Photo courtesy Adeolu Eletu on Unsplash.
Mutual funds are used by people as an investment option to reach their life goals. The goals can be short-term and long-term. SEBI has categorized the equity funds making it easier for people to understand and invest in them. A person should be aware of the significance of the schemes so that he is able to invest wisely, avoid duplication and diversify his portfolio.
The time horizon and risk factor also come in to picture. The funds may not give good returns in the short term but over a longer time frame, they perform much better than any of the fixed or post office deposits. Since the equity markets are volatile a person should invest in the funds according to his risk profile. The equity schemes are the ones that invest in equities and equity-related instruments. The categorization of the equity fund schemes according to SEBI guidelines is as given below:-
Large Cap Fund:-
The funds that invest a greater part of their corpus in companies having large market capitalization are called the large-cap funds. At least 80% of the investment of the large-cap fund should be in large-cap stocks. Market capitalization decides the risks and the advantages of investing in a company. Large-cap companies have a good track record of generating wealth over a long period of time.
As per SEBI, the large-cap companies are the top 100 companies in ranking according to their market capitalization. The companies are strong financially, having gone through many cycles of boom and recession, and have wide industry recognition. They are for the risk-averse investors and can give moderate returns over a longer time frame of five to seven years. The large-cap companies react mildly to the market volatility and their shares can’t appreciate as fast as the mid-cap or the small-cap companies. The liquidity in these shares is very good as they are widely recognized with plenty of information being available about them, but are quite expensive. Some of the large-cap companies in India are; Reliance Industries Ltd, ITC Ltd, Unilever Ltd, HDFC, Asian Paints, Kotak Mahindra Bank, etc.
Mid Cap Fund:-
The mid-cap funds invest in shares of mid-sized companies. The SEBI guidelines mandate that at least 65% of the investment of the fund should be in mid-cap stocks and the companies from 101-250 rankings in terms of market capitalization come under this category.
Mid-caps have expanded from small caps over a period of time and if they maintain their growth they could become large caps. When the economy grows fast these stocks give better returns than the large caps but when the economy slows these companies and stocks are affected more.
Midcap companies are more volatile as compared to large-cap companies but generate better returns over a period of time as large-cap companies are mature and can’t grow as fast. Compared to the small caps the volatility of midcap stocks is less. It is good to have an investment horizon of eight to ten years to benefit from the growth of the mid-cap stocks and some of them would become large caps in the future. Some of the midcap stocks in India are; Escorts, Trent, Gujarat Gas, Sundram Fasteners, Deepak Nitrite, Relaxo footwear, etc.
Large & Mid Cap Fund:-
According to the SEBI guidelines a large and Mid-Cap fund has to invest at least 35% of its investment in large-cap stocks and another 35% in mid-cap stocks, and this means that 70% of a person’s money is invested in the top 250 companies in India. As these funds have exposure both in large-cap as well as midcap stocks they can customize themselves to higher risk-return tradeoffs as compared to the large-cap funds. These funds let a person take advantage of the growth of midcap stocks, but are less risky as compared to pure midcap funds due to the presence of large-cap stocks. The funds are suitable for persons with an investment horizon of at least 5 years and are suitable for life’s goals like a child’s education, buying a house, or early retirement.
The small-cap funds have to make at least 65% of the investment in the small-cap stocks. These are the companies that come after the top 250 companies in terms of market capitalization.
The small-cap stocks are risky and volatile in the short term but can provide a much higher return in the long term as compared to the large caps. The small-cap companies grow and become mid-caps and finally if their growth continues become large caps over a number of years or even decades.
During the bull market, the small caps provide good returns but when the market conditions are bad these stocks are significantly affected. Many investors invest in small-cap funds with a short-term investment horizon but it may be noted that this is not right and the small caps require time to grow and give excellent returns. They are for persons with higher risk tolerance.
A person can invest in small-cap stocks with an investment horizon of 7 to 10 years and these funds can help in achieving life goals like children’s higher education, buying a home, or even investing for retirement. Some of the small-cap stocks are; J.K.Paper, Delta Corp, Sobha Ltd., Thyrocare Technologies Ltd. Etc.
The multi-cap funds invest in stocks across the market capitalization i.e. their portfolio consists of large-cap, midcap, and small-cap stocks. They are also referred to as diversified equity funds and the SEBI guidelines say that at least 65% of their portfolio should be in equity and equity-related instruments. The diversification reduces the risk of exposure to few a stocks/sectors and they are less risky as compared to a pure mid-cap or a small-cap fund. A multi-cap fund is considered good for investment as a fund manager can invest across the market spectrum.
An investor having an objective of wealth creation over a long term and moderate risk tolerance should invest in a multi-cap fund. These funds have more risk than a pure large-cap fund which invests only in companies with large market capitalization. Before investing in a multi-cap fund you can check the past performance of the fund manager in other schemes and how he has managed the fund across the market cycles.
