio frequently depending on market dynamics."

A passive investor does not really stand a chance to make money today. With the number of mutual funds mushrooming by the day, it will be even more important for investors to choose the right type of fund and the right fund manager.

That's not easy. You have to assess the fund manager's track record, understand his investment philosophy and check if the portfolio is in sync with the stated objectives.

And before putting in money you must be reasonably sure you like the portfolio of stocks or bonds the fund owns.

Evidently, picking up single stocks or bonds is much simpler. But that extra hard work you put to invest in funds can be quite rewarding. As a small investor you have the benefit of diversification.

With as little as Rs 2,000, you can own a blue-chip portfolio which possibly cannot be replicated if you were to invest in the market directly. Here are some kinds of funds that could steal the show this year.

Be active in equities

Actively managed funds will do better this year also. These plain vanilla equity funds invest in a basket of stocks across sectors.

Index funds are a big success in mature markets like the United States, but in India, as also in other developing markets, there is a strong  case for actively managed funds. The main reason is that there are imperfections in the information flow, and professional managers are in a better position to exploit these and profit from them.

"India has always been a bottom-up story and hence it makes sense to invest in actively managed funds," says Samir Arora, chief investment officer, Alliance Capital Mutual Fund.

Seconds Ved Prakash Chaturvedi, chief executive officer, Tata TD Waterhouse Mutual: "Actively managed funds will continue to do well for the next five years at least."

Tasty bites from oil

Oil stocks may dominate stock markets this year. Pitching on the divestment of Hindustan Petroleum and the public offering in Bharat Petroleum, analysts are gung-ho about these stocks. HPCL is already up 35 per cent since December 6, 2002 when the divestment minister said in Parliament that divestment would happen for sure this year.

Analysts from various fund houses have put out reports with a target price of over Rs 500 for HPCL. Though expectations are not as high from BPCL, the general mood is bullish.

Other petro stocks such as Indian Oil Corporation, ONGC and Reliance Industries are also likely to remain buoyant this year.

For Reliance, in fact, there are multiple triggers this year in the form of gains from the gas find, upturn in the petrochemical cycle, upside from its Infocomm project and so on.

Investors should, however, remember that the idea of investing in a petro sector fund should be to capture the event-driven upside. So timing of the investment will be critical.

Bonds with a dash of stocks

Plain vanilla bond funds have had their good times. This year, debt funds with splash of equities may be a better choice.

And that's precisely what you get in the so-called Monthly Income Plans.

The reason is simple. Most analysts and fund managers agree that this year will belong to equities and bonds will face tough times.

At best, bond funds will give returns of about seven  per cent. The advantage with MIP is that a large part of its portfolio is still safe in fixed-income securities, but a small portion is invested in equities which can add a few percentage points to your returns.

The equity component does make these funds gyrate more than a plain debt fund. These funds should be chosen not because of their objective of distributing dividends every month, but because of their asset allocation strategy.

Alternatively, investors can even buy plain debt funds and a small portion of an actively managed diversified equity fund or index fund.

For fixed income

A Fixed Maturity Plan is just a tax efficient fixed-deposit scheme.

This innovative product by the mutual fund industry seeks to minimise the risk associated with bond funds by matching the maturity of the fund with that of the fund portfolio.

In FMPs you don't have the flexibility of withdrawing money when you want it without being charged a penalty for early withdrawal.

An FMP allows you to choose the maturity period as per your requirement and the fund manager invests money in a basket of fixed-income securities in a manner that ensures that the fund's holdings mature exactly when the fund is due for redemption.

This reduces the 'price risk' associated with a debt portfolio. The idea is to minimise the uncertainty in debt fund returns by eliminating price risk.

Timing it better

You are often told that trying to time the market is futile. Not true. In Indian markets timing has proved to be critical historically.

Especially in equity markets, if you invest at higher index levels, the chances of your making decent returns is bleak even in the long run.

There are some mutual fund products which can help you time the market, but scientifically.

Equity: The only way to make money in equities is if you buy low and sell high. Identifying the 'low' and 'high' in equities can be difficult, but Franklin Templeton PE ratio fund claims to provide a solution.

