The primary objective of making any investment is to earn returns on it and grow your wealth. Returns on investment can either be market-linked or fixed. There are various investment products under different investment categories. For example, direct equity investment like stocks or mutual fund investments are examples of market-linked investments whereas fixed deposits or post office time deposits are popular fixed return investment products.
Equity and Non-Equity Investments
Fixed return instruments, as the name suggests, offer investors a predetermined (fixed) rate of return during the investment tenure. Since fixed return instruments are considered to be safe and secure, they are typically preferred by investors with low-risk appetite.
On the other hand, in the case of market-linked investments such as equity investments, returns are neither fixed nor assured but dependent on the performance of the underlying asset. Market-linked instruments can further be subdivided into two key categories equity investment and non-equity investments. In the case of equity investment, the amount is basically invested in the stocks and equity derivatives of listed and unlisted companies.
A major chunk of non-equity investments is channelled into bonds (government or corporate) as well as a range of money market instruments such as treasury bills, certificate of deposits, commercial papers, repurchase agreements, etc.
Since market movements play a crucial role in the performance of equity investments as well as non-equity investments, these investments feature a significant element of risk. In the following sections, various aspects of investments made into equities will be discussed in greater detail.
Types of Equity Investments
As mentioned in the previous section, equity investments comprise a basket of investment options. Each option has a unique set of risks and rewards. The following are some of the key types of equity investment options available to investors in India.
Shares have been around for over three centuries now (the first was issued by the Dutch East India Company in the early 18th century). Shares are units of partial ownership of the company one has invested in and such investor is called as a shareholder of the company. Profits of the company are ideally distributed in proportion to the shareholding of each investor in the company.
Shares are traded on designated stock markets (exchanges) such as the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) if they belong to listed companies. Shares can belong to unlisted companies too and may be privately exchanged through off-market transactions.
The overall performance of a company along with its comparative performance with respect to its peers impacts the price of its shares either positively or negatively. As long an investor manages to buy at a low price and sell at a higher price, shares can generate profits, if the opposite happens, a loss is incurred.
Though the potential profits are high in case of the equity investments as compared to other investment products, the risks are often equally high. Shares of companies that have assets featuring a higher valuation are termed as large market capitalization (large cap) companies. Smaller companies that have lower capitalization value are designated as mid cap and small cap companies.
Equity Mutual Funds Investment
A mutual fund is an investable fund pooled from multiple investors which invests its corpus in assets like equity or bonds. An equity mutual fund primarily invests its assets in listed market securities. Equity mutual funds are ideally meant for investors who have a limited idea about which stocks to invest in due to either lack of time or knowledge.
An equity investment made through mutual funds features limited exposure to a specific company share and allocates its assets to a number of companies operating in various sectors. Because mutual fund houses create a well-diversified portfolio, individual price movements tend to have only a limited impact on the investment as a whole. But, these investments being market-linked are not completely risk-free either and the rate of returns are not assured.
Apart from diversification, equity mutual funds come with the added advantage of the professional fund management, transparency and ability to regularly invest small amounts through SIP, make equity mutual funds an ideal investment opportunity for investors who have a limited understanding of financial markets.
Futures and Options
Apart from the cash market where equities are bought and sold, an investor can also trade equities in the derivative market. A derivative is a financial security which derives its value from the underlying equity asset. In the derivative market, an investor can either invest in futures or options contracts.
Future and Options (F&O) contracts basically allow the investor to buy or sell the underlying stock at the current price but defer the delivery to a predetermined future date. While in case of a futures contract, both the parties (buyer and seller of the futures contract) are legally obligated to execute the agreement at a specified date, the options contract gives the investor the right but not obligation to execute the agreement as per the agreed price at any time during the contract.
Being a derivative, the performance of thisequity investment is specifically dependant on the performance of the underlying equity i.e. stock or index they are derived from. Essentially, an F&O investor buys units of a futures contract by estimating whether the price/value of the underlying share/index will go up or down in the future. Thus F&O is basically a bet that the investor is making with respect to movements of the underlying asset/index.
F&O contracts can be used by the investor either to earn money by speculating price movements of the underlying stock or to hedge current investments. F&O allows an investor to buy or sell equities of a company in large quantities by just depositing a small amount of margin money. This way, these leveraged products have the potential to earn higher returns as compared to equity. But the higher returns opportunity comes at the cost of higher risk exposure. Additionally, F&O contracts have short expiry dates typically up to 3 months, which makes these unsuitable for long term creation of wealth. It is therefore advisable to tread with caution while dealing with F&O segment.
Arbitrage in the stock market refers to purchasing and selling of the same stock at the same time but on different exchanges to take advantage of price differential opportunity available in different markets.
If as an individual investor, you may find it difficult to spot arbitrage opportunities in the equity market, however, you can invest in arbitrage mutual funds to participate in arbitrage opportunities. Arbitrage funds are a type of equity-oriented hybrid fund that invests in equities, equity derivatives (such as F&O) and various debt/money market instruments that generate returns through simultaneous purchase and sale of the securities to take advantage of price mismatch on different exchanges.
Arbitrage schemes typically invest in equity and derivative market simultaneously. This ensures that the investor makes a profit no matter which way the market moves. It must, however, be pointed out that this type of equity investment strategy often involves very thin net margins from individual transactions after payment of charges such as securities transaction payments have been made.
