Asset Class in Mutual Fund: Meaning, Types and Factors

In the previous chapter, we studied the classification of mutual funds based on organisational structure, portfolio management and investment objective. This chapter focuses on classifying mutual funds based on the types of asset classes they invest in. But what do you mean by asset class? To recap, an asset class is a group of various financial instruments that share similar financial characteristics and act similarly in the marketplace, eg. equity, gold, etc.

But the question arises: why is there even a need to diversify your portfolio among various asset classes? Let’s quickly understand this.

Significance of Asset Allocation 

Let’s know the workings of asset allocation with the help of an illustration. Imagine a store specialising in winter apparel like jackets, scarves, gloves, etc. It also sells winter gear similar to ice skates and skis. As a result, it does significant business around the winter season. Still, come summer, the store tends to do zero business. Now the store has decided to expand its range of products. They opened a section where they vend all kinds of apparel that could be worn in warmer seasons. They have begun to vend other accessories similar to regular rollerskates, skateboards, etc. Now, the store generates business in both winter and summer.

Moreover, the store has decided to open several departments that vend books, groceries, cabinetwork, electronics, etc. Now, once a bitsy, little window store, it is a huge departmental store that does great business each time around. Before, the entire store business depended on winter, but now with a departmental store that sells all kinds of products each time around, the business continues to shine with a much lower threat. Asset allocation works on a similar conception wherein the pitfalls are minimised with the help of diversification of investments across asset classes.

You can benefit from asset allocation in the following manner:

• Optimal Return: Numerous investors invest in an ad hoc manner. Some investors are, moreover, too aggressive or conservative and invest accordingly. This might lead to over-investment in a particular asset class while under-investment in others. As a result, they cannot earn consistent returns on their investments. Proper asset allocation will help you determine how much return you can anticipate on your investments based on the investment risks you're taking. This is so because you are invested in multiple asset classes at once, thus limiting the portfolio drawdown in uncertain times. When one asset class underperforms, others might outshine it, thus helping you earn optimal returns. 
• Minimises threat: While each asset class has its share of pitfalls and prices, diversifying your investments reduces volatility. Asset allocation ensures that portfolio threat is spread across multiple asset classes. 
• Lowers Stress: Investing should not be stressful! Instead, it should help you sleep better at night. Asset allocation across multiple asset classes significantly reduces your stress regarding the safety of your investments. lower stress fosters confidence and helps investors invest in regular intervals. Also, proper asset allocation/ diversification helps investors manage volatility or loss much better.
• Asset Allocation Maintains Discipline: As discussed earlier, asset allocation can limit portfolio drawdown, especially during uncertain times. This motivates investors not to panic sell their portfolio securities and thus helps them in becoming long-term investors. Therefore, asset allocation fosters discipline and helps in financial security.   

As per Securities and Exchange Board of India (SEBI) guidelines on categorisation and Rationalization of schemes, mutual fund schemes are classified as –

1. Equity Schemes
2. Debt Schemes
3. Hybrid Schemes
4. Solution-Oriented Schemes - Retirement funds and Children’s fund
5. Other Schemes - Index Funds, Exchange-traded funds and Fund of Funds

This chapter will focus on the first three types of mutual funds. Other categories will be covered in the next chapter. 

Equity Schemes

As the name suggests, equity funds are mutual funds primarily investing in equities and equity-related instruments. These funds are usually suitable for investors with long-term investment horizons [minimum 5 Years +], as the return from these funds can be volatile in the short term. These funds aim to offer long-term capital appreciation for investors and thus are suitable for investors with higher risk appetite. 

Investors should note that equity funds can focus on specific market sectors or may even follow a different investment style. Let’s understand the types of equity schemes in detail. Please note all the definitions and allocations have been taken from the Association of Mutual Funds of India [AMFI]. 

Large-cap funds

These equity funds invest at least 80% of funds in large-cap stocks. Large-cap stocks, also called blue-chip stocks, are the biggest companies in terms of market capitalisation. As previously learned, market capitalisation equals the market prices of shares multiplied by the total number of shares outstanding. Usually, it includes the top 100 companies' biggest companies in terms of market capitalisation as the target universe. These companies usually have a market capitalisation of greater than Rs 20,000 crores. They are often part of broad market indices such as NIFTY 50 and SENSEX, primarily because they have a strong market presence. Thus, these companies are comparatively less volatile when compared to mid or small cap companies and thus are suitable for investors who want exposure to equities with limited risk exposure, as these companies are usually fundamentally sound.

