Different Types of Mutual Funds and What They Mean for Investor

In the previous article we looked at what are Mutual Funds and whom they are suitable for. In this section we will focus on the various types of Mutual Funds which can be categorised as follows:

Based On Asset Class:

1. 1. Equity Funds

Equity funds primarily invest in stocks. The pooled money is invested into stocks of different companies and the gains and losses associated with these funds depend on how the invested shares perform. Equity funds are considered to have the highest potential to generate returns over a significant period through capital gains. Hence, the risk associated with these funds also tends to be higher. Thus, these funds are best suitable for investors seeking to maximise gains over a period of time and are willing to accept higher risk to do so.

1. 1. Debt Funds

Debt funds invest primarily in fixed-income securities such as bonds, securities and treasury bills. Since the investments come with a fixed interest rate and maturity date, it can be a great option for passive investors looking for regular income (interest and capital appreciation) with minimal risks. They have a low-risk-low-return outlook and are ideal for investors with a low risk appetite looking at generating a steady income. However, they are subject to credit risk.

1. 1. Money Market Funds

These funds invest in short-term debt instruments, looking to give a reasonable return to investors over a short period of time. These funds are suitable for investors with a low risk appetite who are looking at parking their surplus funds over a short-term. These are an alternative to putting money in a savings bank account.

1. 1. Hybrid Funds

As the name suggests, hybrid funds (Balanced Funds) is a mix of bonds and stocks, thereby bridging the gap between equity funds and debt funds. The ratio can either be variable or fixed. In short, it takes the best of two mutual funds by distributing, say, 70% of assets in stocks and the rest in bonds or vice versa. Hybrid funds are suitable for investors looking to take more risks for ‘debt plus returns’ benefit rather than sticking to lower but steady income schemes.

Now that we have a broad understanding of the various types of funds based on asset class, we can begin to look at types of funds within the asset class. As mentioned in the previous article we will mainly be focusing on equity funds.

Types of Equity Funds:

We will now spend some time understanding the most common types of equity funds. To aid investors, and to simplify the investment process, SEBI has recently come up with regulations on the categorisation and reclassification of mutual funds. To do so, SEBI mandated that a Mutual Fund Company can now only have one scheme in each category (previously these companies would have multiple schemes in the same category causing considerable confusion). Also SEBI has enforced a standard methodology to categorise schemes to ensure schemes are now true to label.

1. 1. Large Cap Funds

Large cap funds are funds which invest in well established companies in the equity market. SEBI has defined large caps as the top 100 companies in terms of market capitalisation. The market cap of these companies is usually in excess of 20,000 crores. Due to their large size and well established presence, these companies provide greater liquidity than smaller companies and are usually subject to less volatility. However, their growth potential is usually lower than those of smaller companies. Hence, large cap funds are more suitable for investors looking at good stability on their return on investment over a period of time. A quick look at various fund category returns tells us that on average, as on 31^st December 2020, the top 10 large cap funds by AUM have delivered a 12.8% 1 year return and a 7.3%, 11.4% and 10.7% return for the 3 year, 5year and 10 year periods respectively.

1. 1. Mid Cap Funds

Mid Cap companies are companies whose market cap is above Rs. 5,000 Cr. but less than Rs. 20,000 Cr. SEBI has defined mid cap companies as the 101^st – 250^th companies in terms of market capitalisation. Stocks of mid cap companies are more volatile than large cap companies and hence riskier. However, these companies also have the ability to turn into large caps over time thus offering a higher growth potential to investors. Hence, the return and risk potential of Mid Cap Funds are higher than large cap funds but lower than small cap funds. Hence, these funds are better suited for investors willing to tolerate a higher volatility in exchange for higher growth potential. A quick look at various fund category returns tells us that on average, as on 31^st December 2020, the 10 largest mid cap funds by AUM have delivered a 22.7% 1 year return and a 4.2%, 11.4% and 13.7% Y-o-Y return for the 3 year, 5year and 10 year periods respectively.

1. 1. Small Cap Funds

Small cap funds invest in Small-cap companies which are those that have a market capitalisation of less than Rs 5,000 crore. SEBI has defined small caps as the 251^st company and lower in terms of market cap. As such companies have greater growth potential but also higher risk, these funds are a great option if an investor is willing to bear a higher level of risk in order to earn higher returns over a period of time. Once again, a look at the average fund category returns for the top 10 largest small cap funds by AUM as on 31^st December 2020, shows us that, over 1 year, small cap funds have delivered a 24.9% return and have delivered Y-o-Y returns of 1.1%, 11.2% and 14.0% over a 1 year, 3 year, 5 year and 10 year period respectively.

1. 1. Multi Cap Funds

These funds invest in stocks across market capitalisations i.e. their portfolio comprises of large cap, mid cap and small cap stocks.  A look at the average fund category returns shows us that for the 1 year ended 31^st December 2020, the top 10 largest multi cap funds by AUM have delivered a 13.4% return and have delivered Y-o-Y returns of 6.5%, 11.0% and 11.2% over a 1 year, 3 year, 5 year and 10 year period respectively. As per latest SEBI guidelines, these funds must allocate at least 25% of their portfolios in large cap, mid cap and small cap stocks respectively. Earlier there were no such guidelines and fund managers had flexibility to allocate portfolio weights across these categories as per their analysis.

1. 1. Sectoral Funds, Thematic Funds and Focused Funds

Sectoral funds invest in stocks of a particular sector e.g. banking, pharma, etc. due to this reason, they are considered riskier investments than funds diversified across various sectors. These funds are hence better suited for more experienced investors who wish to take exposure to a particular sector. Common sectors in this category include Banking, Infrastructure, Pharma etc. Thematic funds invest in stocks of multiple sectors revolving around a determined theme such as Consumption or PSUs etc. once again these are considered as higher risk investments than an average product.

Focused funds are funds which hold a concentrated portfolio of securities. Unlike other equity funds which hold a broad or diversified mix of positions, these funds tend to hold 20-30 companies or less. The idea here is to sacrifice potential diversification benefits in favour of a smaller number of high conviction ideas. As of 31^st December 2020, the 10 largest focused funds by AUM have delivered Y-o-Y returns of 15.3%, 6.7%. 12% and 11.6% for the 1 year, 3 year, 5 year and 10 year period.

1. 1. Equity Linked Savings Scheme (ELSS)

ELSS funds are equity funds are equity oriented schemes which offer tax exemption of up to ₹1.5 lakh under Section 80C of the Income Tax Act.

As the name suggests, an ELSS fund is an equity fund where a major portion of the corpus is invested into equity or equity-related instruments. These funds have a mandatory lock in period of 3 years. The income that you earn at the end of these 3 years will be considered as Long Term Capital Gains and will be taxed at 10%. Gains up to ₹1 lakh are not taxable.

So now, we have an understanding of the various types of equity funds. Needless to say, the selection of a fund must be based on your own objectives and risk tolerance. If you want more stable returns over a long period and minimise volatility, you should probably assign a higher weightage to large cap funds in your portfolio. On the other hand, those wishing to earn potentially higher returns and are willing to bear higher risk may assign a higher weightage to the small and mid-cap theme.

In the next article we will focus on certain terms you will regularly come across while investing in Mutual Funds.

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