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The types of funds that most investors can safely ignore

Among the five broad categories, SEBI bunched schemes into further sub-categories to bring uniformity in their features. Such classifications have made comparisons easier for investors. However, there are some fund types that investors can safely ignore.

A couple of years back, the market regulator Sebi standardised the categories for mutual fund schemes and defined its characteristics. Among the five broad categories, it bunched schemes into further sub-categories to bring uniformity in their features. Such classifications have made comparisons easier for investors. 

However, there are some fund types that investors can safely ignore. 

Credit Risk Funds

 It is an open-ended debt scheme that invests in lower rated corporate bonds. Sebi defines that a fund should invest at least 65 percent of their assets in below the highest rated bonds to be called a credit risk fund. Therefore, these funds invest majorly in bonds rated below ‘AAA’ – that is ‘AA’, ‘A’ or lower rate bonds. 

Where is the kicker?

However, these funds have given lower growth rates than that that of a relatively safer corporate bond fund that invests at least 80 percent in highest rated instruments. 


In the last five years, credit risk funds, gave average annualised growth of 6.5 percent as against 7.3 percent for a corporate bond funds. In the last 10 years, it was 7.2 percent as against 7.8 percent for corporate bond funds. Considering the risks associated with investing in lower rated debt securities, the trade-off for potential investors is hard to justify. For most fixed income investors looking for stability and for meeting their short term requirements, these funds don’t make much sense as part of their portfolios.


Solution-oriented Mutual Funds

Solution-oriented schemes like retirement or children funds are often touted as one-stop-solution for meeting your specific financial goals. They often come with multiple asset-allocation options (equity-debt combination). However, it is nothing but a hybrid scheme. Moreover, there is a lock-in period of five years. 

Also, investment options are wide open for these funds. Funds can easily take a higher (equity) risk than their peers in their quest for more returns. More importantly, there is the risk of moving away from your targeted asset allocation strategy by investing in these funds - as you remain unsure of what proportion of your investment is going into equities or debt.

Instead of goal-based funds, you can easily mix and match and invest in a combination of appropriate equity and debt funds in the proportion of your preference. In the process, you will not only diversify your bets but also stand a better chance of achieving your financial target. 

Small cap funds

For every unit of risk taken, small cap funds have poorly rewarded their investors in terms of returns as compared to that of mid cap or large cap funds. 
To qualify as small cap fund, the equity fund needs to invest at least 65 percent of its portfolio in small cap stocks. In the past, these funds have been unable to adequately compensate investors for the higher portfolio risk taken. Across time horizons, they have underperformed as compared to mid cap funds. 

In the last five years, small cap funds gave an average annualised growth rate of 8 percent as against 8.4 percent for mid cap funds. In the last 10 years, they gave a CAGR of 12.2 percent as compared to 14 percent for mid cap funds. 

For every unit of risk taken, small cap funds have poorly rewarded their investors in terms of returns as compared to that of mid cap or large cap funds. 

Lack of liquidity

Moreover, lack of trading in the small cap counters creates liquidity management issues for fund managers. Often, bigger-sized small cap funds close for subscription or increase stake in mid caps and large cap stocks for dearth of investing opportunities and the need to retain fund liquidity. You are better off investing in mid cap funds that anyway take a slight small cap exposure.

Takeaway 

Three type of funds – credit risk (debt), solution-oriented schemes and small cap (equity) don’t add any significant value for most investors based on the evidence so far. Better to stick to the boring but reliable options that will get you to your goals with greater reliability.

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