The fund takes the help of the most popular valuation parameter -- the price-earnings (PE) ratio -- to take a view of the market.

The PE ratio can be defined as the ratio of the stock price of a company to its earnings per share. It indicates how financial markets view the company.

The fund has an in-built 'buy-sell' mechanism which is triggered by the PE levels of the target index -- the NSE Nifty. The scheme will change its asset allocation based on the PE ratio band.

The PE band being considered by the fund is 11 to 28 - the range in which the market has been hemmed in for the past five years.

The scheme will automatically balance its asset allocation every month based on the weighted average PE ratios of the stocks of the Nifty index. But this does not eliminate subjectivity completely.

The fund manager still can go wrong in reading major market movements, especially at the peak and trough.

However, the good thing is that the changing asset allocation will ensure that there is some level of profit booking at every stage.

Debt: A dynamic bond fund seeks to vary its asset allocation based on market conditions. In other words, it follows a dynamic asset allocation process. So if the fund manager is very bearish on the market he can liquidate his entire portfolio and hold cash.

And in case of extreme bullishness, he can keep his entire holdings in long duration gilts. The flexibility to alter asset allocation depending upon market conditions is a big advantage.

By moving into cash completely, a fund manager can arrest the fall in net asset value when the market tumbles.

Most plain vanilla debt funds do not have this flexibility because of limitations posed by their offer documents. The only flipside to this is that it leaves a lot to the discretion of the fund manager.

One wrong move can take a heavy toll on the fund's performance.

This is where Standard Chartered's process-driven approach helps minimise risk. Standard Chartered Grindlays Dynamic Bond Fund follows its proprietary 3D approach which captures the market mood based on economic fundamentals, market psychology and market valuations.

This approach lessens subjectivity and has worked well across countries, says Naval Bir Kumar, chief executive officer, Standard Chartered Mutual.

The next big thing

Exchange Traded Funds -- that's the latest equity product gaining popularity globally. After the unprecedented success of index funds in the Unites States, it's  this fine-tuned version of an index fund that's attracting attention.

With investor interest both from the retail segment and the institutions soaring, its assets under management have risen to over $100 billion compared with $465 million when the first ETF hit the market in 1993.

According to year-end statistics, the worldwide statistics ballooned to about $103 billion, an increase of 39 per cent from the previous year.

The number of ETFs more than doubled during 2001 going from 92 to 202 products with 230 listings on exchanges around the world.

ETFs are also index funds, in the sense that they track the chosen index and their portfolio replicates the index. The difference is that ETF's units are bought and sold in stock exchanges and not directly from the mutual fund company.

As against an index fund which is bought and sold at the day's closing net asset value, investors here can get intra-day prices.

The critical difference between ETF and index funds lies in the unique way in which units are created and redeemed. In case of ETFs the number of units on the block keeps on changing.

Instead of a one time initial public offer,  an ETF creates and redeems units continuously through designated institutions called 'authorised participants.'

The net asset value of the ETF, expressed on a per share basis, is the value of the underlying constituents of the benchmark held by the ETF, plus the accrued dividends less the accrued management fee.

Although the price at which an ETF trades is subject to the same supply and demand dynamics of a normal share, the creation and redemption process ensures that the price trades very close to the NAV.

Since ETF shares can be created or redeemed at NAV, a material discrepancy between the trading price of the ETF and its NAV can be arbitraged away. Besides, ETF are like the spot price for the index.

So, like any other stock where there is a possibility of arbitrage between cash and futures market, there is a possibility of arbitrage between the ETFs and index futures.

Since authorised participants exchange a basket of index stocks for an equivalent value of units in the scheme, ETFs have lower tracking errors compared to index funds which accept cash buy stocks from the market.

Similarly, ETFs do not hold any cash like index funds for redemption considerations. Thus tracking errors and expenses for ETFs are significantly lower.

In India, Benchmark Mutual was the first to launch ETFs based on the Nifty called the Nifty BeES. Last week, Prudential ICICI launched an ETF based on the Sensex.

With the convenience and cost savings that ETFs offer, they look like superior alternatives to open-end index funds and index futures.

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