For well over two decades now, Value Research has been at work bringing order to the chaotic world of India's mutual funds. An integral part of of this work--perhaps even the most important part, without which nothing else is possible--is our system of fund classification.
The Need for Classification
There are close to two thousand mutual funds in India. These are suited to all kinds of investment needs, from ultra-safe ways of parking temporary cash for a few days, to making superlative but volatile returns over periods of years or even decades. There are funds that invest in corporate or government bonds, in stocks (both domestic and global), in precious metals, in commodities, and even funds that invest in other funds. Unless investors can categorise this zoo in some way, it would be impossible to choose the right investment, or to make any useful comparison between funds.
The Basics of Classification
Classification has to be logically derived from the characteristics of the funds, as well as the needs of investors. To better understand the current set of changes, let's review the basics of the classification system. Fund classification 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.
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. Then, we subclassify the equity, debt or hybrid class into further categories.
Current Changes
Our current changes in the system only pertains to the categories within the equity class. Debt funds and hybrid funds will continue as they are. Even within equity, the changes are being made only to diversified funds. Sector, international, tax-savers or other special purpose funds remain unchanged.
In equity, these are the new categories that we have from October 1, 2015 onwards, in ascending order of risk and volatility.
- Large Cap Funds: Mostly invested in large-cap stocks.
- Multi Cap Funds: Invested across large- and mid-cap stocks.
- Mid Cap Funds: Mostly invested in mid-cap stocks.
- Small Cap Funds: Mostly invested in small-cap stocks.
The Details
To decide which capitalisation band of stocks a fund follow, we crunch the data on every fund's last eighteen months' portfolios. For each of these months, we calculate the asset-weighted geometric mean of the market capitalisation of the companies that each fund has invested in. Then, we calculate the arithmetic mean of these 18 values. This mean is a single number that represents the market capitalisation of the fund's last 18 months.
Now, we need to compare this to the market capitalisation of the entire universe of large, mid, small etc companies. To ensure that these ranges adjust dynamically, we define these in a way that they move up or down with the markets. We define as large cap, the smallest number of companies (meaning the largest companies) whose market cap can add up to 50 per cent of the total market cap of the BSE. The lower bound of this range, i.e., the market cap of the smallest of these companies, is the cutoff point for the large cap range. All those funds whose 18 months average portfolio market cap (defined above) is more than this cutoff point are classified as large cap funds.
Just as the large cap cutoff is defined for the largest companies that add up to 50 per cent of the market's total capitalisation, the multi-cap, mid-cap and small-cap ranges are defined as the next 20, 15 and 15 per cent respectively.
The above calculations are redone at the beginning of every month, as soon as funds have released their previous month's portfolios.
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