types of mutual funds schemes as per SEBI October 2017 Circular

October 2017

No discussion on the mutual fund universe is complete without mentioning the SEBI’s October 2017 circular on MF categorisation. This was a significant move as it helped to simplify the fund landscape. To really understand why this circular is so important, we must look into the past.

In the past, the mutual fund industry was somewhat chaotic. Asset management companies offered a plethora of plans that had similar investment goals, often leading to confusion and misunderstanding among investors. An AMC would promote a ‘large-cap fund’, which should include only large-cap stocks; however, they sometimes included small-cap stocks as well, resulting in a more volatile portfolio and higher returns. This posed an issue for a typical large-cap investor looking for market returns as well as lower volatility, which goes against the purpose of investing in this type of product.

Before October 2017, many issues came into the picture due to the absence of proper divisions and definitions for mutual funds.

Multiple funds – An AMC typically rolls out multiple funds with the same investment aim. For instance, it was commonplace for them to offer several large-cap or mid-cap schemes, although the distinctions between them were vague.

Lack of definition – An AMC may identify a fund as either large- or mid-cap, but it actually includes stocks of other sizes. The issue here is that there is no clear standard for defining market capitalisation.

Portfolio composition- Portfolio composition was not well-defined in the mutual fund schemes. For instance, a mid-cap fund was expected to invest in mid-cap stocks, but it was often observed that a considerable amount of small-cap stocks constituted its portfolio even though the name indicated a focus on mid-caps.

These difficulties spawned a series of further issues. A major worry was the rating of funds. For example, if a fund containing small-cap stocks is misrepresented as a large-cap fund and rated against a large-cap index, it could cause problems. The yield from such a ‘large-cap fund’ (especially in bullish markets) might be miscalculated, giving the investor an abnormal gain, which could be deceiving.

SEBI addressed these problems with their October 2017 circular.

The circular provided a clear market capitalisation for stock, solving problems that had been plaguing the mutual fund sector. According to its definition –

Large-cap stocks – 1st to 100th company in terms of full market capitalisation

Mid-cap stocks – 101st to 250th company in terms of full market capitalisation

Small-cap stocks – 250th company onwards in terms of full market capitalisation

The formal definition made it clear what market capitalization was, and the AMCs had to obey it.

Additionally, SEBI mandated that a AMC can have only one fund per category (except for thematic investing, index funds, and funds of funds). This directive prohibited AMCs from providing a variety of strategies with closely related investment approaches. To help clarify this point, SEBI also described the portfolio requirements. To put it in perspective; consequently to this circular, if an AMC was to manage a large-cap fund, then the regulator not only specified which stocks are considered large-cap but also set the minimum percentage of these stocks that should be present in their portfolio.

Let’s move on to exploring the various mutual fund categories and subcategories. We must ascertain our financial situation before investing in any of these options.

– The Mutual fund universe

There are mainly 5 categories for mutual funds, under which there are several sub-categories-

1. Equity

2. Debt

3. Hybrid

4. Solution-oriented

5. Other schemes

This is the full breakdown of categories and subcategories:

First, we will concentrate on Equity. According to SEBI’s circular, an Asset Management Company is authorised to oversee one fund per category. For instance, they could manage a single large-cap, mid-cap, small-cap and so on.

Under Equity, an AMC may offer a variety of sub-funds, which can span across multiple sectors.

– Equity Category

The equity category is the most popular among retail investors. These schemes invest in equity, i.e., listed company shares and there are nearly 11 subcategories within it. Every style comes with its own timeline of wealth generation and varying levels of risk and reward. However, the ultimate aim remains the same – to generate wealth.

I have had countless conversations about investing in mutual funds. It is safe to say that many of these people have had unrealistic expectations when it comes to equity funds. They often view mutual funds as an identical substitute for investing directly in stocks, adopting a trading-like attitude which can be extremely detrimental to their capital.

It is almost impossible to generate wealth with equity investments in a mutual fund without the right frame of mind. So, what is the correct outlook when investing in an equity-oriented mutual fund?

The response to this query varies depending on the type of mutual fund that you are considering. It is important to dodge certain generic mistakes though;

Equity-oriented mutual funds are not the answer for your near-term monetary objectives. When I say short term, I’m alluding to roughly 2-3 years. Put money into equity-linked funds only if you have the necessary time for it. As an illustration, I started investing in an equity mutual fund in 2006 and am still doing so 14 years later. What I’m attempting to convey is that you need to maintain a very long-term outlook with respect to mutual fund investments. This is just my view but anything less than 10 years could be fruitless as far as creating wealth is concerned.

One of the usual inquiries is to ask why not use equity mutual funds for shorter term investments. There have been times when short term returns have increased significantly. It takes a lot of research and analysis to time this right. In this case, if you as an investor can successfully time the market, then why bother with investing in mutual funds at all? You could possibly just put money into stocks directly.

