Did you know that a category of mutual funds tries to invest in stocks that aim to ride the business cycles and generate reasonable returns?
In this post, we will see what business cycle funds are and whether you should invest in them.
What is business cycle investing?
The business cycle swings in the economy over years, marked by phases of growth followed by downturns. Business cycle investing is an investment strategy that seeks to profit by anticipating and taking advantage of these cycles.
Rather than focusing on the day-to-day ups and downs of the stock market, business cycle investors look for changes in economic conditions that can indicate how the business cycle is shifting. They invest based on these long-term forecasts and manage their portfolios accordingly.
The business cycle refers to periods when the economy experiences periods of strong growth followed by periods of moderate or no growth. It's a natural part of the business cycle that businesses grow quickly during phases of expansion before they run into problems such as competition and over-investment, which causes them to slow down or even stop growing before they expand again.
Investors aware of this pattern can take advantage of it by buying stocks with good potential at bargain prices during downturns and then selling them off at higher prices as they grow through their expansion phase.
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What are business cycle funds?
When we specifically talk about business cycle investing, the economy is divided into four main periods: expansion, peak, contraction and slump.
A business cycle is the movement of the economy through various periods. A few months or several years may pass during the business cycle. Understanding that the economy works best during a boom or expansion period and poorly during a recession is helpful.
A business cycle can be started by changes in interest rates or an increase or decrease in inflation. Many investors find it difficult to estimate when a phase will start or conclude because the length of each phase varies. Economic cycle funds can, however, make money since sector performance varies across the business cycle.
For instance, during the expansion and boom stage, the finance and automotive industries perform well. FMCG and the pharmaceutical sector, on the other hand, are defensive sectors that perform well during a recession.
Fund managers of business cycle funds look for sectors that might see a turnaround during the business cycle. For instance, an expansion phase is appropriate for the infrastructure, capital goods, metals, banks, vehicles, etc. The next step is to choose equities from these sectors that might perform better.
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Benefits of investing in business cycle funds
Potential to gain from first mover advantage
You could invest in business cycle funds if you are trying to gain the first mover advantage. Business cycle funds seek to identify the upcoming market leaders and anticipate changes in the business cycle.
Benefit from global investments
Additionally, business cycle funds might have exposure to overseas investments, which could help you take advantage of global possibilities.
Invest across market cap
Business cycle funds can invest in various industries, market capitalizations, and themes. It enables you to seize opportunities across the market.
Limitations of investing in business cycle funds
Follows top-down approach
Fund managers of diversified equity mutual funds follow a bottom-up approach. They put the importance of the individual stock more than the sector. However, in the case of business cycle funds, it follows a top-up approach. The fund identifies sectors and then picks up stocks in those sectors. If the fund puts your money in the wrong sectors, you could lose money even if the market as a whole is doing well.
Not a new approach
The performance of business cycle funds depends on how well the stages of a business cycle are identified and how the portfolio is divided up. It means that these funds put more money into large-cap stocks when the economy slows down. Also, when the economy is growing, these funds put more money into mid-cap and small-cap stocks. The strategy is not new and is used by many equity funds, including Flexi-cap funds. However, Flexi-cap funds are not mandated to put at least 80% of their portfolios into this theme.
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Who can invest in business cycle funds?
If you are an investor who is knowledgeable about investment topics and the market, you might want to think about business cycle funds. Additionally, you can invest if you understand market timing and have higher risk tolerance.
Moreover, suppose you have already diversified your portfolio. In that case, you can invest a certain percentage of your overall portfolio in business cycle funds to act as a kicker for your portfolio returns.
However, if you are a newbie investor, you should look for diversified funds where the fund manager has complete freedom and the mandate doesn't force them to invest in a particular sector or theme.
Padmaja Choudhury is a freelance financial content writer. With around six years of total experience, mutual funds and personal finance are her focus areas.