Our focus today will be more on the broad types of mutual funds. We look at the 3 broad classifications of equity, debt and hybrids and how it fits into an individual’s financial plan.
An equity fund invests more than 65% of its corpus in equities. All other funds are classified as non-equity funds. The idea of an equity fund is to compound wealth over the long term through a diversified approach to equity investing. Broadly, equity funds can be classified into Diversified and Focused Funds.
The core focus of equity investing is diversification of risk. Broadly, there are 3 types of diversified funds and here is how they fit in.
- Large cap funds create a portfolio of established blue chip names. Here the skill of the fund manager lies in generating alpha by timing the cycle right. These funds are suitable for investors who want to create wealth in the long run with reasonable levels of risk.
- Multi-cap funds are diversified across capitalizations. They add alpha to the portfolio by investing in mid cap stocks too. Since these stocks entail a higher level of risk, this is best suited to investors looking to grow money and willing to take a higher level of risk.
- Index funds are passive funds with the portfolio tracking the index. There are index products like ETFs where the expense ratio (TER) is 200 bps lower than active equity funds. Index ETFs can constitute up to 25% of the diversified portfolio.
Focused funds are in contrast to diversified funds, and hence, they are more risky. They bet on a narrow theme or a few sectors and portfolio returns are dependent on the performance of these sectors. Here are 3 types of focused funds.
- Sector funds are focused on one or two sectors or industry groups. Many of these sector funds can be highly risky although they promise higher returns in an up cycle.
- A slight variant of sector funds are thematic funds. Themes are a collection of sector. For example, rate sensitivity can be a theme and this would include sectors like banking, NBFCs, autos and real estate as all are vulnerable to rate movements.
- Mid cap and small cap funds are high risk funds that offer higher growth potential but run the risk of volatility as well as liquidity risks. Focused funds must not be more than 20% of your overall equity fund allocation.
Debt funds invest in fixed income instruments and can be classified based on duration and credit quality. Debt funds are essential for any portfolio to give stability and regular income. Normally, the proportion of debt increases with age and risk aversion.
- Long duration funds benefit when rates are going down but lose out when rates are moving up. These are complex calculations and active calls on duration are best avoided.
- Credit quality is a lot simpler. G-Sec funds are safest but the yields are much lower. Investors can get better returns by opting for income funds that also invest in corporate and institutional debt. There are credit risk funds that invest in AA rated debt and structures to enhance returns. Since the purpose of debt funds is stability it is best to stick to safety.
As the name suggests, hybrid funds are a combination of equity and debt. These hybrid funds come in 3 categories.
- Balanced funds combine equity and debt in different proportions based on the risk appetite of the customer and range from 80:20 to 20:80.
- Arbitrage funds combine equity and equity futures in a long/short combination. Returns are at par with debt funds but equity makes it tax efficient.
- Dynamic funds give the discretion to the fund manager of debt / equity mix and can give higher returns but also entail risk of individual bias.