Dividend Yield Fund:-
There are many companies in the stock market that share a part of their profits with the shareholders by declaring dividends. Dividend yield mutual funds are the funds that invest in companies that declare high dividends. These are profit-making companies so they are able to declare a good dividend.
A dividend yield fund has to invest in dividend-yielding stocks, with at least 65% of the funds to be invested in stocks. The criteria for the fund manager are to select companies giving high dividend yields. When the share price of a company is high, even a good dividend declared by it may not amount to a high yield so the fund manager will not invest in it.
The dividend yield companies are generally stable so they are good for investors who prefer stability. When investing in a dividend yield fund see the performance of the fund across the market cycles. Look for a fund that has a higher allocation for large-cap stocks if you want lower volatility, and the corpus size of the fund should be reasonable and not too small.
The value fund invests in stocks that are undervalued in price based on their fundamentals and 65% of the portfolio should be in such stocks. These are well-established companies that appear to be undervalued over a period of time and are good dividend-paying companies. Once the market realizes the true value of these stocks the price of the stock increases, resulting in gains to the investor or the fund. The persons investing in this fund should have a long-term horizon as the stock may take a long time in reaching its intrinsic value.
Before investing in a value fund an investor should study how the fund has performed across the market cycles and the investment horizon of the person should be at least 5 years. A fund that invests across sectors and the market caps would be a good option. This is one of the ways of diversifying the mutual fund portfolio along with investing in the growth sectors.
The contra fund follows a contrarian investment strategy with at least 65% in such stocks. The fund managers of these schemes have a contrarian view and invest in stocks that are depressed at that time. This is against- the-wind kind of investing style. In the stock market, people often follow a herd mentality; their investment is devoid of a rational basis and avoid some stocks due to the short-term triggers. This results in mispricing and the contrarian fund manager invests in such stocks thereby trying to make massive gains. The portfolio of a contra fund has defensive and beaten-down stocks that have given negative returns during a bear market.
Both the value and Contra funds are different and a fund house can offer either value or contra fund, but not both. Value stocks are currently undervalued but have good fundamentals while contra funds select sectors or stocks that are underperforming due to short-term concerns. The thinking is that the asset will come to its real value once the short-term concerns get mitigated. An investor should invest in a contra fund if he can stay invested for 3-5 years.
A focused fund invests in a limited number of stocks and as per the SEBI guidelines, it can invest in a maximum of 30 stocks. These funds can invest in stocks of any market capitalization; be it large caps, midcaps, or small caps. The aim of these funds is to deliver maximum returns by investing in well-performing assets.
The focused funds are also called ‘concentrated funds’ or ‘under diversified funds’. These funds are for individuals who can tolerate high risk. There are a limited number of stocks in the portfolio and the fund manager bets on stocks which he thinks can provide high returns. Sometimes even one or two stocks not performing well can alter the result.
The fund managers investing in this fund invest in equities after doing research in great detail, trying to bring high returns to the investors. When the markets are polarized, which means only a few stocks are propelling the market, and most of the stocks are not participating these funds can give high returns. A person thinking of investing in focused funds should have a time horizon of at least 5 years.
Sector-specific funds invest in one particular sector of the economy like banking, infrastructure, pharmaceuticals, information technology, real estate, utility, etc. The investment should be at least 80% in stocks of a particular sector. The returns from these funds can be very high when the sector of an economy is growing very fast, but when the sector is out of favor for a period of time the returns are very poor. Before investing in a sectoral fund an investor should try to gain good knowledge about the sector and should limit the investment of this fund to 5-10% of the portfolio. Timing is very important in these funds and a person should have an investment horizon of at least 5 years before investing in this fund.
Thematic funds invest in stocks of companies that follow a particular theme and as per SEBI the investment in a particular theme should be 80% of the total assets. Like if a fund follows the ESG theme it will invest in stocks of companies performing well on the ESG (environment, social, and governance) front and could invest across sectors like FMCG, financial services, IT, consumer durables, etc. These are more diversified than the sectoral funds so they have less risk as compared to the sectoral funds. When the mutual fund gets the theme right it can generate market-beating returns. The investment horizon of a person investing in these funds should be at least 5 years.
Persons looking for tax savings as well as generating wealth can invest in these funds. ELSS funds invest at least 80% in stocks in accordance with the Equity-linked saving scheme 2005, notified by the finance ministry. They are also called tax saving schemes and are eligible for deduction under section 80C of the income tax act up to Rs. 1.5 lakh. The ELSS funds have a mandatory lock-in period of 3 years and at the end of the 3 years tenure would be eligible for long-term capital gains (LTCG) tax at the rate of 10% if the income is above Rs 1 lakh.
The ELSS funds can invest across sectors, themes, and market capitalizations. A person should be prepared to be invested in these funds for 5 to 7 years where they can recover from any short-term equity losses.
There are many equity funds available in the market and an investor should be well aware of the schemes before making any investment. Help and recommendation of a financial advisor can be taken if a person is a new investor, and the risk profile and time horizon have to be taken into account. A person can create wealth over a longer time horizon when he invests in equity mutual funds.