What are the “must have” mutual fund categories in a portfolio?

A viewer on our YouTube channel wants to know,  What are the “must have” mutual fund categories in a portfolio?

But do you even need mutual funds in a portfolio? The answer is no. Mutual funds are a good choice, but they are only a choice. There are other ways to invest, even if they bear a higher risk (e.g. direct equity) and higher tax (e.g. fixed deposits). Also see: How to invest without using mutual funds. Investing in mutual funds does not make a person “financially literate”.

With that out of the way, it is easier to answer the question – the other way around: which are the mutual fund categories we can safely avoid or are unnecessary?

First, we will eliminate regular plans, dividend (IDCW) options and closed-ended MFs.

SEBI classifies mutual funds as:

1. Equity Schemes
2. Debt Schemes
3. Hybrid Schemes
4. Solution-Oriented Schemes – For Retirement and Children
5. Other Schemes – Index Funds & ETFs and Fund of Funds

Among these, we can eliminate Solution-Oriented Schemes. These are unnecessary as they come with lock-in rules such as:

• Retirement Fund: Lock-in for at least 5 years or till retirement age, whichever is earlier
• Children’s Fund: Lock-in for at least 5 years or till the child attains the age of majority, whichever is earlier

We can also eliminate ETFs as index funds are better suited for retail investors. ETFs have price risk as we need to buy and sell from other unit holders and not the AMC like a mutual fund.

If you choose equity index funds, you can eliminate equity schemes and equity-oriented hybrid schemes as well! Although it is an excellent idea, let us not be so drastic!

Equity scheme categories

• Large Cap Fund: Eliminate. Most funds don’t beat the benchmark. See Active Large Cap Mutual Funds vs Nifty 100 performance analysis.
• Mid Cap Fund: Eliminate. Most funds don’t beat the benchmark. See Myth Busted: Active mid cap mutual fund managers can easily beat the index.
• Small cap Fund: Eliminate. Too risky and unproductive, most funds don’t beat a mid cap index. See: Is there any proof small cap mutual funds would outperform in the long term? And Why are you not recommending mid cap and small cap funds?
• Large & Mid Cap Fund: Neither eliminate nor a must-have. May underperform indices.
• Flexi Cap Fund: Neither eliminate nor a must-have. May underperform indices.
• Multi Cap Fund: New kid on the block. It can be risky. Eliminate.
• Dividend Yield Fund: Silly idea. Risky. Eliminate.
• Value Fund Value: Fascinating idea but risky. Eliminate.
• Contra Fund: Fascinating idea but risky. Eliminate.
• Focused Fund: Buy a Sensex index fund if you like 30 stocks. Eliminate. Are Focused Mutual Funds better than Index Funds?
• Sectoral/ Thematic Fund: Way too risky. Eliminate. See Why Thematic/Sectoral Mutual Funds Are Not Worth Your Investment
• ELSS: The New Tax Regime has made these redundant.

Hybrid scheme categories

• Conservative Hybrid Fund 10% to 25% investment in equity & equity-related instruments and 75% to 90% in Debt instruments – Eliminate unnecessary (ps. Although I am invested in one, it is not for everyone. See Why I started to invest in the Parag Parikh Conservative Hybrid Fund.
• Balanced Hybrid Fund 40% to 60% investment in equity & equity-related instruments and 40% to 60% in Debt instruments – new kid on the block. Eliminate as they are not necessary.
• Aggressive Hybrid Funds 65% to 80% investment in equity & equity related instruments; and 20% to 35% in Debt instruments – Can be used as a replacement for equity funds for long term goals. Sadly, no index funds are available at the time of writing. See Why is diversification the only free lunch in investing? And Why we badly need an aggressive hybrid index fund!
• Multi-Asset Allocation Fund Investment in at least 3 asset classes with a minimum allocation of at least 10% in each asset class – Can be used as a replacement for equity funds for long term goals.
• Dynamic Asset Allocation or Balanced Advantage Fund Investment in equity/ debt managed dynamically (0% to 100% in equity & equity related instruments; and 0% to 100% in Debt instruments) – Too risky if the strategy fails. Best avoided by most investors.
• Arbitrage Fund Scheme following arbitrage strategy, with a minimum 65% investment in equity & equity-related instruments – not necessary but can be used as a tax-efficient alternative for short-term debt funds.
• Equity Savings Equity and equity-related instruments (min.65%); debt instruments (min.10%) and derivatives – unnecessary. Eliminate.

Debt scheme categories

• Overnight Fund Overnight securities have a maturity of 1 day – not for retail investors.
• Liquid Fund Debt and money market securities with maturity of up to 91 days only – Suitable for emergency cash (one component of it), for income and as a goal nears its deadline.
• Ultra Short Duration Fund Debt & Money Market instruments with Macaulay portfolio duration between 3 – 6 months – Risky. Eliminate
• Low Duration Fund Investment in Debt & Money Market instruments with Macaulay duration portfolio between 6- 12 months – Risky. Eliminate
• Money Market Fund Investment in Money Market instruments having maturity of up to 1 Year – Suitable for those who desire a bit more returns than from a liquid fund. Credit risk and interest risk are typically low.
• Short Duration Fund Investment in Debt & Money Market instruments with Macaulay duration of the portfolio between 1 year – 3 years – Risky. Eliminate
• Medium Duration Fund Investment in Debt & Money Market instruments with Macaulay portfolio duration between 3 – 4 years – Risky. Eliminate
• Medium to Long Duration Fund Investment in Debt & Money Market instruments with Macaulay’s portfolio duration between 4 – 7 years – Risky. Eliminate
• Long Duration Fund Investment in Debt & Money Market Instruments with Macaulay portfolio duration greater than 7 years – Risky. Eliminate
• Dynamic Bond Investment across duration- Risky. Eliminate
• Corporate Bond Fund Minimum 80% investment in corporate bonds only in AA+ and above rated corporate bonds – Not a bad idea. Though the credit risk is higher, a less volatile replacement for gilt funds
• Credit Risk Fund Minimum 65% investment in corporate bonds, only in AA and below-rated corporate bonds – Risky. Eliminate
• Banking and PSU Fund Minimum 80% in Debt instruments of banks, Public Sector Undertakings, Public Financial Institutions and Municipal Bonds – Risky. Eliminate
• Gilt Fund Minimum 80% in G-secs, across maturity – Only for those who appreciate the risks and the importance of rebalancing in a long term portfolio.
• Gilt Fund with 10-year constant Duration Minimum 80% in G-secs, such that the Macaulay duration of the portfolio is equal to 10 years – Risky. Eliminate
• Floater Fund Minimum 65% in floating rate instruments (including fixed rate instruments converted to floating rate exposures using swaps/ derivatives) – Risky. Eliminate

In summary, while there are no must-have mutual fund categories (as MF investing in itself is not necessary), the following categories will satisfy the needs of most MF investors: Index funds, Large and Midcap funds, Flexicap funds, Aggressive Hybrid funds, Multi-Asset funds, liquid funds, money market funds, corporate bond funds, gilt funds.

Note: Not all categories in this shortlist are not necessary for an individual. For example, someone choosing a category among Large and Midcap funds, Flexicap funds, Aggressive Hybrid funds or Multi-Asset funds do not need any other category in this subset. Naturally, those with a large net worth are an exemption as they need to add funds to reduce concentration risk.

The investor must evaluate their needs first, determine the appropriate risk necessary to accomplish their goals, choose a suitable asset allocation and then think about suitable product categories within each asset class. Then and only then should they select products. Process first, products last.