Three types of funds you can look at in this red-hot market

When the markets are doing well, like they are right now, investors can become like kids in a candy store.

Take the case of investing in a mutual fund. When you enter the fund universe, you instantly see over 1,400 funds spanning 40 categories staring at us. The options can excite and confuse us in equal measure.

It can excite us because we see most equity funds in a bull market gunning out great returns; it can confuse us because we forget our risk appetite and goal and simply end up chasing returns.

However, this is where we can trip up, especially investors who are fairly new to the market and unaware of how quickly things can change. Simply looking at performance numbers can make us commit unforced errors that we may later repent. But worry not, here are three fund categories that can help you navigate all stages of the market with relatively less anxiety.

Equity Linked Saving Scheme (ELSS)

Also known as tax-saving mutual funds

Why are they good?
It helps you grow your wealth and save taxes at the same time.

Who should look at these funds?
Investors who have opted for the old tax regime. You can claim a tax deduction of up to Rs 1.5 lakh under Section 80C of the Income Tax Act.

New tax regime investors can also look at them if they want to be disciplined with their investing, however, they will not be getting any tax deduction benefits.

What you should be aware of?
These funds have a three-year lock-in period. However, it is still better than other tax-saving options like the Public Provident Fund (PPF), which has a 15-year lock-in.

On second thoughts, a three-year lock-in isn't too bad for new investors. This feature will instil discipline for the long-term, which is a secret weapon to build wealth.

Moreover, the three-year lock-in allows investors to ride out short-term market swings and achieve good returns in the long run.

How does it perform?
We analysed the three-year rolling returns of an average ELSS fund on a monthly frequency over the last seven years. To our pleasant surprise, you'd have earned over 12 per cent returns 58 per cent of the time, even if you had invested money in an average ELSS fund.

Hybrid funds

What is it?
Hybrid funds invest across multiple asset classes, typically a mix of equity and debt, which can help reduce the impact of market volatility on your investment.

While there are many types of hybrid funds, we suggest two categories:

• Aggressive hybrid funds
  
• Balanced advantage funds

Aggressive hybrid funds
These funds are best suited for first-time investors.

Since they invest up to 65-80 per cent of the money in equity and the remaining in debt, it offers the best of both worlds: i) potential high returns of equity and ii) the relative safety of debt. The debt portion provides a much-needed cushion during turbulent times.

Balanced advantage funds
Balanced advantage funds (BAFs) also invest in debt and equity.

But, unlike aggressive hybrid funds, these funds have a flexible asset allocation strategy. Basically, a fund manager looks at how the financial markets are doing. When the markets are doing well, BAFs might suggest investing in equity to potentially earn good returns. When the markets are not so great, they might lean towards safer options like bonds to stabilise your investment.

The two aforementioned hybrid funds are crafted to provide a well-rounded solution, making them particularly suitable for investors who appreciate a middle-ground approach to wealth accumulation and preservation.

In fact, the graph below bears testament to that. Both the hybrid funds fell less than an out-and-out equity index when markets slumped during the COVID outbreak, the global financial crisis and when Indian banks were hit with toxic loans.

Index funds

What does it do?
These mutual funds replicate a market index. They buy the same companies listed on the index they track and in the same proportion.

Let's say the Sensex is home to Reliance, ITC and HDFC Bank, each with a 4 per cent share, an index fund tracking the Sensex would also own the same companies and in the same proportion of 4 per cent.

What type of index fund should you look at?
New investors should only invest in index funds that either track Nifty 50 or Sensex, the two most popular indices in India.

Who should look at these funds?
If you feel hybrid funds are too bland for your taste and ELSS schemes do not apply to you because you are in the new tax regime, this category of fund is for you.

Plus, these funds are effective, easy to manage and charge lower fees, making them a cost-effective investment option.

How does it perform?
In the last 10 years, index funds tracking Nifty 50 have given an annual return of 13.36 per cent.

Points to remember

• Don't hesitate to invest, thinking the market has already peaked significantly. Markets are designed to make new highs.
  
• Choose an ELSS scheme if you are in the old tax regime.
  
• If you are new to investing and are scared of experiencing short-term fluctuations in an equity market, start with a hybrid fund. (We prefer aggressive hybrid funds.)
  
• If you are still confused, get an index fund.
  
• Don't chase returns. Don't look at mid-cap and small-cap funds, simply because they are churning out jaw-dropping returns. That's because they are highly volatile and can spook the daylights out of you if you are not accustomed to volatility and periods of negative returns.
  
• Last but not least, start a systematic investment plan (SIP). Don't invest your money in one go. SIPs can help you sail the highs and lows of a market.
  
• Start small and develop familiarity. As a new investor, the biggest challenge is not getting scared and running away. So even if the market falls, try to stay invested longer. Equity has historically performed well in the long run.

Also read: Money magnets of 2023