While the Securities and Exchange Board of India has done well to identify different mutual fund categories, at times, it can be very difficult for investors to decide which equity mutual fund categories to choose from.
There are close to 40 categories in the Indian mutual funds ecosystem, out of which 12 are equity. On top of that, there are 2 more hybrid funds that invest substantially in equity investments; these are also used as low-risk substitutes for equity funds. In other words, you have a wide variety. And with such a wide variety, comes confusion about what to choose and what to avoid.
To be fair, while every category may have its use cases, all of them are not required by most investors. So which ones to choose? How to identify which equity fund categories to pick schemes from?
Here we discuss category decisions for Balanced to Moderately Aggressive investors, who are fine investing 50-70 percent of their portfolio in equity. Also, it is assumed that such investors are willing to remain invested for at least 5 years (or more) in mutual funds.
Passive Large-cap Index Funds
Every sensible long-term portfolio should have a decent allocation to largecaps. And the most efficient way to include that is via large-cap index funds. The reason for this as I explained in Active vs Passive Largecap Funds is that over the last few years, the number of active large-cap funds that beat the index has reduced. Even the margin of outperformance (for those funds which are able to manage that) has also reduced substantially. So, the lack of consistent outperformance and low costs are the reasons that make a case for simply using index funds for core largecap exposure.
Tip: Use Nifty50, Nifty100 or Sensex-based index funds for your largecap allocation.
Flexicap Funds
Flexicap funds have the flexibility to invest across stocks from different market capitalisation categories without any minimum or maximum restrictions. So, a flexicap fund manager has the freedom to invest any proportion of the fund‘s portfolio in stocks from large-, mid- and smallcaps. This makes these funds a good between having a pure large-cap allocation and a pure mid-smallcap allocation.
Tip: If you are an aggressive investor, then having flexicap funds and skipping largecap funds is acceptable as well. However, having both is not wrong either as you will then have high exposure to largecaps (due to the pure largecap fund and largecap portfolio of the flexicap fund) with a flavour of mid to small caps (via flexicap fund). Do read how to choose between largecap & flexicap funds.
Midcap Funds & Smallcap Funds
Many investors want to invest in standalone midcap funds and smallcap funds when they look at the high returns delivered by these two categories in the recent past. Given their structural nature, smallcap funds are riskier than midcap funds but don’t necessarily give higher returns at all times. Also, they can be a lot more volatile than any other fund category. So, while investing in the midcap fund category is still fine for many, the smallcap fund category is best avoided. Aggressive investors won’t agree with this view but that is fine. Most common people investing in mutual funds aren’t (and shouldn’t be) too aggressive anyway.
Tip: Limit your exposure to these categories to 30-35 percent and also have the patience to stay put for 5-7 years.
Also read | Powering small-cap funds: Stocks in top holding that drive performance
The Others
There are many other equity categories we’ve left out in the above list. Let’s quickly run past them to see if they should be in your portfolio or not:
- Focused fund: A focused fund is not for everyone, as the returns can be quite similar to those of a flexicap fund. Yet for some investors, a focused fund makes sense, but scheme selection is crucial.
- Sector fund: If you choose the wrong theme and invest too early or too late, the returns can be spectacularly bad for sector & thematic funds. So given that it’s a high-risk, high-return kind of bet, it is best avoided.
- Large & midcap fund: This category must invest at least 35 percent in largecap and midcap stocks, while the multicap funds need to have at least 25 percent each in large, mid and smallcap stocks. While this restriction may work well at times, it can also backfire. So flexicap funds are better than these two categories given the freedom it has in this space.
A conservative investor (or rather saver) is one who doesn’t want to invest too much in equities. He may invest just 10-20 percent in equities.
For such investors, things need to be kept simple. Their equity requirements are easily met with largecap index funds (for example Nifty50 Index Funds). This alone is enough. But if they want to explore other categories, then additional flexicap or aggressive hybrid funds can be considered.
That’s it. The investors need to evaluate their requirements first, and then pick fund categories based on their risk appetite and investment horizon.
And beware, just picking the right fund categories will not help. The schemes within each category vary from being good, not-so-good, and really bad. So, you need to be careful while picking funds from the shortlisted categories as well.
Disclaimer: The views expressed above should not be considered professional investment advice or advertisement or otherwise. No specific product/service recommendations have been made and the article itself is for general educational purposes only. The readers are requested to take into consideration all the risk factors including their financial condition and suitability to risk-return profile, and take professional investment advice before investing.
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