Prime Funds is our list of recommended funds across equity, hybrid, and debt funds. Well, that’s straight enough to understand. But knowing the list of best funds to invest in is just part of the process. Knowing how to mix them and use them in the right allocation is the other part. Therefore, we bucket Prime Funds into categories that are more usable and offer an idea of how to use them, instead of the normal SEBI classifications.
(Of course, PrimeInvestor subscribers always have access to Prime Portfolios, our ready-to-use portfolios for various time frames and needs. This is suitable if you are new to mutual funds. But if you wish to build your own portfolio with our recommended list of funds, then read on).
But for those of you used to SEBI’s categories, Prime Funds may seem incomplete. For those of you newer to mutual funds, you may be at a loss on how to allocate between Prime Funds. And there are some of you who just plain wonder why we classify the way we do!
In this three-part series, we’ll explain how we categorise funds in Prime Funds and how to use each category in your portfolio. If you’re already an MF veteran, then this series is not for you!
In this first part, we will cover equity funds. In the next, we will take up debt and hybrid funds.
Equity funds – why SEBI’s categories don’t work
Let’s understand why we reclassify funds Prime Funds in the first place. Any portfolio needs a mix of stability (that comes from large-cap stocks) and aggression (that comes from mid-cap and small-cap stocks, as well as the nature of fund strategy). However, the equity fund categories don’t always neatly fit into these slots.
The problem lies in the fact that some SEBI categories are defined based on market-cap allocation and some that are defined by the strategy they follow. Relying purely on SEBI-defined categories has the following drawbacks:
- You may miss good funds that fit a particular need because the fund was in another category.
- You may not realise the actual risk in a fund or its return potential and make higher or lower allocations than you could have otherwise done.
- You may not know how much to allocate to each SEBI category, given their sheer number.
We’ll explain further.
Large-cap funds are clearly large-cap. But four other categories also feature funds with predominant large-cap exposure: flexi-cap, value/contra, focused, dividend yield. Then there are index funds that are built on large-cap indices. So, while large-cap funds find it hard to beat the Nifty 100, there may be funds from the flexi-cap or value basket that could well do so, for marginally higher risk.
Running a quick scan in our MF Screener, for example, shows that at least a third of the value & contra categories had large-cap allocations of 70% or more in their March portfolios. The Contra funds in our Prime Funds have heavy large-cap allocations. Similarly, funds in the flexi-cap category have at least 60% in large-caps.
The same holds for funds with a heavier tilt towards mid-cap or small-cap stocks – there are several categories that have higher allocations to these market-cap segments. For example, SBI Focused Equity in our Prime Funds currently holds about 30% in mid-cap/small-cap stocks and has gone even higher before. The extent of exposure will obviously differ between funds and categories. But the fact remains that these funds still play the role of high-return, high-volatility in your portfolio.
The table below captures how different categories can suit the same purpose.
Therefore, classification based on the SEBI category would mean that funds from the same category could have very different risk-return profiles. Your allocation to these funds needs to be based on their volatility and return potential. Unless you are aware of the differences, you may be misled in your approach.
The other aspect with relying purely on SEBI categories is the sheer number. There are 10 different equity fund categories! Should you have allocations to each of them? Wouldn’t that lead to too many funds? Which category can you skip? Which needs to necessarily form part of your portfolio?
We re-classify Prime Funds in order to address these three drawbacks. Our fund rating methodology is also designed to deal with these overlaps. Therefore, each Prime Funds equity set pulls suitable funds from across categories:
- Equity – moderate houses funds that have a large-cap tilt, or which are not overly aggressive in their strategy, or are index funds that track low-volatile or large-cap indices.
- Equity – aggressive houses funds that have a higher mid-cap or small-cap allocation, have aggressive strategies or relatively unproven track records, or are index funds tracking high-risk indices.
- Equity – tax saving features ELSS funds eligible for deduction under Section 80C of the Income Tax Act.
- Strategy/thematic has sector-specific or thematic funds that need timed entry and exit
Now, let’s get into each of these and explain how to use them.
Equity – Moderate
This Prime Funds classification is designed to meet the basic foundation of your long-term portfolio.
