In 2017, SEBI defined mutual fund categories based on the type of securities the schemes within each category can invest in as per SEBI’s mandate. Different scheme categories have different risk profiles. An AMC can have only one product in each scheme category. SEBI’s scheme categorization enabled investors to select the appropriate scheme category according to their investment needs, compare different schemes within the same category and make informed decisions.

While SEBI’s scheme categorization has clarified risk characteristics and labelling of different mutual fund schemes, investors now have to navigate through a fairly large number of categories – 10 equity fund categories, 16 debt fund categories and 7 hybrid fund categories. In addition to these categories, there are solution oriented funds, ETFs and index funds. In this article, we will discuss some broad principles about how to select mutual fund scheme from different categories.

Investment needs / financial goals

This is one of the most important considerations in making any investment decision. Investments should have a purpose and be linked to your financial goals. The most important aspect of investment needs or financial goals is the investment horizon or tenure. Your goals can be short term, medium term and long term. You should always choose scheme categories based on your investment horizon. Equity funds or equity oriented hybrid funds (e.g. aggressive hybrid funds, balanced advantage funds etc.) are always suitable only for long investment tenures. Recommended minimum investment tenures for equity funds is 5 years.

You can invest in debt funds if you have short to medium investment tenures. If you have very short investment tenures e.g. less than 1 year then overnight funds, liquid funds, ultra-short duration and money market funds are suitable. For medium investment tenures e.g. 1 to 3 years, you can invest in low duration funds, short duration funds etc. For investment tenures of 3 years or longer, you may invest in longer duration funds.

Risk profile

How to choose between scheme categories – Risk profile is another important factor to consider in choosing mutual funds. Different investors have different risk appetites depending on their age, assets / liabilities, financial situations, investment experience etc. You should ensure that the risk profile of a scheme matches with your risk appetite.

You should invest in equity funds only if you have high risk appetites. Certain categories of equity funds can be more volatile than others e.g. midcap, small cap etc. You need to have very high risk appetites for these scheme categories. Hybrid funds may be more suitable if you have moderately high risk appetites.

If you have low to moderate risk appetite then debt funds are suitable for you. If you have low risk appetites you should invest in debt funds which have very short maturity or duration profiles e.g. overnight funds, liquid funds etc. These funds have relatively low volatilities. If you have moderately low to moderate duration profiles, then you can invest in debt funds of duration profiles which are longer than 12 months.

Please note that category suggestions above are purely illustrative to indicate the fact that, different categories have different risk characteristics. Different schemes within the same scheme category can have different risk profiles. SEBI requires AMCs to label the risk profile of each scheme in the Riskometer. You should always refer to the scheme Riskometer and make informed investment decisions. Consult with your financial advisor if you have any doubt on how to choose mutual fund scheme.

Liquidity

Liquidity of an investment is, how easily and how soon you can convert your mutual fund units to cash if the need arises. For some investments you may need immediate liquidity if need arises, while for others you may not need liquidity immediately and can afford to hold for longer horizon. You need to consider four factors as far as liquidity is concerned:-

• Type of scheme: There are two types of schemes – open ended funds and close ended funds. You can redeem units of open ended funds any time, while close ended funds can be redeemed only on maturity. If you need liquidity you should invest in open ended funds.
• Lock-in period: Some mutual fund schemes e.g. ELSS, have lock-in periods. Lock-in period for ELSS is 3 years. You cannot redeem within the lock-in period.
• Exit loads: Exit load is the charge levied on redemptions within a certain period of time from the investment date. Some mutual fund schemes do not have exit loads, while others have exit loads. Scheme categories like overnight funds and ETFs do not have exit loads. Liquid funds charge exit loads, for redemptions within 7 day of investments and no charge thereafter. Even within the same scheme category, many schemes may charge exit loads while others may not charge exit loads. Exit load structures can also differ from scheme to scheme. You should go through the Scheme Information Document (SID) to know the exit load structure and make informed investment decisions.
• Volatility: This should also be an important consideration as far as liquidity is concerned. For the investments where you may need immediate liquidity e.g. an emergency fund, you do not want high volatility. On the other hand, if you do not have immediate need for the money, you can invest in volatile funds according to your risk appetite.

Tax considerations

You can claim deduction of up to Rs 150,000 from your taxable income under Section 80C of Income Tax Act 1961 by investing in Equity Linked Savings Schemes (ELSS). Investors with high risk appetites may consider ELSS for their tax savings investments given the wealth creation potential of ELSS in the long term.

Apart from tax savings, one may invest in different scheme categories based on individual tax considerations. For example, capital gains in debt funds e.g. liquid funds, for investment held for less than 3 years are taxed as per the income tax rate of the investor. Equity fund capital gains for investment held for less than 1 year is taxed at 15%. Arbitrage funds, which are similar in risk profile to liquid funds, are treated as equity funds from a tax perspective. Investors in the higher tax brackets may invest in arbitrage funds to get tax benefits.

However in our view, one should not invest in a scheme category purely based on tax considerations. Your investment needs and risk appetite should more important factors than tax considerations.

Investment Experience

You may invest in certain scheme categories for specific purposes based on your investment experience and knowledge. For example, you may invest in certain scheme categories like sector funds, focused funds, value funds, fund of funds etc., to supplement your core investment portfolio, if you understand the underlying characteristics of these scheme categories and the scheme in particular. It is important that you understand the investment strategy, even if it is at a high level and not invest based on perceptions, suggestions of friends or relatives, tips / recommendations on social media etc. You should read the scheme information document and consult with your financial advisor before investing.