The problem with a bull market is that it distorts the picture for investors. Suddenly investors become more 'adventurous' and are willing to take on more risk than what their risk appetite permits for the lure of earning a higher return.

They are unforgiving in their quest for returns and the risk involved is the last thing on their minds. So regular investments like diversified equity funds appear boring and the investor is on the look out for the most 'exciting' investment opportunities.

Over here, we have highlighted 3 categories of equity funds that investors must avoid because the risk�reward proposition usually works against them over the long-term.

Sector funds
Sector funds or sector-specific funds have a mandate to invest in just one sector. In the past, particularly during the TMT (technology/media/telecom) boom in 1999-early 2000, there was a flood of sector funds targeting the technology/software sector. Apart from this, there were already some sector funds in place with the mandate to invest in the FMCG (fast moving consumer goods) and pharma sectors.

While some of these sector funds had their place under the sun, most of them were caught wrong footed when the market rally ran out of steam in March 2000. Sector fund managers soon woke up to the harsh realties of managing single-sector funds.

Speaking of harsh realities, NFO investors were aghast to see their tech fund NAVs lose almost 85 per cent of their value in a matter of a few months. Sample this, K Tech's NAV at one stage dropped to as low as Rs 1.86! Six years after launch, its NAV is yet to see the light of Rs 10 (the price at which units were issued to NFO investors).

On hindsight, investors for their lives could not figure out what made them invest in sector funds. Maybe they should have first checked with their mutual fund agents about the commissions they were making on sector funds or the overseas trip they were promised for meeting their sector fund targets.

While we haven't seen sector funds being launched over the past few years, there is always the danger that investors may take a fancy to them all over again. Our advice - avoid sector funds, unless you have a view on the sector and know exactly when to invest in it and exit from it. Sector funds are high risk investment avenues and over the long term (3-5 years) they rarely outperform well-managed diversified equity funds.

Have sector funds outperformed diversified equity funds over 5 years? Click here to compare any technology, FMCG or pharma fund with Sundaram Growth Fund, one of the more conservatively managed diversified equity funds.

Thematic funds
One learning for AMCs (Asset Management Companies) from the 'sector fund disaster' was that single sector funds are extremely difficult to manage once the rally in that sector fizzles out. Thematic funds were meant to be the solution to that malaise. Thematic funds invest in a theme rather than in a single sector.

So while the fund manager's investment options remained restricted to the theme, he still has several sectors to choose from within that theme. A theme like infrastructure for instance, has several related sectors like cement, steel, capital goods/engineering as also unrelated sectors like banking and finance.

When it comes to stock-picking, this gives the fund manager more flexibility when he is managing a thematic fund as compared to a sector fund.

However, that is not to say that thematic funds make prudent investments. At the end of the day, a theme imposes a restriction on the fund manager and goes against the principle of diversification, the cornerstone of mutual fund investing.

We can't think of a single theme that is so enduring that it will make the fund manager forget every other theme till the time that fund is in existence. When that theme runs out of steam (and it will some day!), the fund manager will wish he was managing a 'true blue' diversified equity fund. The investor will certainly wish for that, even if the fund manager doesn't!

At the risk of being repetitive, our advice to investors is that they should consider investing in well-managed diversified equity funds with established track records rather than invest in the hottest thematic fund. Your diversified equity fund manager will in all likelihood be upto the task of identifying the theme, and the good thing for you is that he will also be able to exit from the theme when it fizzles out. Unfortunately, the 'thematic' fund manager will not have the same luxury.

Aggressively managed funds
Bull markets have a strange effect on fund managers. They entice fund managers into taking on higher risk than they would otherwise have taken on. And in a market rally, higher risk often results in higher gains. How else can you explain equity funds like Taurus The Starshare, that one never hears of otherwise, doing exceptionally well only during a bull run?

We have the answer to that question. It's because the fund manager pursues a no-holds barred investment strategy. He has no qualms about exposing nearly a third of his net assets to a single stock! Nor does he think twice before loading nearly 80% of his assets on the top 10 stocks. When the fund manager is game with taking that kind of risk, it's little wonder if his fund tops the rankings every other week.

But we know how investors can play a lot smarter than that. Consider a well-managed diversified equity fund like Sundaram Growth Fund. This fund is among the more conservatively managed equity funds in the country. It usually never invests more than 5 per cent in a single stock, compared to Taurus The Starshare's 31.9 per cent in its leading stock (as on March 31, 2006). The top 10 stocks in Sundaram Growth Fund usually never exceed 40 per cent of net assets compared to Taurus The Starshare's 77.9 per cent (as on March 31, 2006).

Our benchmark for evaluating the diversification of an equity fund's stock portfolio is to assess the concentration of assets in the top 10 stocks. If the top 10 stocks account for less than 40 per cent of net assets (which is also a global benchmark), the fund is well-diversified in our view. To that end, Sundaram Growth Fund qualifies as a diversified equity fund, but Taurus The Starshare fails to make that grade.

Now we got a question for the investor. Despite all the risky and aggressive investments made by Taurus The Starshare (96.7 per cent NAV appreciation over 1-Yr), why is it that it still cannot outperform Sundaram Growth Fund (96.8 per cent over 1-Yr)? We have taken the last 12 months for comparison because that's the period when we saw stock markets clock the fastest growth in this particular rally. Ideally, it is over this period that Taurus The Starshare's aggressive strategy should have yielded the best results.