Mid-cap funds

These equity funds must invest at least 65% of funds into mid-cap stocks. Mid-cap stocks are the next 101st - 250th biggest companies in market capitalisation, beyond large-cap companies. Usually, these companies market capitalisation ranges from Rs 5,000 to Rs 20,000 crores. These are relatively smaller companies than large-cap stocks, and that’s why investors wish to invest in these companies due to their potential to become large-cap. However, these companies can be more volatile than large-cap stocks and, therefore, more risky. Investors who want exposure to equities with comparatively higher risk appetite can look to invest in such funds. 

Small-cap funds 

These equity funds need to invest at least 65% of the funds in small-cap stocks. Small-cap stocks are the companies beyond the 250th rank in market capitalisation. These companies usually have a market capitalisation of less than Rs 5,000 crores. These companies can be the riskiest compared to large-cap and mid-cap but also offer the potential of the highest returns due to their exponential growth opportunities. 

Therefore, in terms of riskiness, small-cap stocks are the riskiest, and large-cap stocks are the least riskiest. As the name suggests, mid-cap stocks lie in the middle of the risk scale. 

However, suppose investors wish to invest in a mix of stocks with different market capitalisations without investing in separate funds for each category. In that case, there are other types of mutual funds too that offer such an investment opportunity:

• Large and Mid-cap funds

By definition, these funds invest a minimum of 35% of the funds in large-cap stocks and a minimum of 35% in mid-cap stocks. Thus, an investor gets exposure to large and mid-cap stocks by investing in a single fund. The remaining 30% of the allocation is at the discretion of the fund manager. Thus, if you want to reap the benefits of the stability of large-cap companies with little extra risk of mid cap companies, then this fund is for you.

• Flexi-cap funds

As the name suggests, these funds are free to invest in large-cap, mid-cap, or small-cap stocks and thus are flexible across market capitalisation. As per SEBI’s definition, at least 65% of the funds must be invested in equity and equity-related instruments. Thus, the fund manager can invest in any market capitalisation stock with no minimum restriction. Therefore if you want to simultaneously invest in large cap, mid cap and small cap companies in a single fund to reap the benefits associated with all three, then this fund is for you. Please note allocation across various market capitalisations is at the fund manager’s discretion. 

• Multi-cap funds 

Don’t confuse this category of funds with flexi-cap funds, as although they resemble a similar investment approach of investing in different market capitalisation stocks, the fund manager must invest a minimum of 25% in large-cap, mid-cap, and small-cap stocks. Thus, unlike flexi cap funds, a minimum of 75% of the investments should be in equity and equity-related instruments, with a 25% minimum restriction in each category of stocks. These funds are also referred to as Diversified Equity Funds – as they invest across stocks of different market sectors and segments. Diversification minimises the risk of high exposure to a few stocks, sectors, or segments. Thus, the underlying principle behind the multi cap fund and a flexi cap fund is same, just the fact that multi cap funds have a minimum subscription clause. 

Summary Table for the Above-mentioned Funds:

The other categories of equity mutual funds based on investment style or sector-specific focus can be:

• Sector-specific and thematic funds 

As the name suggests, these are the types of equity funds that primarily focus on investing in a particular sector or theme like infrastructure, agriculture, banking, information technology, etc. SEBI has mandated that these funds be invested in at least 80% of stocks of a particular sector or theme. 

Since these funds focus on a particular sector or theme, these funds offer less diversification and can be riskier for investors. Also, the timing of investments in these funds becomes crucial as specific sectors tend to be cyclical in nature and thus are impacted by the phases of market cycles. 

Thematic funds have a broader focus than sector-specific funds as they tend to invest in a broad theme rather than a specific sector. Thus, they offer more diversification than sectoral funds. 

• Value funds 

This mutual fund category is based on the investment style where the fund manager follows a value investing style. As the name suggests, these funds aim to invest in undervalued stocks and hold them long-term as their value unlocks. In the valuations chapter, we understood various approaches to valuing a company's stocks. We learned that when the stock trades below its intrinsic value, it is considered undervalued. Value mutual funds aim to invest in such stocks. Thus if value style of investing suits your investment thesis, this fund is for you. 

