Indian retail investors invest in different funds and think that it is diversification of portfolio but that is completely wrong. Diversification of investment means investing in different asset class to negate the fluctuation in any particular investment vehicle. There is a common saying that Dont put all of your eggs in one basket which is the basic principle behind investments with diversification.

Categorize the mutual funds and invest into as many categories of mutual funds as possible to make mutual fund portfolio well diversified.

So let us categorize the types of Mutual Funds

Balanced Funds

Mutual funds that invest in equity as well as debt and money market instruments are termed as balance funds. Normally equity instruments are the major portion of the investment profile ranging from 60 to 80% and rest in debt and money market instruments. The fund house with a variation percentage predetermines the equity to debt investment ratio that they can use to switch majority of the investment into debt at any given point of time.

Taking an example of HDFC Balance fund we see asset allocation of 60% in equity with deviation of 20%. Similarly in debt they have asset allocation of 40% with deviation of 30% and so this fund at any given point of time can go major equity to major debt asset allocation.

Large-cap funds

Funds that invest in companies with large market capitalization are known as large cap funds. The definition of large cap stocks are defined by each fund differently and so understanding the fund investment style helps understanding what kind of diversification one can achieve investing in the fund.

• HDFC Top 200, its investment objective is to invest in BSE 200 Index scrip’s, which will always be large cap companies, and so this fund is a large cap fund for sure.
• HDFC Focused Large-Cap fund may invest in those companies with market capitalization greater than or equal to that of the company with the lowest market capitalization in the CNX Nifty Index.
• Franklin India Blue-chip Fund does not define the size of the company for investment but only invests in large-cap companies with strong financials and market leaders.

Blue-chip, Top 100, Top 200, Equity funds are some of the common names used for large cap funds but investing in each of those funds from same or different fund house does not diversify mutual fund investments.

Mid Cap & Small Cap Funds

Funds that invest primarily in medium size companies or medium market capitalization companies are termed as mid cap funds and funds that invest in small size companies or small market capitalization are termed as small cap funds. Ideally mid and small cap companies are clubbed together into one group by fund houses to name the fund as mid and small cap funds. The idea is to invest into small and medium companies without too much segmentation.

Small and mid cap category of funds tend to avoid the market leader and try to invest in future leaders and have higher returns but with at the price of higher risk.

Arbitrage Funds

Arbitrage funds are funds that remain in cash or debt investments and look for arbitrage opportunities in various market segments like difference in pricing between cash and derivatives segment.

Index Funds

An index fund is benchmarks an index for investment. Some of the popular indexes for mutual funds are Nifty, Sensex, Nifty Junior, Nomura MF Index, and CNX 500 etc.

Investing in Index funds along with a large cap fund may not provide the needed diversification and it may just lead to investing in the same companies through different funds.

Tax-saving ELSS Funds

Funds that have 3 years of locking period and provide tax benefit under the section 80C are termed as tax saving ELSS funds. Every fund house has one tax saving scheme and normally this fund invest in large cap stocks. Check fund specific investments if you prefer to diversify your assets with tax saving funds.

Remember investing in an ELSS fund with a large cap fund may not provide the needed diversification.

International Funds

As the name suggest, funds that invests in opportunities outside India. Some of the funds in this category include L&T Indo Asia Fund, Birla Sun Life Intl. Equity Fund, and DSPBR World Gold Fund. Investing in international fund can provide great deal of diversification. Remember that there are quite a few international funds but all the international funds are not same and some invests in International Equities, where as other invest in international commodities like gold or oil internationally and some international fund are specific to some countries like China, Brazil.

Sector Specific Funds

Funds that invest in particular sectors like infrastructure, banking, Information technology, FMCG, power etc. are call sector funds. Like International funds, sector specific funds provide better diversification but unless you want to be diversifying the complete portfolio yourself, it is better to be investing in diversified funds.

Diversified Funds

Funds that neither invest in any particular sector nor invest in any particular sized companies are termed as diversified funds. Diversified funds can be a large cap, mid cap, small cap or even an international fund but normally if a fund is in those categories we tend to name them with those categories and not name them as diversified fund but any fund that does not invest in any given sector is ideally a diversified fund.

Funds of Funds

Funds of Funds or FoF is a mutual fund which invests in different mutual fund schemes instead of stocks and the biggest advantage of investing in funds of funds is you get access to high end closed ended funds and schemes which a retail investor may not be able to invest because of minimum investment limits.

There are 2 kinds of funds of funds i.e. equity oriented and debt oriented. Equity oriented fund of fund invests majorly in equity funds and debt oriented fund of fund majorly invests in debt funds.

Gold Funds

Gold funds primarily invest in Gold ETFs. I prefer to be investing in Gold ETFs directly than investing in Gold funds.

Debt Funds

Debt funds invest in short-term or long-term bonds, Central Government Loan, State Development Loan, NCDs or Non Convertible Debentures or any other money market instruments. There can be lock-in periods for investments in such Government instruments but you can invest in those instruments through debt funds without any lock-in period.

Apart from lock-in periods, you are also able to invest in good schemes at any given point of time that may not available when you want to be investing in a debt fund. As an example if I want to invest in LIC Housing Finance Bonds or Power Finance Bonds in 2014, I have no choice but to use a debt fund only.

Hybrid Funds

Most of the Balance funds invest majorly in equity to be treated as equity fund for taxation (needs 65% of investment in equity) but funds that do not have equity major investment profile and invest in equity, debt as well as any other money market investment instruments are known as hybrid funds. Few examples of hybrid funds are:

• L&T India Equity and Gold Fund Fund that invest in equity market as well as in Gold ETF.
• Kotak Multi Asset Allocation Fund Fund that invest in bonds, gold as well as very small portion in equity.

Final Thoughts

Diversifying portfolios with investments in different areas always helps but keep in mind that you should always keep track of your Investments and from time to time switch your investment vehicle that may not be able to make most for you.