Ever wondered why there are so many types of mutual funds. But you need to choose a type of mutual fund to invest, And which one suits you best? Read on!
Investment in a mutual fund scheme is into a pool that in turn invests in various asset classes. Every mutual fund scheme has a set objective. You must invest in a type of mutual fund scheme whose investment objective reflects your own needs and likes. So someone who can invest for longer-term OR take the higher risk should choose equity funds. Those who want safety can invest in a gilt fund that buys into Government Securities. Sadly, many investors get confused with different terms used by the industry and rely on advisors who charge huge commissions.
This post is an effort to demystify the jargon.
There are many fund schemes that are offered by Asset Management Companies. The list of such schemes is technically unlimited, as new schemes are launched by the day. However, some of the popular fund types are discussed below with an aim to educate the average mutual fund investor.
Open-Ended vs Close Ended Funds
In simple terms, an open-ended fund is a fund in which investors can invest money or withdraw from the fund on any working day. Investments/ withdrawals are made on the basis of prevalent NAV. A closed-ended fund is a fund which is open to subscription only at the time of its inception or launch. It is open to subscription only for a limited period of time. The fund is usually managed for a fixed period of time, say for 3 years or 5 years. During this period, new investors cannot subscribe to the units directly from the fund. Similarly, existing investors cannot redeem their units directly from the fund. However, the fund units are mandatorily listed on a stock exchange. Hence, investors may purchase or redeem units by trading on the stock exchange. After the period of investment is over, the money is returned to the investors based on the NAV at the time of closing.
Equity / Debt/ Balanced / Gold funds
Based on the underlying asset class in which the investments are made, mutual funds are broadly classified into Equity, Debt, and Hybrid or Balanced Mutual funds.
Equity Funds :
If a scheme is designed in such a way so as to invest the money predominantly in equity shares and equity-related instruments, then such a fund is called as Equity Fund. There are different types of equity funds in the market, which we will understand separately.
Debt Funds :
If a scheme is designed to invest predominantly in debt securities then it is called as ‘Debt Fund’. A debt fund predominantly invests in Government Securities and Corporate bonds. There are different types of equity funds in the market, which we will understand separately.
Balanced Fund :
In a balanced fund, the proportion of debt and equity is in the ratio of 60% to 40%. The fund manager has the flexibility to move the money from equity to debt and vice versa. For example, if the fund manager feels that equity markets have gone up significantly, he might want to sell the equity component and move the money to debt. Similarly, if the equity markets crash or fall significantly, then the manager may want to increase his exposure to equity by moving a part of debt money into equity. Balanced funds allow this flexibility to the fund manager.
Gold Fund :
These are funds that invest only in Gold. Whatever money is invested by various investors into this fund is used to buy Gold. Whenever an investor wishes to take back her money, gold to that extent is sold and the money is redeemed. The investor earns a return equivalent to what she would have earned by directly investing in Gold. Gold funds are superior to holding physical gold (either in bar form or in the form of jewelry) as there is no risk of damage, loss by theft, storage costs, etc. There is no risk with respect to the purity of gold. The best thing is that Gold funds allow investors to invest even small amounts such as Rs.1000 into Gold.
Actively Managed vs Passive Funds
Actively managed funds :
Actively managed funds are funds that allow the fund manager to design and invest in an investment portfolio as per the investment objectives of the fund. The fund manager has complete freedom in selecting the industry sectors and the specific companies in those sectors, subject to the limitations of the investment mandate and any other regulatory limitations. The fund manager can add or remove (buy or sell) the securities in the portfolio based on his view of the market. The performance of the scheme depends on the skill of the fund manager. The investment management fee of these funds is higher than that of the passively managed funds. The investment manager always aims to beat the performance of the benchmark index.
Passively managed funds :
Passively managed funds are funds that simply replicate an underlying asset or an index. The Gold fund explained earlier is an example of a Passive mutual fund. Index Funds explained later, are managed by simply replicating a specific index such as BSE Sensex or NSE Nifty and fall under the category of Passive funds. The job of the fund manager in a passively managed fund is to closely monitor the selected index and replicate the index in terms of returns. Usually, the proportion of each share in the scheme’s portfolio would also be the same as the weightage assigned to the share in the index. Since the fund manager is not trying to beat the market or pick stocks based on research, his job is relatively easier compared to the fund manager of an actively managed stock. The investment management fee of a passively managed fund is less than the fees of an actively managed fund.
Growth vs Income funds
Growth funds :
The investment objective of growth funds is to provide long term capital appreciation. The fund invests almost its entire money into equities. The fund is expected to provide superior returns over the long term. Depending on how aggressive the fund is, it invests in the equity of companies that have huge potential to grow, resulting in a significant increase in their share prices.
Income Funds :
The investment objective of Income funds is to provide a regular and steady income to its investors. It predominantly invests in Government securities, Corporate bonds and Debentures and high dividend paying equities. The potential for Capital appreciation is limited.
