1. How to choose between different categories of equity mutual funds

How to choose between different categories of equity mutual funds

Here is a short description of some of the most popular equity mutual fund categories and how they can suit your financial goals

By: | Updated: February 17, 2016 12:25 PM
mutual fund Midcap mutual funds generate higher returns during bull market phase.

Rahul, a 32-year old marketing professional, is thinking of investing in equities through mutual funds, given that he is looking at more than 5 years’ investment horizon. He is a do-it-yourself kind of person who wants to learn about investment products and manage his own investments.

However, with over 460 equity-oriented mutual funds to choose from and each of which claims to be the best avenue of investing, he is really confused about how to align his financial goals with the investment objectives of equity funds.

Here is a short description of some of the most popular equity mutual fund categories and how they can suit your financial goals:

1. Diversified equity/Multicap/Flexicap funds: These funds do not have any set asset allocation or investment strategy. They are free to invest in any type of companies irrespective of their market capitalisation or industry segments. Depending on the market conditions and liquidity requirements, some of these funds may also invest a part of their portfolio in debt and money market instruments. As the portfolios of these funds are well-diversified, the risk to investments is lesser than most other equity fund categories. These funds are also better wealth creators as their fund managers face no restriction in exploiting investment opportunities across all market caps and sectors.

2. Large cap funds: These funds invest primarily in companies with large market capitalisation. These companies are usually industry titans and are part of important stock indices, such as BSE Sensex, Nifty 50, Nifty Next 50, BSE Top 100 and BSE Top 200. As these companies have the size and scale to survive bad market and economic cycles, investment in large cap funds are considered to be the safest of all mutual fund categories. The flip side, though, is that you cannot expect exceptional returns during bull market phases. Opt for these funds only if you prefer moderate yet sustained returns over high returns with higher risk.

3. Midcap funds: These funds invest in mid-sized companies in terms of market capitalisation. Mid-sized companies usually have higher growth potential than their large cap peers. Companies in fast-growing industries such as logistics, media and consumer retail are hard to find in large cap space. As a result, midcap funds generate higher returns during bull market phase. However, their main disadvantage is that they take most of the beating during a market crash and equally longer time to recover from such crashes. Thus, even if you are an aggressive investor, you should not have your entire investment in midcap funds. Ideally, you should have 20%–30% of your portfolio in midcap funds.

4. Small cap funds: These funds seek capital appreciation by investing in small cap companies. As both the growth potential and risks associated with these companies are higher than their counterparts in large cap and mid cap space, small cap funds can outperform other fund categories during a bull market and fall more than others during a falling market. Choose these funds if you have higher risk appetite and long investment horizon. Allow these funds to witness at least one bull phase and don’t invest more than 10% of your portfolio in them.

5. Equity Linked Savings Scheme (ELSS): These are diversified equity funds that come with additional tax benefits. Under Section 80C, ELSS investments of up to Rs.1.50 lakhs can be deducted from your gross total income. The flip side is that these funds have a 3-year lock-in period from the date of investment. However, there is no restriction on redemption once the lock-in period is over. It is a good option for those seeking tax benefits along with higher returns.

6. Sectoral funds: These funds invest in securities of specific sectors, such as pharmaceutical, banking, FMCG, infrastructure and information technology (IT). As the  fund managers of these schemes do not have the independence of investing beyond their predetermined sectors, the performance of these funds more or less follows the performance of the sector itself. As these funds aim to take advantage of industry cycles, a well timed investment can give solid returns. However, you need to closely follow the performance of the sector that you are invested in and exit the sectoral fund before the sector runs out of favour in the market. Some of the best performing sectoral funds over the three-year period include SBI Pharma Fund (33.75% CAGR), ICICI Prudential Technology Fund (24.12% CAGR) and Reliance Pharma Fund (27.70% CAGR)

The author is a managing director, Paisabazaar.com

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