The recategorization of mutual funds was the second biggest mutual fund news of 2018.
The biggest news is still negative returns on mutual fund SIP’s.
The recategorization was a long time coming. SEBI has made it clear through its actions that it wants to make mutual funds investor friendly.
By recategorizing mutual funds, SEBI has cleared a lot of confusion new investors typically face.
Before the recategorization, AMC’s were allowed to offer multiple funds under the same category.
For example – HDFC AMC used to offer two balanced funds – HDFC Balanced Fund and HDFC Prudence Fund.
Think from the perspective of a new investor.
You are already confused by questions like…
What are the best mutual funds for me?
How long to invest?
Where to invest?
When to invest?
Do all mutual funds help you save taxes?
If you see the same fund house offering multiple funds under the same category, you are only going to be confused further.
SEBI’s mandate forced AMC’s to have only one offering under a category.
In this blog, we are going to see how SEBI has recategorized equity mutual funds and made them a lot simpler to understand.
First let’s understand one important terminology to understand what follows.
Market capitalization indicates the size of a company.
The new categorization rules of SEBI mandate that the full market capitalization of companies be used.
Full market capitalization is calculated as follows –
Now, if you calculate the full market capitalization of all the listed companies, you can rank them.
When ranked in a descending order (highest market capitalization first) …
- Companies ranked from 1 to 100 are defined as large cap companies
- Companies ranked from 101 to 250 are defined as mid cap companies
- Companies ranked from 251 onward are defined as small cap companies
Additionally, this ranking is fairly dynamic. Every 6 months, the ranking is updated due to which companies may jump from being mid cap to large cap or vice versa.
Now, let’s dive right in to the categories of equity mutual funds that has arisen from the recategorization initiative…
Large Cap Mutual Funds
Large cap mutual funds invest in companies that are large cap according to the new SEBI definition.
Additionally, large cap mutual funds are considered to be the safest among pure equity mutual funds.
Among pure equity mutual funds, large cap mutual funds have a ‘low risk-low return’ profile.
SEBI mandates that large cap mutual funds invest at least 80% of the money they receive from investors in large cap companies.
Large and Mid Cap Mutual Funds
As the name suggests, this type of funds invest in large cap as well as mid cap companies.
So, you have the robustness of large cap companies and the potential for high returns of mid cap companies in one fund.
SEBI mandates that large and mid cap mutual funds invest at least 35% of the money they receive from investors in large cap and mid cap companies each.
Both risk and return in large and mid cap mutual funds tend to be higher than purely large cap funds.
Mid Cap Mutual Funds
Mid cap mutual funds invest in companies that are mid cap according to the new SEBI definition.
SEBI mandates that mid cap mutual funds invest at least 65% of the money they receive from investors in mid cap companies.
Both risk and return in mid cap mutual funds tend to be higher than large and mid cap mutual funds.
Small Cap Mutual Funds
Small cap mutual funds invest in companies that are small cap according to the new SEBI definition.
SEBI mandates that small cap mutual funds invest at least 65% of the money they receive from investors in small cap companies.
Both risk and return in small cap mutual funds tend to be higher than mid cap mutual funds.
Multi Cap Mutual Funds
Multi cap mutual funds are free to invest in companies belonging to any market capitalization.
A good multi cap mutual fund can shift gears as per changing market conditions. When the market is breezy and bullish, the fund manager can invest in the otherwise risky mid cap and small cap companies. When the market seems not so great, the fund manager can invest in robust large cap companies.
In terms of risk and return, a multi cap fund is most similar to large and mid cap funds.
Everything said, most multi cap fund managers generally have a bias toward a certain categorization. For example, Mirae Asset India Equity Fund is a multi cap fund with a bias toward large cap stocks.
Focused Mutual Funds
This is a new category introduced by SEBI.
As the name suggests, these funds tend to focus on a relatively small number of stocks.
SEBI has mandated focused mutual funds to have no more than 30 stocks.
A typical diversified fund generally has more than 30 stocks.
Focused mutual funds can, however, invest in any stock irrespective of the companies’ market capitalization.
Investing in a small number of stocks exposes focused mutual funds to what is known as concentration risk.
To explain this with a simple example, let’s consider two mutual funds. Mutual fund A is a focused fund and mutual fund B is a multicap fund.
Let’s say mutual fund A has exposure to 25 stocks in equal proportion. So, it has 4% exposure to 25 stocks.
On the other hand, mutual fund B which is a multi cap fund has exposure to 50 stocks in equal proportion. So, it has 2% exposure to 50 stocks.
Let’s say 2 stocks which are part of both mutual funds A and B go bust. Meaning, their value becomes zero.
In this case, mutual fund A loses 8% in value. If the AUM of mutual fund A was Rs. 1000 crore, now it has become Rs. 920 crore.
