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How exactly does an equity fund invest your money

07 Jul 2023

Most of us are aware that equity mutual funds pool monies from thousands of investors and then invest the money in the stock market. But managing such a large quantum of money cannot be done randomly. There has to be a clear cut process that is adopted to invest the monies. Let us look how the process of investing in equity mutual funds works. Here we understand the mutual fund investment process and the mutual funds working process. Here is how to go about it!

Identify the sectoral mix for investment

The first step is to identify the sectoral mix of investments. If it is a sectoral fund or thematic fund then the task is a lot simpler. Normally, equity funds in India are diversified and hence they have a large universe of stocks to invest in. The first step is to get the sectoral allocation right. Normally, diversified funds try to benchmark their sectoral allocation to the Nifty and then tweak it for generating alpha. For example, if the Nifty has 35% exposure to the BFSI sector then the diversified cannot be too far away from that number. Once the sectoral mix is decided, it is normally approved by a formal Investment Committee.

Identify the stocks to invest in

Once the sectors are identified, the next step is to focus on the specific stocks. Here, funds typically adopt a bottom-up approach. The allocation to stocks is based more on company specific research. That is where institutional brokers come into play. They give the fund managers stock ideas with justifications and a colour of flows. Once the short list of stocks is prepared, it is once again approved by the Investment Committee. Quite often, the fund management team will also rely on the power of technicals to help them time their entry better. After all, when you are managing a huge corpus, then even a few basis points difference in the level of entry can make a difference.

Ratify the investment with macro themes

Investment in stocks can never be a stand-alone activity. For example, even if you have identified the right stocks to invest, the question of macros arise. Should the fund invest in stocks when the RBI is about to hike interest rates? Should the fund buy stocks when inflation is going up? Should the fund wait for lower levels if it is expecting the GDP and IIP numbers to be weaker? These are some of the macro variables that must be flagged before the investment decision.

Avoiding sectoral and thematic concentration

The key here is to avoid thematic concentration. For example, your asset mix may make your portfolio vulnerable to certain macro shifts. For example, if your fund portfolio is heavy on industrials then they largely depend on the revival of the capital investment cycle. Similarly, banks, autos and realty are all dependent on low interest rates to be profitable. When rates are rising, all these interest rate sensitives are exposure to risk. The same rule applies to commodities, which are normally subservient to industrial demand. The fund will also check that it is not vulnerable to any major themes playing out negatively.

Keeping liquidity available in the fund

Last, but not the least, the fund needs to keep liquidity on hand. Normally, the cash in the fund ranges from 4% to 8% depending on the need for liquidity and the investment opportunities in the market. A high cash ratio is normally considered inefficient. But some cash is required to take care of any redemption pressures that the fund may face. Typically, out of every Rs.100 that the fund collects, Rs. 2.50 goes towards the Total Expense Ratio and Rs.6.00 goes on liquidity maintenance. It is only the residual amount that the fund actually gets to invest.

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