Breaking down Equity Mutual Funds
Mutual funds are of three types: Equity, Debt, or a combination of the two called Hybrid funds. In this article we will discuss equity mutual funds.
According to SEBI, an Equity Mutual Fund invests at least 65% of its corpus in equities and equity related instruments. Here is a brief guide on the various categories of Equity Mutual Funds and how each fund category will complement your investment goals.
Before we begin, you need to have a clear understanding of market capitalization. A company’s size is an important criterion for Mutual Funds when picking stocks for an equity portfolio. Market Capitalization is the total value of a company traded on the stock market. It is calculated by multiplying the total number of shares available with the public by the current market price of the stock.
Large Cap: 1st – 100th company in terms of market capitalization
Mid Cap: 101st – 250th company in terms of market capitalization
Small Cap: 251st company onwards in terms of market capitalization
As of December 2018, stocks with market cap of above Rs 27000 crore are large caps; stocks with market cap of more than Rs 8000 crore and less than Rs 27000 crore are mid caps and stocks with market cap of below Rs 8000 crore are small caps. (Source: AMFI; these numbers are subject to revisions)
Large Cap Funds
Large Cap Funds predominantly invest in stocks of large companies. These companies are leaders in their respective industries, eg: like HDFC bank in banking sector and Reliance Industries in refineries. Large Cap Funds invest at least 80 percent of the corpus in large cap companies.
Mid Cap Funds
Mid Cap Funds invest in mid sized companies. These are growing companies. You can have an investment tenure of 3 to 5 years when investing in mid cap funds as these funds invest in stocks which would need at least this much time to deliver for growth. Mid Cap Funds invest at least 65 percent of the corpus in mid cap companies.
Small Cap Funds
Small Cap Funds predominantly invest at least 65 percent of their corpus in small companies. You can have an investment tenure of 5 years when investing in small cap funds.
Large & Mid Cap Funds
Large & Mid cap funds invest in both large and mid-sized companies. These funds are less volatile compared to pure mid cap funds. They invest at least 35 percent of the corpus in large cap companies and 35 percent of the corpus in mid cap companies.
Multi Cap Funds
These funds invest in a combination of large, medium and small companies, thus diversifying or minimising risk.
Focussed Funds invest in a concentrated portfolio of stocks. It invests in a maximum of 30 stocks and may be slightly riskier than diversified funds. This is because allocation to each stock can be in the range of 5% to 10% of the portfolio.
Equity Linked Savings Scheme (ELSS) is a type of equity fund which qualifies for a tax deduction of up to Rs 1.5 lakhs under Section 80 C. Each investment in the ELSS scheme is locked-in for 3 years. An ELSS fund is like a diversified equity fund, investing across market capitalisation.
Sectoral funds invest solely in a business that operate in a particular industry or sector of the economy. Investors who have a high-risk appetite prefer these funds. You can choose and invest in a sector fund when you believe the sector will outperform the overall market. For example, if you believe there will be a series of rate cuts and banks would benefit due to that, banking sector fund will be a beneficiary. Sector funds tend to be riskier and more volatile than the broader market because they are less diversified. It is prudent to allocate not more than 5% of your portfolio in sector funds.
Other Category Funds
Categories such as dividend yield funds, value funds and contra funds have a defined strategy and the fund manager follows the same. These funds do not have a market cap restriction and will follow a multi cap strategy investing across different market cap segments. The risk level of these funds will be like that of multi cap funds.
Dividend Yield Fund
Dividend yield is the ratio of the past dividend paid per share to its market price. Companies with high dividend yield pay a substantial share of its profits in the form of dividends. Dividend yield funds invest in dividend yield stocks. A dividend yield fund does not have any obligation to pay dividends. Hence a dividend yield fund has more to do with identifying value stocks and not stocks that would be paying high dividend.
The fund manager of a Value Fund looks for companies with good businesses that are trading cheap. When the market realises its potential, the stock price of the company will move up. Value funds are typically for long term investing as they have the potential to steadily grow over time.
Contra funds take a contrarian view of the market. These funds may invest in stocks that have given negative returns or underperformed the market. The fund manager identifies those underperforming stocks which have the potential to grow in the future.
The categorisation of mutual funds has brought in more transparency and clarity for the investors. It will be easier now for investors to distinguish between funds. You should have an investment horizon of at least 3 years when investing in equity mutual funds. By staying invested for a longer period, the benefit of compounding helps you grow your investment. You must review your portfolio to align it with your financial goals. We shall discuss the debt and hybrid fund categories in other articles.