• Contra funds 

These are the mutual funds that take a contrarian view of the market. What does that mean? Underperforming and defensive stocks that are beaten down by the markets are picked by these mutual fund managers to perform better in the future. These are usually those stocks that have given negative returns during bear markets but have the potential to perform better in the future. These funds generally carry the risk of getting investment calls wrong, as catching a trend before the herd is not possible in every market cycle. Thus, these funds can typically underperform in a bull market.

• Equity Linked Savings Scheme [ELSS] funds 

These funds are among the tax savings category of mutual funds. These funds invest 80% of their funds in equity and equity-related instruments. However, investors should note that these funds have a lock-in of 3 years, i.e. once the investor has invested in the ELSS funds, the investment amount gets locked in for three years, and investors cannot withdraw these funds until the lock-in period ends. The investors investing in this category of funds are eligible for deduction under Section 80C of the Income Tax Act up to ₹1,50,000. 

• Focused funds 

This is the only category of equity mutual funds where the fund managers are allowed to take concentrated positions. By concentration, we mean that the fund managers invest only in a limited number of stocks. As per the Security and Exchange of India or SEBI guidelines, focused funds are mandated to invest in a maximum of 30 stocks. Therefore, these funds can be highly risky for investors due to their volatile nature, as the stocks are high-conviction bets of fund managers. These stocks can be among the large-cap category, mid-cap, or even small-cap. 

• Dividend yield funds

Dividend yield refers to dividends paid per share divided by the share price. Therefore, dividend yield funds aim to invest in those companies that pay high dividends. The premise behind investing in such companies is that high dividend companies are high profit-generating companies. Therefore, the investor can get their exposure to profitable companies that pay dividends to them. It is important to note here that the criteria is not merely high dividends but a high dividend yield. If a stock pays good dividends, but its market price is very high, the dividend yield is low, and the fund might not invest in it. 

Summary Table for Funds Discussed Above:

These were broadly the categories of equity mutual funds. Each fund predominantly invests in the equity class, with differences in their investment style, market capitalisation, or focus. Equity funds are risky, as mentioned earlier, as equities are a volatile asset class. 

If the investor wants more stability in their portfolio, they can look for debt mutual funds, which is the focus of the next section. 

How To Invest in Mutual Funds on Angel One?

1. Open the Angel One app. On the Home page, go to ‘Mutual Funds’.
2. Choose the Mutual Fund that you want to invest in from the various lists provided on the Mutual Fund portal.
3. Choose whether you want to invest via lump sum or SIP mode.
4. Enter the amount that you want to invest.
5. Click on the payment button to complete the payment and start your investment.

• Debt Mutual Funds

A debt mutual fund primarily invests in bonds and debt securities. As you might have studied, debt securities are fixed maturity instruments that pay regular interest in coupon payments with the return of principal at the end of the maturity period of such securities. These instruments can be shorter-term and long-term maturity instruments in the form of treasury bills, commercial papers, government securities, corporate bonds, etc. 

Debt funds can be categorised based on the tenure of securities, issuers of securities or the fund management strategies. 

Based on tenure, debt funds can be broadly categorized as:

• Overnight funds 
• Liquid funds 
• Ultra-short duration funds 
• Low duration funds 
• Money market funds 
• Short duration funds 
• Medium duration funds 
• Medium to long-duration funds 
• Long duration funds 

Based on issuers of securities, debt funds can be categorized as:

• Gilt funds 
• Corporate bond funds 
• Infrastructure debt funds 

Based on fund management strategies, debt funds can be categorized as:

• Floating rate funds 
• Dynamic bond funds 
• Fixed maturity plans 

Let’s start with the fund's categorisation based on tenure. Please note that under this category, although investors might get overwhelmed by the various types of debt funds available, they shouldn’t be worried about it, as understanding them is very simple. One common line of characteristics that links all the kinds of mutual funds based on tenure is the maturity of the debt instruments they invest in. Thus, shorter-term debt funds invest in short-term debt securities, while longer-term debt funds invest in long-term debt securities. We hope you got the basic gist of it. Let us move on further to discuss the types of funds:

• Overnight funds 

This category of debt funds invests in overnight debt securities having maturity of up to 1 day. This means the portfolio's securities mature daily, and the fund manager uses the proceeds from the maturity to buy new overnight securities. Thus, it is suitable for very short-term investors who want to park their excess funds for a single day up to a few days only. These funds are safer and have low-risk factors due to minimal volatility and high liquidity. 