What: When we say ‘moderate funds’, we mean funds that have at least 70% allocated to large-cap stocks on an average over the past couple of years. The fund categories that this Prime Funds set draws from are large-cap, index, flexi-cap, contra/value (currently – this may widen if we add more in our quarterly reviews).
Why: Large-cap oriented funds are the best suited for these due to their lower volatility than their mid-cap or small-cap peers. Over the past 15 years, for example, the Nifty 100 was loss-making about 20% of the time in 1-year periods. The Nifty Midcap 150 was in losses 27% of the time, with higher loss extent. Standard deviation in return (measures volatility) is far lower in the Nifty 100 than the Nifty Midcap 150. Using these funds as the base of a long-term portfolio will allow containing volatility, prevent big declines, but still ensure a reasonable return.
How much: All portfolios need allocation to Equity – Moderate funds, regardless of risk profile. However, you can use your risk and timeframe to decide how much you need to allocate. Broadly, you can use the following guidelines:
- When your timeframe is shorter at 3-5 years: This timeframe means your overall equity allocation itself will be low (anywhere between 15-50%, across risk levels). The majority of this needs to be in Equity – Moderate funds. Conservative investors can hold the entire equity in these funds. Else, you can keep this exposure at about 30-40% (of the portfolio) and hold the remaining 10-20% (of the portfolio) in Equity – Aggressive funds. This can be based on whether you are moderate or very aggressive in risk and if your timeframe tends more towards the upper end of the band.
- When your timeframe is longer at 5-7 years: In these timeframes, overall portfolio equity allocation can go much higher - up to 65% or even 70% if you’re especially aggressive. Again, the allocation to Equity – Moderate funds should be based on your risk level. You can allocate entirely to these funds if you want to keep a lid on risk. But as you move up the risk profile, you can begin reducing the exposure. A ballpark would be between 30-40% (of the portfolio) – higher allocation if you are moderate risk taker and lower if you are aggressive. When you are paring the allocation down, you need to be more careful with the range of aggressive funds you use (see the section on Equity - Aggressive).
- When your timeframe is above 7 years: In these timeframes, you can push up to 80% in equity. Here, while you may be conservative know that the time frame gives you the freedom to take some additional risk in exchange for returns. So, try to avoid allocating fully to Equity - Moderate. You can be choosy about aggressive funds, instead! For other risk profiles, it is entirely your choice – just don’t cut back too drastically. Try to hold at least 30% (of your portfolio) in Equity – Moderate funds.
Fund differences: The Equity – Moderate is a mix of funds across categories plus passive funds. Because of this, there are some differences between the funds. This apart, each fund is different in terms of strategy from the other, as this is needed for a diversified portfolio. Prime Funds aims at having a good mix!
That said, some funds can be riskier than the others. The risk comes from both market-cap allocation as well as strategy followed. The index funds (housed under the Passive sub-section) are the least risky. Next in line would be the plain vanilla large-cap funds. This would be followed by those that have some allocation to midcap stocks – like some of the Contra or Flexicap funds in our list.
Generally speaking, the more conservative you are, the more you can stick to passive and large-cap funds. Next, when your timeframe is longer and/or your allocation is higher, you can mix in the relatively riskier Equity – Moderate funds to kick up returns. Read the ‘Why this fund’ to know the strategy and suitability of each fund.
Equity – Aggressive
This Prime Funds classification is designed to include funds that invest in mid-cap and small-cap market segments to deliver higher returns, but which come with more volatility.
What: When we say ‘aggressive funds’, we mean funds that have a moderate to high exposure in mid-cap or small-cap stocks, or which follow aggressive investment strategies. The fund categories that this Prime Funds set draws from currently are midcap, smallcap, flexi-cap, focused, multi-cap, large-and-midcap and index.
Why: When markets rally, the best way to capture that upswing is through midcaps and smallcaps given their high return nature. The max 1-year return that the Nifty Midcap 150 threw up over the past 15 years, for instance, was 169% compared to the Nifty 50’s 112%. Therefore, allocation here will give a portfolio the return push it needs.
