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Complexity vs Classification: Different types of funds

Only a good categorisation system will help investors in choosing the right mutual fund


Complexity vs Classification

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, it would be an impossible task. However, the task is made easier if you could divide the funds into categories and sub-categories according to their investment characteristics. Then you can first analyse which category meets your needs.

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But who is to create the categories? On what basis are they created? How are funds placed in the categories? That's where a specialist mutual funds research and analysis service like Value Research comes in. 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 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, for example, which sector or industry they would invest in.

In the accompanying infographic, this classification is depicted as a tree. The root of the tree is all mutual funds. The first level of branches is the basic asset types. These are equity and debt (fixed income). There's also an others category in which we have placed gold funds since it doesn't fall in any of the other categories. Equity and fixed income funds are further sub-divided 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 and not have to be compared with too many other funds from other fund companies.

However, an investor's interest is best served by keeping things simple. There are a 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.

This article first appeared in December 2014.

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