Growth Mutual Funds

People invest in mutual funds for several reasons. While some investors may want steady income from their investments, others might look at capital appreciation and growth. It is the second category of investors that invest in growth mutual funds. A growth fund puts its money in investment avenues that have the potential to grow at a faster pace, but which may involve a higher amount of risk. Generally, a growth mutual fund makes investments in equity, in stocks that have the potential to grow. Dividends are of secondary importance in a growth fund’s scheme of things.

Large-cap funds

In theory, growth mutual funds are any funds that invest in equity in the expectation of capital appreciation. Some feel that large-cap funds shouldn’t really find its place in the category of growth mutual funds since returns are not higher than normal. However, in a growing economy like India, large-cap funds too have good opportunities for capital appreciation and can be considered growth mutual funds.

A large-cap fund is one that invests in well-established stable companies with large market capitalisation. Large-cap funds invest in these `blue chip’ shares because they are relatively stable and secure. These are suitable for investors who have a low risk appetite.

Mid-cap funds

Mid-cap funds are perhaps a better fit for the growth mutual funds tag. They are suitable for investors who are willing to bear more risk in order to make higher returns. Mid-cap funds invest in those companies that are still in the growth stage, unlike large-cap companies which are mature. They tend to be more volatile. That is, NAVs of mid-cap funds tend to fall sharply during a bear phase than large-cap funds. However, when the stock market is bullish, returns from mid cap funds tend to be higher.

These growth mutual funds are not suited for investors who are new to the stock market or are risk-averse since they may not be able to handle such volatility in stock prices with any degree of equanimity. While some of these mid-cap companies have the potential to grow into giants, the ride may not be a smooth one, and any bump on the road could lead to panic among investors and cause prices to hit rock bottom. Some stocks could even fall by the wayside.

In order to realise maximum gains, investors will need to stay invested in these growth funds for a longer period — at least 10 years. According to the Securities & Exchange Board of India (SEBI) guidelines, companies that are ranked between 101 and 250 in terms of market capitalisation fall into the mid-cap category.

Small cap funds

Another type of fund that fits perfectly in the growth mutual funds category is a small-cap fund, which invests in shares of companies that are still in their infancy. Since most of these companies are relatively unknown, risks can be high in these types of growth funds. It needs the skills of an experienced fund manager to find shares of companies that show promise. The payoffs can be substantial from these growth funds, if you are a risk taker. Like mid-cap funds, these too need to be held for longer periods of time to realise true gains.

Because of the risks involved, buyers of small cap stocks tend to panic during a bear phase and rush to sell them. Since these stocks are relatively illiquid, fund managers may find it difficult to offload these shares during a bear phase and may have to sell them at a discount when there is redemption pressure. The result will be sharp drop in NAV.

According to SEBI guidelines, all listed companies except those that fall in the first 250 in terms of market capitalisation fall in the small cap category.

Benefits of investing in a growth mutual fund

• Capital appreciation: Well, capital appreciation is one of the reasons why people invest in growth funds – the prospect of more than average growth in the longer term. Certainly, the risks are high, but in a growing market like India, many companies will be on a high growth trajectory and you cannot afford to miss the bus. In fact, equity has outperformed most other asset classes in the past few years.

• Diversification: Even if you are a cautious investor, growth funds should be part of your portfolio. You can restrict them to a low percentage, like 25 percent for instance, but there should be some growth funds in your kitty so that the portfolio is adequately diverse and helps you maximise returns.

• Easy to invest: Investing in a mutual fund is easy to do. Most websites offer online investment with a minimum of fuss.

• High liquidity: Equity funds are quite liquid and you can redeem your growth fund whenever you wish to do so.

• Low analyst coverage: The mid cap and small cap companies that growth mutual funds invest in are not extensively covered in the press or attract the attention of analysts. So a keen-eyed fund manager can pick up promising companies with good long term prospects at a low price.

Disadvantages of investing in growth mutual funds

• High risks: Growth funds involve a higher level of risk than other investment avenues. They are quite volatile and tend to fall faster when the market is in a bear phase. However, they do perform better during a bull phase.

• Long wait period: Most growth mutual funds don’t offer great returns in the short term. If you want to realise true gains, you will have to wait for a longer period of time, say 10-15 years. So growth funds tend to be more suitable for younger investors than older people.

• No certain returns: Growth funds tend to be actively managed. That is, they require much more intervention from a fund manager. The fortunes of the growth fund will depend on the skills on the fund manager. If she’s good at picking out stocks with potential, you should be able to get above normal returns. If she isn’t, you may not get the returns you expect.

• Higher costs: Since growth funds are actively managed, costs could be on the higher side. These funds tend to have higher expense ratios since they have to spend a lot more on experienced fund managers and do much more research on buying stocks.

• High price earning ratios: Growth funds invest in companies with promise. The only problem with that approach is that many others could share that same outlook. As a result, these stocks could be expensive and have high price-earning (P/E) ratios.

How to choose a growth mutual fund

It’s not enough to know what a growth fund is; you must also know how to choose one. Here are some pointers:

• Risk appetite: You must remember that growth funds carry risks. If you are a conservative investor looking for stable returns, your best option would be a diversified large-cap fund. On the other hand, if you are willing to take risks and enjoy higher returns, you could go in for mid-cap or small funds.

• Make the right choice: There are many growth mutual funds in the market, so you must do a careful comparison before investing in any one of them. The best way of doing it is by comparing returns. You should compare returns over several time periods – one, three or five years – and find one that performed the best during these periods. The Angel BEE app offers comparisons of growth funds to help you make the right choice. It has the ARQ hyper-intelligent investment engine for selecting the best mutual fund schemes.

• Check the costs: Investing in growth mutual funds involves some costs, like the expense ratio, which is what it charges you to manage your investments. The Expense ratio is the amount that is used for management, marketing, and administrative expenses. A 1% ratio means that 1% of the fund’s total assets will be used for expenses. A high expense ratio will reduce your returns, so you have to make sure that you choose a growth fund that has the lowest figures.

• Time frame: Time frame is important while you’re making your investment calculations. Stock markets move up and down in the short term, but the longer-term trend has generally been upward. So you have to be invested for the long term to reap the real benefits. Generally, a time frame of 10-15 years is ideal, but even five years should get you reasonably good returns. Younger people should put more of their money into growth funds. If you want to invest for the short term, a debt fund could be more suitable since returns are predictable.

• Fund manager: As we have mentioned earlier, the performance of growth mutual funds hinges on the competence of a fund manager. A star fund manager will be in a position to pick up stocks with great potential and make above-average returns for the growth fund. Do check the fund manager’s experience and record in managing a growth fund before investing.