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Is it viable to invest in equity funds? Dhirendra Kumar looks for an answer keeping in mind the Budget implications

Now where do I put my money?” asks Mukesh Khanna, a Mumbai-based entrepreneur. Many investors like Khanna will have to rethink their strategy for making investments, courtesy Yashwant Sinha. The Union Budget 2002 has some serious implications for a tax-paying investor. Although dividend distribution tax on funds has been abolished, the dividend is no longer a tax-free income in the hands of investors. Henceforth, dividends will be taxed at the marginal rates of taxation applicable to the investors. A considerable hike for investors in the higher income tax brackets. Further, equity funds have been brought under the tax net. Dividends of equity funds will now be charged at a flat rate of 10 per cent.

At the first instance, it appears that the current Budget announcements have rendered mutual funds an undesirable investment option. But the way out is a switch to the growth option as against the dividend option of the funds. This saves the investor from the nuisance of a dividend tax. At the same time, the investor can continue to have a steady source of income via the Systematic Withdrawal Plans (SWP) of the growth options of these funds. However, equity funds continue to be significant for long-term investors for reasons more than one.

Making The Right Choice
Before moving any further, let me present a case for equities as for most investors who boarded an equity fund early last year, things look depressing. And the follow-up is the fight to safety, clearly reflected in the preference for fixed income alternatives. This preference shift is understandable, but may not necessarily be correct.

Equity is a volatile asset class. But volatility and performance over a brief period may not be a risk. Measuring performance and the ups and downs of an asset - its price volatility - over a period of one or two years can be misleading, when as an investor you have a time horizon that can be as long as 10 or 20 years. In this context, the most compelling risk we all face is inflation. The ups and downs of stock or bond prices pale against the slow (and sometimes rapid) loss of purchasing power.

The Risk Factor
What we really have is existential risk, the risk that inflation and taxes will erode the purchasing power of our savings. A realistic definition of risk should measure investments in two ways - the probability that the investments you choose will preserve your capital over the investment time frame and the probability that the investments you select will outperform alternative investments for the period.

In this context, equity may not be the highest risk investment. It will be investment in cash, bonds and bond funds, which are most likely to lose purchasing power over time. By investing your long-term savings in fixed-income option, your greatest risk may be not taking one with equities, as no other security class can match the long-run returns available from stocks. And the diversified equity funds still hold promise. They reduce your risk and diversify your portfolio. Simply put, these funds build a portfolio of stocks, chosen from various sectors and reduce the risk associated with a particular industry.

Diversity Is The Key
For the uninitiated, diversified equity funds could also be the stepping stone into the world of equities. The portfolio of a diversified equity fund includes securities that are not affected by the same set of variables.

For instance, information technology, pharmaceuticals, consumer goods, cement and aluminium are completely different businesses. Depending on the economy, the trick is to find stocks that do not move in tandem at the same time.

Beware of funds concentrated in few sectors. Don’t count on them as sectors rotate. And they usually make their most abrupt changes just when investors have concluded that a new permanent order has set in. The best way to avoid being caught in rotation is to stay diversified - and to rebalance. Hence, it is important to pick up a truly diversified, yet actively managed equity fund. An actively managed fund will also ride the opportunities thrown up by a particular sector while being prudent with its exposure limits.

The Right Strategy
Diversified equity funds are vehicles for long-term wealth creation, spanning over at least five years and more. Hence, before jumping onto the equity fund wagon consider your objective and the time you have. Then evaluate the fund investment strategy. This is easily decoded with the fund’s sector allocation. After taking into account the return consistency, the allocation to various sectors and stocks, you would have a fair indication of the fund’s diversification. And if the fund changes its investment strategy during your stay, one should reconsider whether the realigned strategy is within your comfort level.

My take from diversified equity funds includes Kothair Pioneer Bluechip, Sundaram Growth and Zurich India Capital Builder for being truly diversified.

(Value Research)