Q. I am a 33-year-old small business owner. I have been investing in gold ETFs and debt mutual funds for the past many years. I now intend to diversify my portfolio. I wish to understand what business cycle funds are, as the same have been suggested by some of my acquaintances. Please explain what are business cycle funds, their advantages, disadvantages and how they are taxed?
Business cycle funds are a subcategory of thematic mutual funds. Thematic mutual funds are open-ended mutual funds that invest a minimum of 80% of their assets in a specific theme. These funds are equity funds since 80% of their assets are invested in equities and equity-related products of a specific sector or theme.
A thematic fund focuses on a certain opportunity or theme that is expected to perform well in the future due to various factors such as economic growth, demographic changes, technological innovation, etc.
For example, a thematic fund that invests in the infrastructure theme will invest in companies that are involved in building roads, bridges, airports, power plants, etc. Similarly, a thematic fund that invests in the consumption theme will invest in companies that cater to the rising disposable income and spending habits of the Indian consumers.
Business cycle funds
Business cycle funds are a type of mutual fund that invests in different sectors of the economy depending on the stage of the business cycle. The business cycle is the periodic fluctuation of economic activity that consists of four phases: expansion, peak, contraction and trough. Business cycle funds aim to capitalise on the opportunities and risks associated with each phase by adjusting their portfolio allocation accordingly.
For example, during an expansion phase, when the economy is growing and consumer confidence is high, business cycle funds may invest more in cyclical sectors that benefit from increased spending, such as consumer discretionary, industrials and financials.
During a peak phase, when the economy reaches its maximum output and inflationary pressures build up, business cycle funds may invest more in defensive sectors that can maintain their earnings and dividends, such as consumer staples, utilities and health care.
During a contraction phase, when the economy is shrinking and unemployment is rising, business cycle funds may invest more in counter-cyclical sectors that thrive in a downturn, such as technology, communication services and gold.
During a trough phase, when the economy reaches its lowest point and signs of recovery emerge, business cycle funds may invest more in growth sectors that can benefit from the stimulus measures and pent-up demand, such as energy, materials and real estate.
Business cycle funds in India
Business cycle funds are a relatively new concept in India. There are only a few business cycle funds available in the market, and they have not been tested through a full business cycle yet. Therefore, investors should be cautious and do their due diligence before investing in these funds.
Who should invest in business cycle funds?
Business cycle funds are suitable for investors who have a long-term horizon and can tolerate high risk. These funds aim to generate capital appreciation by identifying the sectors that are likely to outperform in a given economic scenario and allocating more money to them.
For example, during an expansion phase, business cycle funds may invest more in cyclical sectors such as banking, infrastructure, consumer discretionary, etc., that benefit from higher demand and growth. During a contraction phase, business cycle funds may invest more in defensive sectors such as FMCG, pharma, IT, etc., that provide stability and resilience in a slowdown.
The advantages of business cycle funds are:
- They can potentially capture the upside potential of different sectors at different times and enhance returns.
- They can potentially reduce the risk of investing in a single sector or theme that may underperform for a long period.
- They can diversify the portfolio across various sectors and reduce the impact of sector-specific shocks.
- They can leverage the expertise of fund managers who have the ability to analyse macroeconomic trends and select the best sectors and stocks.
The disadvantages of business cycle funds are:
- They are highly dependent on the fund manager's ability to time the market and identify the right sectors and stocks.
- They may incur higher costs due to frequent portfolio churning and higher turnover ratio.
- They may face higher volatility due to sector concentration and market fluctuations.
- They may underperform diversified equity funds or index funds in some market conditions.
Taxation of business cycle funds
The taxation of business cycle funds is similar to other equity mutual funds. The gains from these funds are taxed as follows:
- Short-term capital gains (STCG) are taxed at 15% if the units are sold within one year of purchase.
- Long-term capital gains (LTCG) are taxed at 10% if the units are sold after one year of purchase and the gains exceed Rs. 1 lakh in a financial year.
Business cycle funds require active management and frequent rebalancing to capture the changing market conditions. They also typically involve higher costs and risks than diversified equity funds. Investors should understand their own risk appetite and investment horizon before choosing a business cycle fund.
These funds are suitable for investors who have a long-term perspective and can tolerate volatility. They are not suitable for investors who need regular income or capital preservation.
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Note: This is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.