Last Updated on August 24, 2019 at 9:13 am
The Mutual Fund space in India is reasonably large and growing. There are almost 50 Asset Management Companies (AMCs) offering more than 1,000 – and counting – schemes. The choice can be overwhelming at times. There are literally thousands of places that list the ‘best funds’ to invest in. This short post approaches the issue from the opposite side – the entire set of funds that you can simply ignore.
This a guest post by S R Srinivasan, SEBI registered fee-only investment advisor. Financially independent, he believes in numbers based insights. You can approach him for your financial needs via srinivesh.in
Mutual Fund Categories – Introduction
Starting late 2017, SEBI has introduced a standard categorization of mutual fund schemes. At the highest level, there are 5 categories:
- Equity Schemes
- Debt Schemes
- Hybrid Schemes
- Solution-Oriented Schemes
- Other Schemes (FoF, ETFs, Index funds, etc.)
These are further divided into sub-categories. In this post, we use the word ‘Category’ loosely to mainly refer to the sub-category.
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Notes: 1. There is no easy way to know the category of a mutual fund scheme. The AMC would, of course, have the right information and should be used as the authoritative source. Many of the mutual fund tools like ValueResearch, Morningstar, etc. use their grouping. It is mostly correct but can be wrong sometimes. e.g VRO groups Index funds along with Large Cap funds, HDFC Children Gift fund as Hybrid Aggressive, etc.
2. Many of the avoidable categories have been voted so by the market itself – they have much fewer schemes. However, there are some very popular categories that are avoidable too.
Solution-Oriented Schemes – An entire category to avoid
There are two sub-categories here – both have a 5-year lock-in in most cases.
- Retirement Fund – Scheme having a lock-in for at least 5 years or till retirement age whichever is earlier
- Children’s Fund – Scheme having a lock-in for at least 5 years or till the child attains the age of majority whichever is earlier
The names can tug at your emotional strings. But there is nothing that these funds do that many other categories of funds can’t do. Why lock into a fund with no perceived benefit? Plus the multiple NAV options in Retirement Funds are a nightmare to choose from.
Hybrid Funds to Avoid
Balanced Hybrid Fund
SEBI defines them this way: Equity & Equity related instruments- between 40% and 60% of total assets; Debt instruments- between 40% and 60% of total assets;
No Arbitrage would be permitted in this scheme
These funds are neither here nor there. A 20% differential is something an investor can manage herself. Unsurprisingly there are only a handful of schemes in this category.
Equity Savings Fund
These have been aptly called Chinese Dosa! There are some folks who like such things. But for most, these funds are more complex than necessary. They invest in a combination of equity, arbitrage and debt. Most Arbitrage funds do this too, and without taking up open equity positions. The typical returns are only slightly higher than Arbitrage funds and Debt funds, but the Standard Deviation is higher, much higher.
A similar risk-return argument can be made for the Multi-Asset Allocation category too.
Debt Funds to Avoid
Medium Duration and above
There are in fact three categories here. The first two are:
Medium Duration Fund – Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 3 years – 4 years
Medium to Long Duration Fund – Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 4 – 7 years
These durations are difficult to manage. SEBI even provides an escape clause of ‘adverse situations’. The funds can reduce the duration to as low as 1 year. In effect, these can act like dynamic bond funds, but with more constraints. Almost all retail investors can avoid this category, though there are almost 20 schemes in each category.
There is also the Long Duration category – Maculay duration should be 7 years or above. The industry itself has voted on this – there are only 3 schemes as of now.
Corporate Bond Fund
This can be a puzzling inclusion in the list of avoidable categories. These funds have to invest at least 80% in corporate bonds that are rated AA+ and above. If you believe the rating, then you can consider them low on credit risk. The duration can be variable and this provides some uncertainty. An interesting aspect comes from diversification. There are many companies in India whose debt instruments have high ratings. However, most of them belong to a few dozen corporate groups. High concentration should be avoided in debt funds. If you do choose a fund from this category, please ensure that the fund is well diversified.
