In the previous blogs we walked you through some of the factors that you should be taking into consideration when choosing a mutual fund to invest in. It is equally crucial to understand the importance of choosing the right type of fund to dedicate your money to so you end up with the best investment plan with high returns.
Up until 2018, funds had the freedom to move around categories when they saw the opportunity, making it difficult for investors to evaluate mutual fund schemes. In order to address this problem, the Securities and Exchange Board of India (SEBI) set up the Mutual Fund Advisory Committee to issue the scheme of classification of mutual funds. The committee classified the schemes in five categories namely: Equity, Debt, Hybrid, Solution Oriented and Others. If you want to know a little bit more about these, go through our Beginner’s Guide to Investment.
It is imperative to realize that we are mostly covering the type of equity mutual funds and that each fund assumes different levels of risk since these funds invest in the stocks and shares of companies on the stock market and returns are dependent on how these stocks perform. The companies that mutual funds invest in are classified by the SEBI as per their market capitalization (the value of a company’s shares in the market) as large-cap (high market value), mid-cap and small-cap (low market value).
Thereafter, mutual funds are classified into different categories based on how much of their corpus is invested in certain classes of companies or based on investment behaviour. Here are the many classifications of equity mutual funds to be aware of when you are looking to invest:
1. Large-cap mutual funds: The equity funds which invest a bigger chunk of their assets in companies or institutions with a large market capitalization. Here large capitalization means companies having a sizable market presence with a long and healthy track record of creating wealth for investors. These are lower risk schemes and are the best option for investors who are risk averse in nature and want an option of safe investment. This option proves to be safe because large corporations generally tend to withstand market fluctuations and slowdowns.
2. Mid-cap mutual funds: We have seen the effect market capitalization can have on returns generated. Mid-cap funds target companies which are generally ranked between 101 and 250 in market capitalization to invest their corpus. This means the companies are relatively more volatile than large-cap companies but more stable than small-cap companies. These schemes are better suited for investors with a higher risk appetite in order to gain higher than average returns.
3. Small-cap funds: These funds invest at least 80% of their corpus into small-cap companies. Small-cap companies rank higher than 250 in terms of market capitalization. Think of a company’s SEBI ranking like competitive examination ranks; the higher the rank, the higher the risk. Even the slightest fluctuations in the market can have astounding impacts on the corpus, hence these schemes are best suited for investors with high risk appetites who are looking for high returns and look for high scope of growth. That aside, we still believe that this is an extremely risky investment choice and one that is best made under the supervision of a financial advisor, if at all.
4. Multi-cap funds: These schemes are a hybrid of investments into large, mid and small cap companies, where the corpus is divided to create different proportions of investment into each type of company. This is one of the best options for risk neutral individuals who want to generate wealth and diversify their investment portfolio simultaneously (which new investors should definitely aim for; read about why portfolio diversification is a must).
5. Equity Linked Saving Scheme funds: ELSS funds are some of the most sought after mutual funds since they offer a tax exemption limit of Rs 1.5 Lakhs under Sec 80C. With a lock-in period of three years, the actual earnings from these funds are Long Term Capital Gains, which are taxed at 10% and have an exemption limit of Rs. 1 Lakh. These schemes are incredibly attractive for tax benefits and are useful for long term financial planning.
6. Dividend yield funds: Dividends (money paid out by companies from its profits to shareholders) are one of the most attractive and fruitful features of investing in equity. The companies which are invested in by these funds are known to roll out high dividends since they generate good profits and have a good track record of wealth creation. These funds are best suited to investors who want good returns and are willing to invest in reputed companies, where the sole driver is the value of the dividend.
7. Sector funds: These schemes are sector specific, meaning the money is invested in a specific segment or industry, irrespective of varying market capitalization or classes of securities involved, like real estate, natural resources, technology to name a few. These schemes are best for investors who want a diversified portfolio from a single sector or segment.
8. Contra funds: A contra mutual fund invests against the existing market trends and purchases stocks which are not performing well currently. The fund manager takes a contrarian view of the stock when it is shunned by investors as well as when there is demand for the same. Both over-performance and under-performance leads to a distorted value of the assets, which the fund manager then tries to capitalize on. The core belief is that any exorbitant price of an asset will eventually normalize in the long-term once the existing triggers are mitigated. Given that, it is not an investment choice for the faint hearted.
9. Value funds: Many seasoned investors swear by a combination of growth and value investing as a method of generating wealth. However, finding the right stocks and purchasing them at the right time requires a lot of effort and awareness of the market. Such funds calculate the intrinsic value of a company based on financials, business model, competitive position, management, etc. If the company’s market value is less than its intrinsic value, it is considered to have ‘value’ (worth investing in). These funds are good choices for investors who have prior knowledge and understanding of the market and not ideal for new investors.
10. Focus funds: Focus funds are a category of mutual funds that invest in a smaller variety of stocks in smaller numbers (the maximum being 30). With this investment scheme, the funds are concentrated on limited variation from very few sectors, instead of a diverse range of stocks with varying market capitalizations. The principal behind the strategy of such funds is to deliver maximum returns by investing mostly in extremely high performing assets.
Each of the classifications outlined above serve a certain investment objective but they might not be necessarily aligned with your own. Do ensure that you’re researching on your own when choosing a mutual fund to invest in to ensure that it will generate the kind of returns you need based on your budget and as part of your long-term financial plans.
We highly recommend that you consult with a financial consultant before you invest.