Selecting the right set of funds that suit your goals and risk appetite can be a daunting task given that we have 37 scheme categories and more than 1,300 schemes. A diversified portfolio should comprise different styles (growth and value) of funds from different asset management companies across market capitalisation (Large, Mid, Small), geography (U.S., Europe, and others), and asset classes (equity, debt, and gold).
Before we get down to selecting the right fit for your portfolio, it is important to understand the different categories of funds and how these funds fit into your risk profile.
Categories of funds
There are 11 categories of equity funds. Each category differs in terms of the universe where it will invest in terms of market capitalisation (Large Cap, Mid Cap, Small Cap, Flexi Cap, or Multi-Cap) and strategy (Value/Contra, Focused, Sector, Dividend Yield).
Equity funds are a high-risk and high-return proposition. Within the equity funds category, Large Cap Funds are relatively low in risk as compared to other categories like Mid Cap, Small Cap, with Sector Funds being the riskiest, as they invest only in one sector.
Large Cap Funds tend to protect your downside in a falling market, since they invest in large and stable companies, while Small Cap funds could see a larger drawdown.
Certain sector funds can offer outsized returns during a specific time period when the prospects for that particular sector look good. For instance, Healthcare did well during Covid. The BSE Healthcare TRI Index was the best performing sector in 2020, which delivered 62.61%. S&P BSE Power was the best performing sector in 2021, which delivered 68.84%. So the best performing sectors keep rotating every year; no single sector will perform well every year. It is difficult to predict which sector will do well in a particular year. So it pays to keep your portfolio diversified across sectors by investing categories such as Flexi Cap and Multi Cap Funds or through a separate exposure towards each market capitalisation through Large, Mid, and Small Cap Funds separately.
Should you invest in Sector Funds?
Read this before you invest in a thematic fund
Debt Funds offer 16 categories which are categorised as per their maturity profile (overnight funds can invest in securities that mature in one day while Liquid Funds can have maturity of up to 91 days) and Macaulay Duration (Ultra Short Term Funds can have MD of 6-12 months while Long Duration Funds can have MD of more than 7 years.
Liquid funds, which invest in securities with maturity of up to 91 days, are low-risk products. At the other end of the spectrum, Credit Risk Funds are the riskiest, as they invest in low rated paper which generate higher yield. Longer duration funds carry high interest rate risk. The return of these funds gets negatively impacted when interest rates move up, which is what we are witnessing right now.
Hybrid Funds, which invest in a mix of two to three asset classes like equity, debt, gold/silver, offer six categories.
It is important for investors to clearly understand the objective and risk-return profile of each of these categories. You don’t have to invest in all the categories.
Asset allocation is like a fire extinguisher
Do we need diversification?
A diversified portfolio will help you protect the downside in a volatile market. If one asset class like equity is not doing well during a downturn, debt funds and gold can limit the downside. If we take the analogy of cricket, you don’t want a team that only comprises top-order batsmen. You need a good bowler, wicket-keeper, fielder, batsman, and so on. Each player has his/her own unique skill set which helps build a team. Similarly, a portfolio consists of different types of funds.
Investment Horizon
If you are investing in mutual funds to grow your wealth your investment horizon needs to be long term. If your investment horizon is less than five years, it is advisable to stay away from equity funds or have low exposure to equity.
What is the benefit of staying invested for the long term? The chances of you earning negative returns come down. Even the standard deviation (which shows the volatility of returns) of your portfolio comes down.
For short-term goals, you can invest in low-duration Debt Funds like Liquid and Ultra Short Term Funds.
You should diversify your portfolio across market capitalisation (Large, Mid, and Small Cap), style (Growth and Value), and asset management companies.
Is there a good or bad time to buy or sell actively managed funds?
In our recent study, we found that between April 2012 and March 2022, Indian stocks owed their outperformance over cash to just 11 months—less than 9.2% of the months in the sample. If you held stocks for all 109 months apart from those 11 months, which we will call "critical months," a term which we will define more precisely below, you would not have beaten cash.
We performed the same test against Indian actively managed diversified equity funds for the 10-year period from April 2012 to March 2022 to determine if the phenomenon applied to them as well. We found that, on an average, outperformance of Indian actively managed diversified equity funds continues to be attributable to a smaller proportion of months: 6 months or 5% of all months, which is similar to the number from the 2021 study of 6 months or 5% of all months. Although this number varies across categories.
So investors should not try to time the market and stay invested.
Is there a ‘good’ time to buy or sell actively managed funds?
Winners keep rotating
No single fund is a top performer every year. We looked at the performance of Large Cap Funds over the last ten calendar years. If you look at this chart below, Mirae Asset Large Cap Fund was the best performing fund in 2017. In 2018 and 2019, Axis Bluechip Fund was the top performer. In 2020, Canara Robeco Bluechip Equity Fund was the top performer. After being in the bottom quartile in 2019 and 2020, Franklin India Bluechip Fund made a comeback in 2021 by occupying the top position.
How we analyse funds
Morningstar Analysts use a research framework to reinforce a consistent, long-term investment process and give all stakeholders the resources they need to provide justified recommendations that are well suited to client needs. We look at the following parameters:
People
- Manager Tenure: Experience, Past history
- Manager Expertise: Large-cap, Midcap, Smallcap
- Workload: Assets managed/number of funds managed
- Strength of the underlying team: Capability of the team. Experience of other managers within the team and Analysts, no. of analyst within the team
- Manager Change: Does the view change? How does it impact the fund?
Process
- Strategy: Large, mid, small Cap, multi cap
- Investment style: Growth, value, blend
- Consistently: Strength/logical/repeatable
- Risk Management: Liquidity, concentration risks, sector, and stock specific risks
- Fund Size: How does the fund house manager inflow? How can it handle redemption pressure?
Performance
- Check the performance from a long-term perspective
- Performance in the context of the investment approach
- Where does the manager derive the fund’s performance?
- Emphasis on the risk/return showing
- Performance drivers
Price
- Expense ratio relative to the peer group
Parent
What priorities prevail at the firm? Stewardship or salesmanship?
- Organization Stability/Financial Strength
- Culture/Stewardship
- Regulatory/Compliance
- Team Buildup/Talent Retention
- Manager Reward Policy
Analyst Rated Funds
Here are some key takeaways:
- Mutual funds are long term investments
- Performance should not be the sole criteria for selecting or exiting a fund
- Sector or thematic funds are for investors who understand sector dynamics. For others, better to stick to diversified equity funds
- If fund selection proves to be a daunting task for you, don’t hesitate to consult an expert
- Know your funds