• Liquid funds 

This category of debt funds invests in debt securities with a maturity of up to 91 days. This fund is suitable for investors who wish to park their investment for up to 3 months. These are usually high-quality securities carrying lower levels of risk. Investors who wish to earn slightly higher returns than the savings bank account want to invest in liquid funds. Due to their short-term nature, these funds are relatively safe and offer low volatility to investors. 

• Money market funds

The Money market is a financial market where trading of short-term securities having maturity of up to 1 year takes place. Therefore, money market funds invest in debt securities having a maturity of up to 1 year. The fund manager can wish to invest in a mix of overnight and short-term securities. These funds are usually suitable for investors with excess liquidity and can park them for a year. 

To understand further funds based on tenure, it is important to understand a term called Macaulay Duration. It is a very important measure in finance and investment to calculate the time for a bond’s cash flows (both interest and principal) to pay back the initial price. In other words, 

Key points to note about it:

• An investor can interpret Macaulay Duration as the average time he can expect to recover his investment amount from a bond through interest and principal payments. 
• It is also a measure of a bond’s sensitivity to interest rates. Usually, the higher the Macaulay duration, the higher the sensitivity of the bonds towards interest rates. 
• Investors usually use Macaulay duration to match the duration of their bond portfolio with the investment horizon. 

Understanding Macaulay Duration becomes important because SEBI has classified funds based on the Macaulay duration of the fund’s portfolio. With that in mind, let’s quickly understand the further categorisation of debt funds using SEBI’s definition.

• Low duration funds:

These debt funds aim to invest in Debt & Money Market instruments with a Macaulay portfolio duration between 6 months- 12 months.

• Short-duration funds: 

These debt funds aim to invest in Debt & Money Market instruments with a Macaulay portfolio duration between 1 year and 3 years.

• Medium duration funds:

These debt funds aim to invest in Debt & Money Market instruments with a Macaulay portfolio duration between 3 years - 4 years

• Medium to long-duration funds

These debt funds aim to invest in Debt & Money Market instruments with a Macaulay portfolio duration of between 4 - 7 years. 

• Long-duration funds

These debt funds aim to invest in Debt & Money Market Instruments with a Macaulay duration of the portfolio over 7 years. 

These were the classification of funds based on tenure. Please note that the understanding of the funds is self-explanatory for the investors. Investors can match their investment horizon with the Macaulay duration of the portfolio to make their investment decisions. 

A Summary Table for the Above Funds is Presented Below:

With that, let’s move on to the subsequent classification of debt funds based on the type of issuer.

• Gilt funds

These funds are solely invested in long-term debt securities issued by the central and state governments. Since the issuer of the securities is the government, these carry a minimal default risk. However, as the duration of portfolio securities is higher, they carry a higher interest rate risk, i.e. as the Macaulay portfolio duration is high, the fund's interest-rate sensitivity is high. Therefore, although the default risk is low, these funds are not risk-free per se. There is another category of Gilt funds with a 10-year constant duration. These funds maintain a Macaulay duration of 10 years.

• Corporate bond funds 

Just like the government needs capital to serve the nation’s development goals, corporations also need capital to fund their capital expenditure and growth needs. Capital raising from equity may not always be a viable solution for them. That’s why these firms issue debt securities to raise money from investors. Such securities are referred to as corporate bonds. Corporate bond funds make at least 80% of their investments in AA+ and above-rated bonds. AA+ is a credit rating given to securities by different credit rating agencies.

Simply put, the higher the rating, the better the quality of security and, therefore, the lower the risk of default. Refer to the table below for more reference. These funds aim to provide a relatively higher return rate to investors as corporates are a risky investment. 

Credit ratings by different credit rating agencies

• Credit risk funds 

These funds are similar to corporate bond funds. However, unlike corporate bonds, which are mandated to invest a minimum of 80% in AA+ and above-rated bonds, credit risk funds need to invest a minimum of 60% of the funds in corporate bonds rated AA and below. Therefore, these funds aim to generate higher returns by investing in lower-quality bonds that provide higher returns. But as the name suggests, these funds carry a high degree of credit risk and chances of default by the portfolio companies. Only Investors with a higher risk appetite should invest in such funds. 

