When we were discussing how many mutual funds you should have in your portfolio, we made a point that you don’t need a fund from every mutual fund category there is. In this article, we will explore mutual fund categories and see which ones suit your portfolio and how to use them.
You don’t need to stick doggedly to the fund category rule book. The defined category is not important – what the fund does and what its portfolio looks like are. We’ll take up each category and explain how it helps the kind of exposure your portfolio needs. To avoid this becoming a massive article that you don’t want to read, we’re splitting it into two parts. In this part I, we’ll take up equity funds. In the next, we’ll cover debt and hybrid funds.
To have equity in your portfolio, you need a medium to long-term holding. Here, you need:
- Some moderate-risk exposure, through large-cap-oriented funds, because this segment falls lesser during a market correction and is the first to recover during a recovery.
- Some high-risk exposure, through mid-caps and small-caps to give returns a boost so that you are not stuck with low returns throughout your portfolio tenure. This, only if you are looking for that extra returns.
Let’s see how you can use equity fund categories for this.
Every long-term portfolio needs a large-cap exposure. But large-cap funds don’t have to be a part of your portfolio. One, most large-cap funds have not been able to deliver better than the Nifty 100 index.
Unfortunately, many large-cap funds have also unable to contain downsides better than the index – going by the downside capture ratio, 6 in every 10 large-cap funds have fallen more than the index during periods of correction since 2018. This further detracts from their usefulness, as the role of moderate-risk funds is to help limit volatility and downsides.
Two, there are other ways to get large-cap exposure. Clearly, large-cap index funds are a good option – specifically, the Nifty 50, the Nifty 100 and the Sensex. Avoid the Nifty Next 50 index as a moderate-risk option, as it is in reality a high-risk, high-return index. The second way to get large-cap exposure is via multi-cap funds (yes, you read that right), explained below.
Please note that this section on multi-cap funds is no longer relevant following SEBI’s new rule that mandates minimum allocation to small-caps, mid-caps, and large-cap stocks for multi-cap funds. We have discussed the impact of these changes in this article.
Many multi-cap funds are increasingly resembling large-cap funds in their portfolio. Though these funds have the freedom to move across market capitalisations, some still maintain a majority large-cap exposure. This usually is because their strategy would be to use large-cap stocks as their portfolio’s core and add mid-cap and small-cap stocks to lift return. For example, Canara Robeco Equity Diversified, HDFC Equity, Franklin India Equity, L&T Equity, ICICI Pru Multicap, Motilal Oswal Multicap 35 all have a steady large-cap orientation.
Considering both focused and multi-cap fund category (we’ll explain why we’re combining them later), 60% of them had a large-cap allocation of 70-75% in the past two years. Due to this tilt, they can be considered moderate risk. The benefit in using moderate-risk multicaps is that they could deliver better than large-caps without upping the risk quotient. Our Prime Funds list has such multi-cap funds – see the section on moderate risk funds.
However, note that using multi-cap funds for moderate-risk exposure needs careful understanding of the fund. We say this because a large-cap allocation alone does not make a fund moderate-risk – its strategy could be aggressive. Consider Franklin India Equity or Aditya Birla SL Equity. Both funds have a 60%+ large-cap holding. But the former is a value-based fund, and can (and has!) go through long periods of subdued returns. The latter fund tactically shifts sector allocations, making it riskier. Funds like these are better fits for portfolios of above 6-7 years.
Such multi-cap funds and those that are more dynamic in their market cap management are good to enhance overall portfolio return. These funds fit in between the pure mid-and-smallcap bucket and the large-cap segment.
This means you can use them in different ways: if you are a conservative investor, they are a route to better returns without the risk of dedicated mid-cap/small-cap funds. If you are an aggressive investor, you can use them instead of increasing allocation to mid-cap/small cap funds to very high levels in your portfolio.
The benefit in using moderate-risk multicaps is that they could deliver better than the large-cap fund category without upping the risk quotient.
Sundaram Select Focus explicitly invests in large-cap stocks alone. Other focused funds can invest across market capitalisations. But like multicap funds, some could have a clear large-cap tilt. Motilal Oswal Focused 25, for instance, holds over 80% of its portfolio in large-cap stocks. Axis Focused 25 is similarly large-cap biased. IDFC Focused Equity, on the other hand, sees allocations swing as does SBI Focused Equity.
Focused funds need to be looked at along with multicap funds for this reason – their nature is that of a multicap fund; only their strategy is investing in few stocks. There could be overlaps between the two fund categories. Motilal Multicap 35, for instance, is focused by strategy but is categorised as multi-cap.
The question is – like multi-caps, can you use these funds as part of moderate-risk equity? You can, provided your risk appetite tends towards the more aggressive side. This is because a focused strategy is inherently higher risk as a few stock calls gone wrong can severely dent returns; this has already happened in Motilal Multicap 35. So if your understanding of the strategy, your risk level, and the fund’s portfolio allows, you can use these funds as the moderate risk component. But don’t make this the only large-cap exposure – always pair with a more diversified fund or an index fund.
Otherwise, focused funds are great fits to drive up your portfolio’s return no matter what your risk level is. Since they invest heavily in only a few stocks, they can generate strong returns across market cycles. Of late, focused fund returns have been improving. Like aggressive multi-caps, they fit in-between a very aggressive exposure and a moderate-risk exposure and can be used as explained with multi-caps.
