Understanding Different Types of Mutual Funds

SEBI classifies mutual funds by what they are permitted to own. That classification is the starting point for a beginner. A liquid fund and a small-cap equity fund are both mutual funds. They are not interchangeable. This article explains the main families — equity, debt, hybrid and index — and, within equity, the meaning of large-cap, mid-cap, small-cap and flexi-cap, in the language a first-time investor needs.

Four Broad Families

Gold funds, international funds and solution-oriented schemes exist as well. Most households make substantial progress by understanding equity, debt and hybrid first.

Equity Funds, Including Large-Cap, Mid-Cap, Small-Cap and Flexi-Cap

Market capitalisation is the market value of a company — share price multiplied by the number of shares. AMFI publishes a list, updated every six months, that ranks listed companies by this measure. SEBI uses that ranking to define three groups:

• Large-cap companies are the top 100 by market capitalisation. They are generally the most established and most traded names. A large-cap fund must invest at least 80 per cent of its assets in these companies. Price swings tend to be smaller than in smaller companies, but the fund can still decline in a market correction.
• Mid-cap companies are those ranked 101 to 250. They are typically growing businesses that are smaller than the largest names. A mid-cap fund must hold at least 65 per cent in this group. Returns can be higher over long periods; declines can also be deeper and recoveries slower.
• Small-cap companies are those ranked 251 and below. A small-cap fund must hold at least 65 per cent in this group. The potential for growth is higher, as is the variability of monthly values. This category is poorly suited to money that may be needed within three to five years.
• A flexi-cap fund may invest across large-cap, mid-cap and small-cap companies, with at least 65 per cent in equity. The manager decides the mix. For many first-time investors, one flexi-cap fund is a complete core equity holding, because size allocation is already part of the mandate.
• A multi-cap fund must maintain minimum allocations across all three size groups. It is more tightly specified than a flexi-cap fund.
• ELSS (Equity Linked Savings Scheme) is an equity fund with a three-year lock-in. Under the old tax regime it qualifies for deduction under Section 80C. Under the new tax regime that deduction is generally not available. The lock-in remains even if the tax benefit does not.
• Sector and thematic funds concentrate on one industry or idea — for example banking or manufacturing. They are additional holdings, not a substitute for a diversified core.

A household does not need one fund from every equity category on the first day. Article 8 returns to how many schemes are enough.

Debt Funds

Debt funds own loans to the government or to companies. Their value can still fall for a period if interest rates rise or if a holding is downgraded. They remain the appropriate family for money that cannot stay in equity.

• Overnight, liquid and money-market funds hold very short-term instruments. They are used for parking money, not for building long-term wealth.
• Short-duration, corporate bond and similar funds are used when the horizon is about one to four years and the investor wants more than a savings account without taking equity risk.
• Gilt funds hold government securities. Credit risk is low. Prices can still move when interest rates change.
• Credit-risk funds seek extra yield by lending to lower-rated borrowers. That extra yield is compensation for additional risk. They are not a beginner’s core holding.

A debt fund is not PPF and not EPF. It does not carry a notified interest rate such as 7.1 per cent or 8.25 per cent. Where a guaranteed rate is essential, those schemes and bank deposits remain available.

Hybrid Funds

An aggressive hybrid fund holds a larger share in equity than in debt. A conservative hybrid or equity-savings fund holds more debt or uses a more defensive mix. A dynamic asset allocation or balanced-advantage fund is permitted to change the equity–debt mix as market conditions change, within stated rules.

Hybrid funds are useful for a household that prefers a single scheme rather than separate equity and debt SIPs. They are less useful as an addition to an already long list of equity funds. The scheme document states the equity range; a fund that remains near 75 per cent equity will behave much like an equity fund when markets fall.

Index Funds and ETFs

An index fund aims to match a published index such as the Nifty 50 or the Sensex. The manager is not trying to select a different list of companies. An exchange-traded fund (ETF) follows a similar idea but is bought and sold on the stock exchange like a share. For most first systematic plans, an open-ended index fund is simpler to operate than an ETF, because it can be purchased in rupee amounts without a demat trade.

An index fund is not safer than the market it copies. A Nifty 50 index fund declines when the Nifty 50 declines. What the investor has given up is manager risk; what remains is market risk.