Since the gains by executing an arbitrage transaction are usually small, arbitrage funds make hundreds of such trades in a day to convert the small gain into a meaningful gain. However, this increases the expense ratio of this investment and reduces the potential returns that an investor can receive from arbitrage funds.
Also Read: Best Arbitrage Funds of 2019
Alternative Investment Funds
Alternative investment funds are a relatively new concept in India for equity investment. As of now, this type of equity investment is tightly regulated in India and only available as an option for only select investor groups. As per the current definition, AIFs are privately held and managed investment fund pooled from domestic or foreign investors including HNIs (High Networth Individuals).
Leading examples of these schemes include hedge funds, angel investment schemes, real estate investment trusts (REITs) and infrastructure funds. These are of course some of the riskiest investments currently available in India with the potential to provide one of the highest returns in the class.
Key Risks Associated with Equity Investment
Every investment which provides market-linked returns is associated with an element of risk. Investment risk basically indicates the possibility of financial loss because of uncertainty involved due to various factors. In the following section, some of the key risks related to investing in equities will be discussed along with common mitigation strategies that mutual fund companies and/or individual investors tend to utilise.
Market risk involves the possibility of investment incurring losses due to market factors. If the financial market is not doing well due to factors such as economic slowdown or other such factors which may impact the overall health of the markets negatively. Market risk is also known as systemic risk as it is broadly dependent on macro factors and therefore, not limited to any particular industry or company. However, different sectors may get affected in different proportion depending on the type of market risk. Since market risk affects all industries, it can only be managed to a certain extent with diversification of the portfolio.
However such systemic risk also provides equity investors with the opportunity to pick up quality stocks at reasonable valuations that can potentially yield high returns in the long term. This is the reason why those who attempt to time markets tend to make lump sum investments during periods of the market slump caused by systemic risk, however, during such periods, downside protection options are limited for existing investors.
Equity mutual funds invest in individual stocks and these stocks may or may not perform according to expectations. This is the essence of performance risk and it affects both individual stocks as well as entire sectors from time to time. Performance risk tends to affect sectoral or thematic funds to the highest degree as they feature portfolios that focus on a specific industry or industries related to a predetermined theme (consumption, healthcare, energy, mining, etc.).
The key strategy that mutual funds employ to mitigate performance risk is diversification ideally across industries, themes and market capitalizations.
For example, in recent times the pharma sector has been facing headwinds due to both domestic as well as global factors which have negatively affected pharma funds, creating pressure of performance risk on such funds.
Liquidity is the ability of a specific investment to be sold at a fair price and in sufficient quantities as and when required by the investor. Equity investments which can be liquidated as and when desired, face the problem of liquidity risk. Liquidity risk can force you to sell your investment at a lower price as compared to the fair market price, especially in case of an emergency. Generally, stocks which are traded in low volumes on stock exchanges are more prone to liquidity risk.
In order to control the illiquidity downside of equity investment, many mutual funds retain the option of investing a portion of their assets in various debt and money market instruments that feature a higher level of liquidity as compared to equities. That said, an equity mutual fund will have to maintain a higher allocation of equities in its portfolio as compared to its debt/money market allocation.
Social, Political and Legislative changes can lead to changes in the performance of a business. For example, if a country promotes its homegrown industry by increasing entry barriers to foreign businesses, those local industries are bound to perform better till the time these entry barriers are removed.
Subsequent to removal of protectionism, this advantage may be lost by the protected businesses which might result in a downward movement of their share price. This type of risk exists in case of many businesses and the only strategy currently implemented with respect to managing this type of risk involves diversification across multiple industries as well as across national borders.
Currency/Exchange Rate Risk
Currency risk which is also referred to as exchange rate risk arises due to exchange rate movements between currencies. Investors having investment exposure to foreign equity markets are prone to face currency risks. Apart from that, such businesses which derive a major part of their earnings from global operations also face an exchange rate risk. For example, businesses belonging to pharma, IT or other export-oriented sectors are likely to face exchange rate risk due to their high exposure to foreign markets.
One common strategy to mitigate this risk is the maintenance of a cash reserve or holding highly liquid assets whose allocation can be increased or decreased in order to offset exchange rate changes or other currency-related risks faced by equity/equity mutual fund scheme investor. Such risk mitigation practices are also known as hedging techniques.
Who Should Make Equity Investments
The first characteristic that an equity investor must have is an ability and willingness to take a risk. Market-linked Investment instruments are not suited to risk-averse individuals. The success of your equity investment depends on the investor’s knowledge and skills. However, investors who are constrained due to the limitation of time and/or adequate knowledge can earn smart returns at moderate risk by investing in equity mutual funds.
The next important characteristic is the ability to stay invested for the long term. Investors need to understand that volatility is a characteristic of equity investment which can lead to substantial swings in valuation terms in the short term. Investors are required to stay put during tough times as in the longer term, equity markets have historically always moved upwards.
Investors aspiring for attractive returns at moderate returns should invest in equity and equity related instruments. If you are not an equity market expert, all you require is to pick a good equity fund for investment, embrace market volatility and stay invested for long term to minimize risk and maximize returns on equity investments.
Also Read: Best Mutual Funds 2019