How much: Allocation to Equity – Aggressive funds is a factor of your timeframe and risk. You don’t absolutely need these funds, especially if you’re holding equity in your post-retirement portfolio or you cannot handle market falls. That said, here are some broad guidelines you can follow:
- When your timeframe is shorter at 3-5 years: As explained in the Equity – Moderate section, it’s best to avoid holding aggressive funds for timeframes such as this. If you absolutely must, you can up to 10-20% (of the portfolio) in Equity – Aggressive funds. Decide this based on your risk level and if you’re tending more towards a 5-year holding. If you’re unsure, skip these funds altogether. If you do allocate to aggressive funds, avoid the pure mid-cap and small-cap funds/indexes. Go instead for the ones more multi-cap by nature.
- When your timeframe is longer at 5-7 years: Here too, if you are conservative, you can avoid Equity – Aggressive funds. Else, you can have anywhere between 25-35% of the portfolio in these funds. Higher if you can take the risk and lower if not. But here, be careful about the funds you make part of the portfolio. For instance, don’t go all-in on smallcap funds. Pick midcap funds that score on downside containment. Or mix midcap funds along with the less aggressive funds that hold large-caps as well. This will help you earn the better returns you want but will not lift the portfolio risk to unmanageable levels, given the timeframe.
- When your timeframe is above 7 years: This timeframe is where you can run the length in risk. If you’re conservative, you can limit allocation to say 15-20% of the portfolio. Choose broad-market index funds such as the Nifty 500, or go for funds that do especially well on downside containment. You can avoid pure small-cap funds. For other investors, you can take aggressive allocation to levels as high as 50% if you wish to! Our High-Growth ready-to-use portfolio adopts such a stance. The more middle-ground would be an allocation of 25-35%. The range of fund choices we have given in the Equity Aggressive set allow you to keep good allocations, but still maintain risk at manageable levels.
Fund differences: The Equity – Aggressive mixes pure mid-cap and small-cap funds along with multiple other categories. It has index funds, representing the mid-cap space and the broad-market space. And it has a separate section for ‘Tactical’ funds, which are high-returning funds that can be used to ride market momentum for the time being.
As explained above, the range of options is wide. The pure midcap and smallcap options work well for those looking to exclusively play the space and who want high return. The funds that rank lower on risk but are still aggressive by strategy or by the extent they can reduce large-cap exposure in market cycles are those coming from other categories – like the focused fund, flexi cap or even a broad based theme fund we have in our list, besides, some of the passive funds like the Nifty Next 50 or the Nifty 500.
Use the differences between each fund to balance the level of risk you’re taking. When your allocation is large, it’s best to use a mix of pure midcap and smallcap funds along with the more multi-cap ones. Read the ‘Why this fund’ to know the strategy and suitability of each fund.
Equity – tax saving
This one is simple – it just picks funds from the ELSS category. Typically, these funds tend to be multicap by nature. Therefore, if you are considering these funds as part of your portfolio, then put them under the ‘aggressive’ allocation in your portfolio. We do not look at the pension funds SEBI category for tax-saving purposes, given their moderate performance and the much longer 5-year lock-in.
Strategy/ thematic
This Prime Funds set picks sector and thematic funds. You do not necessarily need these funds in your portfolio, even if you are a high-risk investor. These funds work very well for investors with large portfolios and who can thus diversify more effectively. It also helps investors who don’t own direct stock investments to gain from sectors stock markets are focusing on in a particular market cycle.
Barring a couple, a sector/thematic fund cannot be considered as a steady part of your portfolio – you will need to exit when the theme is done or book profits to take money off a strong rally. For example, a commodity fund may need an exit when the cycle turns but a more broad-based theme fund that is less cyclical may call for profit booking than an exit.
Your approach should be to allocate 10-20% of your portfolio in thematic funds in general (i.e., not one specific fund, but overall to play different sector/theme opportunities). Allocation to these funds needs to come from your overall ‘aggressive’ allocation. And that means you ideally keep the Equity Moderate allocation intact and divert part of your Equity Aggressive allocation to these funds.
As always, do remember that these are guidelines only. Please don’t request us to align your portfolios in lines with these suggestions 😊You can tweak these guidelines based on your understanding and funds you already own. There’s no hard-and-fast rule here!
And if all this seems like too much work – well, we are going to develop a ‘Build your own portfolio’ tool. We hope to have it up in a few months’ time. Until then, here are the links to Part 2 and Part 3 :
Prime Funds: Use them to build your portfolio right (Part 2)
Prime Funds: Using hybrid funds in your portfolio (Part 3)
