There are hundreds of mutual funds in India. If you were to try and understand each one individually before deciding which is suitable to invest in, you are taking on a near impossible task. However, the challenge is made easier once you divide the funds into categories and sub-categories according to their investment characteristics. You may then start analysing which category meets your needs.
Value Research has been classifying funds based on their underlying investments for a long time. Last year, market regulator SEBI came up with a classification system to standardize fund categories for all asset management companies (AMCs). Our own classification system was quite similar to the one mandated by SEBI, but we have fine tuned it to align more closely with that of the regulator.
The purpose of this fund classification system is to help investors match their expectations and risk-taking ability with the type of fund. 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 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 finally, hybrid funds that have both equity and debt. Their relative return vs risk levels are obvious. Within this first level of classification, the primary criterion for classifying equity funds is the size of the companies they invest in. There are funds that focus mostly on large companies or medium-sized or small companies and there are those that keep their assets distributed among all these in some ratio. There are other axes along which equity funds can be classified, like the sector or industry they invest in.
In the accompanying infographic, the first level depicts the basic asset types. These are equity and debt (fixed income). There's also another category in which we have placed gold funds since this doesn't fall into any of the other categories. Equity and fixed income funds are further subdivided into smaller categories based on other characteristics.
And if you go by how fund companies describe their funds, you will end up with a large number of funds that appear to be unique or near-unique. You may feel 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 from other funds.
However, an investor's 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 it helps you realise that making a choice is actually quite simple and a vast majority of funds can simply be ignored.