Planning to invest in mutual funds? A MUST read

If you plan to invest your money in mutual funds or have already plunged into the market with little research, you must read this.

To begin with, you must understand the concept of mutual funds. Mutual funds collect money from investors and invest these funds in different avenues in order to earn money.

Since the volume of transaction is high, mutual funds enjoy the benefit of lower transaction costs. Further, investors automatically get a diversified portfolio with mutual fund investments.

This is because fund houses invest money in different sectors, different companies and different types of investments. So, if you are a novice to the stock markets, mutual funds are a better option for you.

How well a mutual fund does largely depends upon the performance of companies in which its funds have been invested.

So, before choosing a mutual fund you have to understand the companies that these funds are investing in. Mutual funds are basically categorized into three: Small Cap, Mid Cap and Large Cap.  Most fund houses offer products in all three categories.

Cap stands for capitalisation. It is the market value of the total shares of a company.  So, you can get the market cap of a company by multiplying the total number of shares by its current market price.

As the name suggests, small cap funds invest in companies that have small market capitalization. Small, mid and large are relative terms and each fund house decides the limit for themselves. Some fund houses relate their cap with BSE cap index.

For example, a small cap fund invests a majority of its funds(65 - 100 percent) in companies whose market cap are lower than or equal to the market capitalization of the stock in BSE Cap Small Cap Index with the largest capitalisation.

What you should know though is which funds are good for you? The answer to that question depends upon your appetite for risk and the current market situation.

Small cap and mid cap funds are generally considered to be riskier than large cap funds. This is because the former invest in startups and smaller, less established companies while the latter mostly invest in blue chip, reputed companies.

Small and mid cap companies have a larger potential to grow hence they promise greater returns on your investment. Start ups generally fall in this category and offer the opportunity of greater capital appreciation. Here there is potential for high returns but they are unpredictable too.

Large cap companies have generally established their growth and have stable, predictable pattern of returns.

Small and mid cap companies have the ability to instantly react to market situations. Large companies with tiered management may not have that ability built into their system. Hence, small and mid cap funds can react faster to market opportunities. However, they are more volatile too compared to large cap funds.

The advantage of large cap funds is that they invest in reputed companies with large profits. Hence the probability of regular returns is high! However, since these companies are giants in their sector, they are also priced higher. Further, they have a greater ability to stand thick in bad economic times.

Sundaram BNP Paribas Select Midcap,  Kotak Indian Mid Cap Fund and HSBC Midcap Equity Fund are some of the popular mid cap funds in India. HDFC Top 200, Kotak 30, Reliance Growth Fund and UTI Large Cap Fund are some of the large cap funds.

BNP Sundaram Paribas, HSBC Small Cap Fund etc are some of the notable small cap funds in India.

Let us examine the asset allocation of small cap, mid cap and large cap funds offered by the same fund house:

HSBC Equity Fund - Large Cap Fund

HSBC Mid Cap Equity Fund - Mid-Cap Fund

HSBC Small Cap Fund - Small Cap Fund