• Banking and PSU fund 

These funds aim to invest at least 80% of the funds in debt instruments of banks, public sector undertakings, public financial institutions, and municipal bonds. These are government-backed companies and, therefore, carry lower levels of default risk. 

Based on fund management strategies, the categorisation of debt mutual funds can be:

• Floater funds 

In most of the debt funds we studied above, we saw how debt funds are exposed to changing interest rate risk—especially long-duration funds. Floating-rate bonds are a solution to interest rate risk. Floating rate funds invest in bonds and debt securities whose interest is reset periodically so that the fund portfolio earns coupon income that is in line with prevailing market rates and eliminates interest rate risk to a large extent. The fund must invest 65% of the funds in floating interest-bearing debt securities of various publicly listed companies and government securities. Risk-averse investors looking to secure the principal component can opt for such debt mutual funds.

• Dynamic funds 

As understood before, the changing interest rates affect the performance of debt funds. If the interest rates rise, the debt funds experience a fall in returns. Conversely, the debt fund is expected to generate good returns in a falling interest rate cycle. Dynamic mutual funds aim to benefit from rising and falling interest-rate cycles by adjusting their portfolio allocations between short-term and long-term bonds. Therefore, This alteration allows the fund to offer steady returns regardless of the interest rate cycle. These funds are suitable for investors who want to generate returns from their debt investments regardless of the interest rates.

• Fixed maturity plans [FMPs]

Unlike other schemes, FMPs belong to the closed-ended funds category that aims to remove interest rate risk by locking in a fixed yield. This is achieved by investing only in securities whose maturity matches the maturity of the overall fund. FMPs create an investment portfolio whose maturity profile matches the FMP tenor's. Here, investors must commit money for a fixed period as they cannot redeem units prematurely. Thus, these funds can potentially provide better returns than a liquid or ultra-short-term fund since investments are locked in. As these schemes are closed-end, they are mandatorily listed on stock exchanges. Investors who want to buy or sell units of FMPs on the stock exchange can only do so after the NFO. Another important point to note is that only units held in dematerialised mode can be traded; therefore, investors wishing to buy or sell units in such schemes must have a demat account.

• Hybrid Mutual Funds

Until now, we have separately understood equity and debt funds and their classifications. What if an investor wants to simultaneously invest in a mix of debt and equity investment per his/her risk appetite without the hassle of investing in separate funds? In such situations, hybrid funds come as a solution. From the name itself, you can determine that hybrid funds are mutual funds investing in debt and equity securities. Therefore, the hybrid fund portfolio consists of debt and equity components, thus balancing growth and stability in a single fund. The risk and return of the hybrid fund will depend on the equity exposure taken by the fund. Usually, the higher the proportion of equity in a portfolio, the greater the risk based on the proportion of equity and debt in a fund; hybrid funds can be categorised into:

• Conservative Hybrid Fund

As per SEBI mandate, these funds need to invest 10% to 25% in equity and equity related instruments while 75% to 90% in debt instruments. As the name suggests, these funds are suitable for conservative investors as the proportion of debt is high in the portfolio. These funds are more of a debt-oriented hybrid fund for conservative investors who want stability in their portfolio with a little return boost with a small equity exposure. Thus, the main goal is to preserve capital with a small degree of capital appreciation. 

• Aggressive Hybrid Funds

As per SEBI mandate, these funds need to invest 65% to 80% in equity and equity-related instruments while 20% to 35% in debt instruments. Therefore, these funds are suitable for aggressive investors with comparatively higher risk appetites, as the equity proportion is high in the portfolio compared to conservative funds. These funds are more of an equity-oriented hybrid fund for investors looking for growth in their investment with some stability. The risk associated with these funds is lower than that of a pure equity fund.

• Balance Hybrid Funds

As per SEBI mandate, these funds need to invest 40% to 60% in equity and equity-related instruments while 40% to 60% in debt instruments. Therefore, these funds lie between conservative and aggressive hybrid funds and are suitable for investors who want to maintain a balanced proportion of debt and equity in their portfolios.

