Retail investors who face the prospect of falling interest rates on their fixed-income instruments and are looking to dip their toes in the waters of market-oriented financial products so as to increase their returns may justifiably feel intimidated by the maze of investment options.

For a start, investing in stocks on your own requires you to be a bit financially savvy, with the ability to pick sound stocks and, secondly, to ‘time the market’. For newbies, therefore, investments in mutual funds, where professionals manage your money for a fee, offer a way to get a shot at higher returns by gaining from the managers’ expertise. Such investments also allow you to have a diversified portfolio at relatively low investment thresholds. But then comes the daunting task of getting acquainted with the entire universe of mutual funds, and specifically the asset class that best matches your risk profile and offers the kind of post-tax returns you seek.

The simplest way to classify mutual funds is to see them through the prism of the asset classes they invest in: stocks and bonds. The three broad categories of funds — equity, hybrid and debt — can be further distinguished on the basis of fund houses, each of which has its own style, objective and strategy.

But consider this: among just equity funds, or funds that invest in stocks, there are 300-odd equity-oriented schemes on offer from 42 fund houses!

As for debt funds, which carry relatively lower risk than equity funds, there is a whole gamut of fund categories and strategies.

But in the end, what matters to you as an investor is how well you can construct a portfolio based on your risk tolerance, investment objective and time horizon.

Are equity funds for you? To build an inflation-beating portfolio and to create wealth over the long term, your best bet is to invest in equity funds. These funds invest at least 65 per cent (and up to 100 per cent) of their assets in stocks. These are ideally suited for investors in their 20s and 30s, who have the benefit of a longer investment horizon.

Diversified equity funds can be further classified as large-cap, mid-cap, small-cap and multi-cap funds, depending on their choice of stocks. Most large-cap funds are required to invest 80 per cent of their corups in large-cap stocks (market capitalisation of over ₹10,000 crore). The top-performing funds in this category have delivered returns of 18 per cent and 12 per cent over five- and 10-year periods, respectively.

Mid- and small-cap funds, on the other hand, invest predominantly in smaller stocks (with market cap of less than ₹10,000 crore). These funds carry slightly higher risk than large-cap funds, but they typically also offer better rewards during market rallies.

For those who prefer stability in returns and have a moderate risk appetite, large-cap funds are a good bet. They deliver inflation-beating returns over the long run, and tend to cap losses in volatile markets.

For those who are game for more risk, mid- and small-cap funds are good options. The top-performing funds delivered stellar returns of 92 per cent in the market rallies of 2014 (against 52 per cent from large-cap funds).

But in falling markets, these funds also tend to fall sharper than large-cap funds. In the 2011 bear market, for instance, these funds lost 26 per cent.

Within equity funds, there are some that bear a higher risk than generic diversified funds because of their exposure to a particular theme or a sector. Thematic funds such as Franklin Build India Fund (infrastructure), Birla SL MNC fund (MNC), Taurus Ethical Fund (Shariah) and Tata Dividend Yield Fund (dividend yield) and contra funds (Invesco India Contra Fund) and sector funds such as those under categories like FMCG, technology, banking, pharma and so on, fall under this category. These funds carry concentrated bets and their performance is prone to cyclical swings.

Investors who look upon the world as their oyster can invest in global funds, but they are riskier than other diversified funds.

For whom are debt funds? Debt funds may not be as risky as equity funds, but they are not without risk of capital erosion. These funds invest in various fixed-income instruments such as government bonds, corporate bonds and other money market and short-term debt instruments. The net asset value of debt funds rises or falls along with the underlying bond prices.

Liquid funds and ultra short-term debt funds work as alternatives to bank savings and fixed deposits; they are riskier than bank FDs, but carry the least risk amongst debt funds. Liquid funds are the safest in this category, investing only in debt securities with a residual maturity of less than or equal to 91 days. Given the short maturity period, the interest rate risk and credit risk (default risk) are minimal. Liquid funds have on average delivered 6.5-8.5 per cent returns annually over the past five years. Ultra short-term debt funds carry a slightly higher risk, given that they invest in debt securities with residual maturity up to one year. The returns, though, can be higher. Over the past five years, returns from this category have averaged 7-9 per cent.

For investors with a slightly higher risk appetite and longer horizon of, say, 2-3 years, debt funds, which generate returns both from accruals and duration calls (only moderately), commend themselves. Short-term income funds and Banking and PSU Debt Funds fall under this category.

Short-term income funds invest in debt securities that mature up to 3-4 years. Their portfolios usually have a small allocation to long-term gilts and higher allocation to AAA-rated, medium-tenure, corporate bonds. Banking and PSU Debt Funds offer stable returns and minimise risk by investing in good-quality debt instruments, mainly issued by banks and public sector undertakings.

Investors willing to bet aggressively on either credit or interest rate movements can consider credit opportunities funds, regular income funds, dynamic income funds and long-term gilt funds.

Credit opportunities funds invest a relatively higher portion in lower-rated bonds, and so carry a higher credit risk, but their duration, at 2-4 years, puts a cap on rate risk. Regular income funds carry a higher rate risk but lower credit risk. Dynamic bond funds essentially ride on rate movements and alter the duration of the fund portfolio depending on the expectation of rate movements.

Gilt funds, which mainly invest in long-term government securities, carry negligible credit risk, but given their typical tenures of 7-10 years, they are more prone to rate risk. They can generate returns of 16-18 per cent when rates fall sharply, but may pinch investors when rates move up sharp.

Hybrid funds: best of both worlds Hybrid or Balanced funds allocate their assets to equity and debt: the debt portion protects the downside; the equity component boosts returns. The risks vary depending on the mix.

Equity-oriented balanced funds invest more than 65 per cent in equity and the rest in debt. The higher allocation of equity helps deliver superior returns while also offering capital gains tax benefits available for diversified equity funds.

Debt-oriented schemes allocate up to 40 per cent and Monthly Income Plans (MIPs) 10-30 per cent of their corpus into equity, thus pegging the risk. However, the returns are also lower than those from equity-oriented balanced funds. Moreover, as they fall under the category of debt funds, they invite short-term capital gains on investments under three years.

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