However, mutual fund B (a multi cap fund) loses just 4% in value. If the AUM of mutual fund B was Rs. 1000 crore, now it has become Rs. 960 crore.
So, the multi cap fund lost less!
This is the most important difference between focused and multi cap mutual funds.
Another difference is that a focused mutual fund may indicate where it intends to focus. It could be either large cap, mid cap or small cap. This gives the investors a better idea of the risk involved in investing in a particular focused mutual fund.
Value Mutual Funds
Ever heard of Warren Buffet? For starters, he is one of the most successful investors in the history of investing.
Warren Buffet swears by ‘value investing.’
The simple idea of value investing is to discover stocks whose intrinsic value is much greater than its market price. So, you invest in such stocks and when the market discovers this stock after you have they start buying it thus increasing its price.
So, a value mutual fund has similar investing philosophy. The fund manager of a value mutual fund tries to find and invest in stocks whose value is higher than its current market price.
Contra Mutual Funds
Speaking of Warren Buffet, he also has a popular quote –
“Be fearful when others are greedy and be greedy when other are fearful”
This is known as being contrarian.
The entire world (well, almost) is doing something and you are doing the opposite of it.
A typical contrarian scenario is the market dumping a stock hastily but you accumulating the stock!
However, this is not done mindlessly. The fund manager implements a contrarian approach only after due consideration.
Due to the many similarities in investing styles of Value and Contra Mutual Funds, SEBI has mandated that a fund house can offer only one of the two categories and not both.
Dividend Yield Mutual Funds
Dividends make any investor happy!
However, one mustn’t confuse stock dividends and mutual fund dividends.
Dividend yield mutual funds primary invests in high quality stocks that pay high and regular dividends.
These dividends are not necessarily returned to the investors (unless dividend payout option is invested in) In most cases, they are simply reinvested in same/different stocks.
In any case, you should not opt for dividend payout option of any mutual fund expecting a regular cash flow. There are many better options to generate a regular (monthly) cash flow.
ELSS Mutual Funds
Who likes to pay taxes?
We are pretty sure no one raised their hands. Because we have never come across a single person who enjoys paying taxes.
The government is actually trying to help you save taxes via the Income Tax Act.
The Income Tax Act Section 80C states that an individual can reduce his taxable income by up to Rs. 1,50,000. This can be done by investing an equivalent sum in the following assets –
As you can see, Equity Linked Saving Scheme or ELSS Mutual Funds is the best investment instrument to save taxes under section 80C.
So, an ELSS mutual fund differs from a diversified equity mutual fund in two aspects –
- A compulsory 3-year lock-in
- Provision to claim tax benefit of up to Rs. 1,50,000 per financial year
In terms of risk and return, most ELSS mutual funds invest predominantly in large cap stocks.
While most people are aware about the tax advantages offered by ELSS mutual funds, no one really knows how to go about investing in ELSS mutual funds.
You can read this piece to understand what works best for ELSS mutual funds – SIP or lump-sum.
We have saved the riskiest mutual fund type for the end.
Sectoral or thematic funds invest in stocks of companies related to a sector or theme.
A sector could be IT, manufacturing, automobile, pharma etc. A theme could be housing or technology.
The distinction between a sector and theme is very fine (if any!). This is why when it comes to mutual funds sectoral and thematic are terms that are used quite interchangeably.
The problem with a sector is that every sector has a business cycle. When you are investing in a sectoral mutual fund you are not able to diversify among different sectors.
Imagine you having invested in an IT mutual fund. It was doing pretty well when you invested. However, of late the rupee is becoming stronger and stronger against the dollar. IT firms which earn revenues in dollars are reporting less and less profits now. What happens then?
Not only is the IT mutual fund almost completely invested in IT stocks but also bound to do so even when the sector is going through a rough patch. So, you cannot even reverse the bad decision of investing in the IT sector.
This could happen to any sector at any time. That’s just how business cycles are. You cannot predict them accurately.
But what is worse is sector funds continue to invest in the same sector even when the sector is going through a downtrend.
Next time someone asks you to invest in a sector fund, ask that person where he sees that sector going over the next 5-10-20 years. Invest in a sector fund only if he has convincing logic or data, preferably both.
Index Funds (not a SEBI categorisation)
Another type of equity mutual fund is index funds. This is not a separate category per se but can appear under any of the above categories.
An index fund invests in stocks such that it shadows an index.
For example – ICICI Prudential NIFTY Next 50 Index Fund invests in companies ranked from 51 to 100 in terms of full market capitalization. Any guesses which category this fund belongs to?
You are right if you said Large Cap. Remember how SEBI has defined the top 100 companies in terms of full market capitalization as large cap companies?
An index fund can shadow any index like the NIFTY 50 or the SENSEX!
So those are the equity mutual fund categories you must know about.
Invest in the best equity mutual funds via the best investment method – Alpha SIP.
Also published on Medium.