I don’t know how much you remember about your secondary school science classes, but I’d like you to think back to the time when your biology teacher introduced you to Linnaean Taxonomy, or your chemistry teacher introduced you to the periodic table. Before you got to the hard part of having to memorise a lot of stuff, you were told about the important role that classification and naming played in understanding. There are millions of species of living creatures in the world and there are 117 elements in nature. Without a framework for classifying them, it is impossible to make sense of their properties. The differences as well as the similarities between different entities become a lot easier to make sense of once you know which category something belongs to and how something compares to other members of the same class.
This is where mutual funds come in. There are hundreds of funds in India, a lot less than the number of living species in the world, but a lot more than the number of elements. The moment you go beyond the handful of funds that someone is trying to sell, you’ll have to face up to the problem of understanding the taxonomy of funds. Whether it’s a specialist mutual fund site like ValueResearchOnline.com, or a general investment website catering to books/magazines, or even fund companies' websites, you’ll need to understand the classification of funds before you manage to get any meaningful information about them.
Unfortunately, the classification of funds is nowhere near as standardised as that of chemical elements, or living beings. Over the past few months, the analysis and data teams at Value Research have evolved a new, simplified system of classifying funds that is better-suited to the task of investors being able to analyse, compare and select funds. The purpose of any fund classification system should be to help the investor match his own returns expectations and risk-taking ability with the type of fund that he is going to invest in. The first thing to understand about fund classification is that it is almost entirely about dividing the entire risk-return continuum into bands of roughly equal return and risk expectations. This makes the real task, that of identifying funds that are likely to generate higher returns, at lower risk, easier.
At the broadest level, funds are classified according to the ratio of equity and debt investments in their portfolios. There are pure equity funds, debt funds and hybrids that have both. Their relative return vs risk levels are obvious. Within this first level of classification, the primary way of classifying equity funds is by the size of the companies they invest in. There are funds that focus mostly on large, or medium, and small companies and there are those that keep their assets distributed among all these in some pre-set ratio. There are other axes along which equity funds can be classified, for example, which sector, or industry, they would invest in.
And if you go by how fund companies describe their funds, then you will end up with a large number of funds that appear to be unique, or near-unique, as there aren’t too many other funds like them. However, this apparent uniqueness is a marketing imperative. It is something that has been invented by fund companies in order to appear different so that they do not have to be compared with too many other funds.
However, investors’ interest is best served by keeping things simple. There are few long-term investment needs that cannot be met by investing in a balance of funds that are mostly large-cap equity along with a little bit of mid-caps.
The best thing about having a good classification system for funds is to realise that making a choice is actually quite simple and a vast majority of funds can simply be ignored.