Banking and PSU Fund
The traditional view is that these funds are reasonably safe as they hold papers of PSUs and Banks. SEBI defines this category thus: Minimum 80% of assets should be Debt instruments of banks, Public Sector Undertakings, Public Financial Institutions and Municipal Bonds The list is broad and can include many low-grade papers. A fund manager chasing Alpha can be tempted to take on lower quality paper. And the Government may not rescue you if things go sour – particularly if the institution is not too big to fail. If you like a fund in this category, please go ahead. But don’t have illusions that it is ‘Safe’.
Equity Funds to Avoid
Contra Fund
Per SEBI, the scheme should follow a contrarian investment strategy. Specific Contra funds have been very popular in the past, but they have found it difficult to maintain that record. SEBI made this category mutually exclusive with the Value category – an AMC can have either a Contra fund or a Value fund. There are only 3 funds in this category.
Dividend Yield Fund
Per SEBI, a scheme in this category should predominantly invest in dividend-yielding stocks. Since Indian equity investors almost demand regular dividends from their holdings, most large cap and mid cap companies declare dividends. There is very little value that a Dividend Yield fund adds over, say, a Large and Midcap fund. And in any case, dividends received by mutual funds are not passed through – they just increase the NAV. There is then little benefit from this category.
Sectoral/Thematic Funds
Some sectors – Infrastructure, Banking, and some themes – Consumption, Opportunities, have been popular with investors. These funds are definitely more volatile than broad-based equity funds. There have been many comparisons made on the sectoral composition of, say, Nifty 50 over the years. About 10 years ago, the Energy sector had 40+ weight in the index and FSI had a weight just above 10. The situation is almost reversed ten years later – FSI has a weight of almost 40 and Energy around 15. And it is not unidirectional either. The weight for IT had grown over the years and fallen. So unless you are very confident about your selection, you can give these funds a miss.
Small Cap Fund
There are some good funds in this category. But overall, the category suffers from many of the ills of Indian equity – all the way from poor management quality to poor governance. In my view, the structural issues in this space would take a long time to be resolved. If you want the thrills high volatility stocks, mid-cap funds offer a much better balance of risk and returns.
And finally, Large Cap Fund
This would raise eyebrows. It has been traditional wisdom to say that large cap funds should be the core of one’s portfolio. There are two reasons that make large cap funds less suitable:
- The tight mandate by SEBI – At least 80% of the assets should be in large cap. This reduces the space for stocks of smaller companies and hence reduces the scope for Alpha. In the past, the funds had a liberal dose of mid-cap and smaller companies to provide a kicker to the performance.
- The growing number, and reducing cost, of index funds and ETFs tracking Nifty 50, Nifty Next 50, Sensex, etc. These provide a lower-cost alternative to active funds
Combined together, these factors keep reducing the advantage of actively managed funds in this space. Investors may find index funds more suitable. To add further spice, there are a few ETFs tracking strategic indices built on large cap stocks.
Conclusion
The list of categories above would exclude more than 25% of the schemes that are in the market now. This should hopefully help you in your selection. If you want a shortlist of funds that you should consider, please look at the Plumbline. The link is featured in the top bar of the site.
Related Articles
- https://freefincal.com/sebi-categorization-and-rationalization-of-mutual-fund-schemes/
- https://freefincal.com/equity-savings-funds/
- https://freefincal.com/macaulay-duration-debt-mutual-funds/
- https://freefincal.com/how-to-select-suitable-debt-mutual-funds-with-low-credit-risk/
- https://freefincal.com/banking-psu-debt-funds-credit-risk/
- https://freefincal.com/large-cap-vs-mid-cap-vs-small-cap/
- https://freefincal.com/only-five-large-cap-funds-have-comfortably-beat-nifty-100/
- https://freefincal.com/should-i-now-switch-from-large-cap-funds-to-index-funds/
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