Focused funds are great fits to drive up your portfolio’s return no matter what your risk level is. Since they invest heavily in only a few stocks, they can generate strong returns across market cycles.
We’re not done yet with confusing you on multi-caps. Don’t blame us – fund categories are that way!
Value funds are in reality multi-cap funds – remember that value is a strategy. As noted above, you have multi-cap funds (by category definition) which follow a value-based strategy. So when you look at value funds, compare it with multi-cap funds too. The value-fund universe is much bigger than just the stated value category.
Next, use these funds (value and value-based multicap) only if your holding period is 6-7 years and longer. Since this strategy may not work in all market cycles, returns can be subdued for a long time. We’re seeing this play out now – barring a few such as Invesco India Contra and Kotak Standard Multicap – most value-based funds beat the Nifty 500 just about 25% of the time when rolling 1-year returns since 2017.
You do not need a pure value fund in your portfolio if you cannot weather such periods of low return. You can avoid this category and instead go for multi-cap funds which have a more blended strategy between value and growth.
Use value and value-based multicap funds only if your holding period is 6-7 years and longer.
Dividend yield funds
Dividend yield is, in other words, a value strategy. Under-valued stocks are usually the ones to trade at attractive dividend yields. This apart, each fund has a very different definition of what it views as a ‘dividend yield’ stock. Finally, note that these funds are under no obligation to pay dividends – dividend yield is just a strategy to discover and identify stocks.
This fund category (barring Principal Dividend Yield) has returned poorly as well. Their average 3-year return based on rolling return since 2017 is just 7.5% against the Nifty 500 TRI’s 10.9% and the multi-cap average of 9.7%. So resist the ‘dividend’ pull and skip this category.
This fund category fits the aggressive portion of any portfolio. The presence of both mid-caps and large-caps gives it a less risky route to higher returns than pure mid-cap and small-cap funds. Do note that funds in this category will vary in their mid-cap allocations – some may have just the minimum mid-cap exposure needed (35%) or close to it while others could take it much higher depending on the market. Because of this large-mid blend, this category can be used in a variety of ways.
Conservative investors can selectively make small allocations here, or avoid it entirely. Moderate-risk investors can use these funds instead of pure mid-cap/small-cap funds; a combination of these three categories with a higher allocation to large-and-mid can also work well. High-risk investors usually like to have big mid-cap/small-cap exposure as other fund categories make lower returns, but this takes portfolio risk and volatility higher than is prudent. This large-and-midcap fund category can be a good option here, as it holds the potential to deliver much more than other categories especially when mid-caps rally.
The large-and-midcap category can be a good option to introduce a high-return component to a portfolio, as it holds the potential to deliver much more than other categories especially when mid-caps rally.
Mid-cap and small-cap funds
These are two fund categories that conservative investors can entirely set aside. While the mid-cap fund category can suit moderate-risk investors, the allocations need to be 20% or lower. Small-cap fund category can be ignored; instead go for the more aggressive mid-cap funds which go for the smaller players in the mid-cap space as well as some small-caps.
Aggressive investors, of course, have no better fit than mid-and-small cap funds. But a 30-35% cap on this allocation is best; if you desire higher allocation, use other categories as explained above. These funds need a timeframe of 5-7 years and longer; if it is shorter, avoid these categories no matter how attractive the returns or how high your risk profile.
These funds need a timeframe of 5-7 years and longer; if it is shorter, avoid these categories no matter how attractive the returns or how high your risk profile.
Index funds that are available now are mostly either the Nifty 50 or the Sensex. As said earlier, they can be used for large-cap exposure, either on their own or along with moderate-risk multicap funds. The Nifty Next 50 is another index which has a few funds built on it, which can be used to lift portfolio returns like aggressive multi-cap or focused funds. As far as other indices go, use them where they are challenging active funds, where their return potential is strong or can provide diversification to your portfolio, or where they fill a gap in active fund offerings. You can check which index funds are good portfolio fits in Prime Funds.
These funds do not need to be a part of every portfolio. For sectors and themes, and some international markets, timing is important. While it can give returns a leg up, missteps on timing can send returns awry. The adage of hold for the long-term will not always work because sectors and themes can remain out of market favour for a long time.
In international funds, stick to broad-market funds and not themes. In looking at markets, avoid those which have drivers similar to our own domestic market. International funds are best used as diversifiers, and choosing a market similar to ours will not help on this front. Depending on the market, these funds can form part of a long-term portfolio.
- You can skip the large-cap fund category altogether, unless you picked one of the few performing ones.
- Instead use plain-vanilla large-cap index funds, or multi-cap funds that have a stable and majority large-cap allocation in your portfolio, or a combination depending on your risk profile.
- Aggressive or dynamic multi-cap funds and focused can be used to boost portfolio returns by any investor – decide allocations based on your risk profile.
- Compare value funds with multicap funds that have a value strategy in order to pick correctly, and use them only if your timeframe is more than 6-7 years.
- Combine or use individually large-and-midcap funds, mid-cap funds, and small-cap funds to get the aggressive exposure in your portfolio.
Please note that the fund names in this article are for examples only. Please use our MF Review Tool to know our buy/sell/hold call on the fund.