• Dynamic Asset Allocation or Balanced Advantage Funds  

These funds invest in both equity and debt securities. However, unlike other regular hybrid funds discussed above, which are mandated to keep their allocation between equity and debt within certain prescribed limits, Balanced Advantage Funds [BAFs] have no such limits and thus move their allocations more dynamically. The decision to move between the debt and equity components depends on the fund manager’s discretion. 

These were the mutual funds classification based on equity and debt. However, how should you make your decision regarding asset allocation? Let’s understand this:

Factors To Consider for Asset Allocation

Determining the right mix of assets for your portfolio is very personal. When making investment decisions, an investor’s asset allocation decision is influenced by various factors such as personal financial goals and objectives, risk appetite, and investment horizon. Let’s understand these factors.

• Time of horizon for investment goal

The time horizon is the number of months or years an investor expects to invest to achieve a particular goal. Different investment horizons entail different risk tolerances. 

For instance, a long-term investment horizon motivates an investor to invest in a higher-risk portfolio consisting of equities, alternative investments, cryptos, etc., with lower reliance on debt. However, if the time horizon is short-term, debt exposure in a portfolio becomes necessary. 

• Risk tolerance

It refers to an investor’s ability and willingness to lose their original investment in anticipation of greater potential returns. Aggressive investors, or investors with high-risk profiles, are more likely to risk most of their investments to earn better returns. While conservative investors or risk-averse investors are more likely to invest in securities that aim to preserve their original investments. Thus, determine your risk tolerance levels and invest accordingly. 

• Age

This factor is crucial in determining your asset allocation. If you are young, say in your early 20s or 30s, your risk appetite tends to be higher as dependencies are lower. Therefore, you can afford to invest higher allocation to risky assets like equities during this period. However, if you are nearing your retirement, the focus should be on capital preservation. Therefore, your risk appetite tends to reduce significantly. Of course, personal situations can change this. However, the general rule of thumb says that the lower an investor's age, the higher the risk appetite. 

Now that you have realised the importance of asset allocation and what factors it depends upon, let’s look at some of the most common diversification strategies.

Diversification Strategies

• Strategic Asset Allocation

This strategy involves determining and maintaining an appropriate mix of various asset classes in the investor’s portfolio. This mix of multiple asset classes in the investor’s portfolio is based on factors such as the investor’s risk profile, age, etc. In this type of asset allocation, timely portfolio rebalancing is done to ensure that the contribution of individual assets in the portfolio is maintained at the pre-specified levels.

Take, for instance - The auto-choice option of the National Pension Scheme (NPS), where investors have the option to choose the maximum equity allocation between 25% and 75% till they attain 35 years of age. However, after 35 years of age, the equity allocation of the investor’s portfolio is reduced by a fixed percentage every year. In other words, you can say that the asset allocation of the NPS portfolio is strategically changed as per the investor’s age.

• Tactical Asset Allocation

This strategy involves tactically changing the mix of various asset classes to take advantage of changing market conditions in an investor's portfolio. The main objective of tactical asset allocation is to benefit from relatively short term market movements, keeping the pre-determined strategic allocation intact over the long term. 

For instance, You increase equity allocation in your investment portfolio during a market downturn for the short term to benefit from the lower market prices of quality stocks. When markets recover later, these quality stocks can be sold at higher prices for a profit to generate higher returns for your portfolio. 

• Dynamic Asset Allocation

This strategy is somewhat similar to tactical asset allocation as it also involves changing the short term allocation of different asset classes to benefit from the changing market conditions. However, unlike tactical asset allocation, dynamic asset allocation is more frequent and rapid as it involves continuous adjustments to the portfolio. That's why this kind of allocation is usually performed using automated systems based on various financial models. If you want your portfolio to be managed using this strategy, you can choose to invest in dynamic asset allocation funds, also known as balanced advantage funds.

• Age-Based Asset Allocation

This allocation strategy takes into consideration your age as the critical factor in determining your portfolio allocation. This is a very generic rule and may need to find universal acceptance. Under this strategy, your portfolio's equity allocation is determined by simply subtracting your current age from the 100. 

For instance, if you are currently age 30, you can have 70% (100-30) equity in your portfolio, and the remaining 30% can be debt or any other asset class.

This sums up our discussion on classifying mutual funds based on asset classes. In the next chapter, we will discuss different solution-oriented and other types of mutual funds.