The old saying ‘time heals all wounds’ is especially applicable to market volatility. The market is unpredictable, yet the only way for an individual investor to make it work in their favor is to give their investments plenty of time. A quick-fix solution isn’t possible when it comes to investing in Mutual Funds.

Investors often have the tendency to hop from one mutual fund to another without having any valid explanation for switching. I believe this isn’t a very wise approach and does not classify as long term investing. The latter involves staying invested in an instrument over multiple years and through varied market cycles. There may be justified causes for changing funds and we’ll discuss them in due course.

Most investors are guilty of getting carried away by newspaper headlines, which can lead to exiting a successful mutual fund prematurely. This was something I experienced myself in 2007 when I pulled out of a fund due to a headline hinting at bearishness. Not only was it the wrong decision, but it also meant that I couldn’t restart my investment journey.

Unfortunately, the direct fund option wasn’t available in the past. Had I invested in the same funds through this option, the returns would have been higher. I’m transitioning all my regular funds to the direct route and I’m hoping this table will look much more impressive over the next 10 years!

I believe having three large-cap funds is excessive, and I should replace two of them with a low-cost index fund. Following this, I’ll further share my views concerning asset allocation and diversification.

Now, we are going to break down a few of the subtypes of equity mutual funds.

– The Equity mutual fund subcategories

Under the heading of equity funds, there are nearly ten divisions. The titles give a good indication of what one might anticipate from these diversified offerings.

A large-cap fund invests primarily in stocks of the top 100 companies in India whose market values are among the highest. These firms are usually thought to be industry leaders and relatively safe investments. Some prominent examples include TCS, Reliance, Infosys and HDFC Bank.

Take a peek at Axis Bluechip fund’s portfolio. It is one of the large-cap mutual funds, and displays its holdings for your perusal.

The portfolio of this fund is mainly composed of large-cap stocks (80%) that are allocated as the fund manager sees fit. Each month, the AMC has to make public its details on their website, which can be found under ‘statutory disclosure’. If you would like to know more about a specific fund, just check there.

An investor who opts for a large-cap fund generally looks to achieve two goals – (1) increasing the value of their capital in line with markers, and (2) reducing the amount of risk associated with small and mid-cap funds.

Simply put, an investor is in search of wealth creation while minimizing the risk to their capital. These are large-cap stocks, designed to be reliable and less prone to volatility. That being said, the stock market inherently brings with it the potential for both reward and fluctuation. As we all know, the only way to buffer against volatility is through patience; this means investing for a prolonged period in order to benefit from returns unaffected by swings in the market.

This analysis allows us to take a peek at how the biggest mutual funds have done over the last decade. The data has been taken from Moneycontrol, which evaluated these funds based on the size of AUM.

It is important to recognise the rewards of long-term investments amongst the funds evaluated here. All have achieved positive returns.

Mid-cap, small-cap and large & midcap funds all have distinct names that hint at what to expect.

A mid-cap fund mainly contains mid-cap stocks, while small-cap funds are made up of smaller firms. Both of these types of shares tend to be more volatile than those of large-cap companies. For that reason, it is important to view any investment in them as a long-term decision and not expect quick returns. To illustrate this point, we can look at the results two years ago of both the small and mid-cap funds –

Over the past couple of years, small and mid-cap stocks have seen an overall downturn in returns. It’s difficult for an individual to accurately predict market cycles and therefore it’s important for us to take a long term approach when investing. Whether it’s two years or three, knowing the right time to invest can be difficult for anyone- but as long as you show intention to hold your investments for the long haul, results are more likely to be successful.

Here is how some of these small and mid-caps have performed over the last ten years –

The funds have all delivered a respectable return. Taking a look at their ten-year performance, it is clear that small and mid-cap funds have outperformed large-cap funds. This makes sense due to the higher volatility of smaller companies’ stocks.

The goal of investing in either of these funds is to create wealth over a longer span of time, similar to large-cap portfolios. Yet, the returns on this kind of fund are notably higher than those offered by large-cap funds and the volatility rate is greatly increased. This result can be attributed to the fact that the companies included in the portfolio have ample room for growth. As they grow, so will your returns.

The ‘large & mid’ cap fund is a combination of both large and mid-cap stocks, unlike an exclusive large/mid/small-cap fund. An example is the DSP large and mid-cap fund, which has holdings in Infosys, Airtel, HDFC Bank, Hexaware, Hatsun Agro, and V Guard. The overall proportions of stocks are set at 35% for each category; however, this may alter slightly depending on the decisions of the fund manager.

A mixed bag of large- and mid-cap funds promises returns that exceed those of regular large-cap funds, yet fall short of those from small caps. The risk here is greater than with large caps but still lower than with mid or small caps. Over the past decade, small- and mid-cap investments have yielded…

Given the abundance of AMCs, it can be difficult to choose a single fund for investments. However, this topic deserves its own discussion and requires examining parameters such as risk, returns, performance, and costs. We will discuss it in the following chapters.