Further Classification of Equity Funds
Diversified Equity Funds :
Diversified mutual funds are equity funds that spread their investments across a wide variety of sectors. The diversification across sectors reduces the risk of concentrating the portfolio in one or few sectors. Diversified funds have restrictions on the maximum amount that can be invested in a particular stock and a particular sector. The biggest advantage of diversified funds is that fund managers can pick stocks without any restriction, based on their research. They can freely move money from one sector to another, based on their interpretation of how different sectors will perform. Thus, diversified sectors are likely to yield good returns, and at the same time, minimize risk through diversification.
Sectoral Equity Funds :
Sectoral funds are funds that invest the entire amount in an identified sector. For example, an IT fund will invest the entire money in IT companies. A Pharma Fund will invest the entire money in the Pharma sector. The advantage of a sectoral fund is that the funds are launched by looking at which sectors will do well and hence, are likely to yield a higher return. However, they are subject to concentration risk. For example, a negative news flow pertaining to the Pharma sector will drag down the prices of all pharma stocks. Thus, the Pharma fund will suffer heavy losses as there is no alternative place to invest the money. The benefit of diversification is lost.
Index Funds :
An index fund is an equity fund that seeks to replicate an index. Thus, the fund achieves diversification as the Index is usually constructed by selecting bell-weather stocks from various sectors. For example, the NIFTY is composed of stocks selected from 22 different sectors. However, the portfolio is restricted to the stocks in the index.
Equity Funds based on Market Capitalization :
Market Capitalization means the market value of the company. It is arrived at by multiplying the market value of the share with a number of shares issued by the company. Equity funds can also be further classified into the following types based on the market capitalization of companies in which the investments are made:
Large Cap Funds :
Large Cap funds typically invest in large companies, with a large market capitalization. There is no regulatory or watertight definition of what is large. However, companies which have been existing for a long period of time and have a track record of performance are typically picked by these funds. These securities are also called “blue-chips”. Since the companies are large, well established, reputed companies with a proven track record, the risk of loss is less in these funds. However, given their large size, the returns are also likely to be relatively lower.
Small and Mid Cap Funds :
These funds are looking for relatively unknown companies which have great potential and can result in huge profits. The funds rely on their high-quality research teams to “discover” such “hidden treasures” and hence, such funds are also named along with such themes (Discovery fund/ Hidden gems, etc). These funds potentially earn a higher return but can also suffer higher losses compared to a large cap fund. Normally, they typically rise more than large-cap funds in rising markets but fall more than large-cap companies in falling markets.
Multi-Cap Funds :
As the name suggests, these funds have the flexibility of investing in any type of company, irrespective of whether it is large or small. It is akin to a diversified equity fund.
Further Classification of Debt Funds:
There are different types of Debt funds. They are briefly explained below:
Gilt Funds :
These are essentially funds that invest in Government Securities. Since the Government is the safest borrower and will not default on its loan commitments, these bonds are not exposed to Credit risk or default risk. However, since the maturity of these bonds is usually long, with many G-Secs being issued for 30 years, these funds are subject to market risk. This is because bond values may fall if interest rates rise, resulting in a fall in portfolio value.
Bond Funds :
Unlike Gilt funds which invest only in Government Securities, Bond funds invest in Government Securities as well as Corporate Bonds. Corporate bonds are exposed to default risk. These funds earn a slightly higher return compared to Gilt funds.
Long Term Bond Funds or Duration funds :
Apart from default risk, bonds are also exposed to interest rate risk. Bond values fall if interest rates rise. Similarly, bond values rise, if interest rates fall. The extent of change in the price of the bond is directly proportional to the “duration” or weighted average maturity period of the bond. Long Term Bond funds essentially bet that interest rates will fall. They invest in long-dated securities. In other words, they invest in securities whose “duration” is high. When interest rates actually fall, there is a steep increase in bond values, resulting in immediate benefit to bondholders. These benefits are passed on to investors of the Long Term Bond Fund.
Money Market Mutual funds :
These funds are also called Liquid funds or Cash funds. Sometimes, they are also called Short term Bond funds, or Ultra Short term Bond funds, depending on the duration of the securities held by the fund. These funds invest in debt securities whose maturities are of less than 3 years, sometimes, less than 3 months. The benefit of a shorter time frame is that the impact of interest rate risk is lower. Default risk is also minimal as the period for which the investments are made is usually short and the fund manager has reasonable visibility into the ability of the borrower to pay back within the short period of time. Given that the duration of investments in these funds is short, the returns, as well as associated risks, are low. The biggest advantage of money market funds is that they provide a very high degree of liquidity. They are so popular and unique that Liquid funds are regarded as a category in itself and not a type of debt fund.
Liquid funds invest in risk-averse and liquid money market instruments such as Treasury Bills, Certificates of deposit and Commercial paper. They aim to preserve capital and earn moderate income while ensuring liquidity at all times. They are considered as a superior alternative to Savings Bank deposits. These funds are ideal for corporates as well as individual investors to park their surplus funds for short periods of time.
Flexible or Dynamic Bond Funds :
Flexible Bond funds, as the name suggests, is flexible with respect to the type of bonds in which it would invest its funds. They invest in long, medium and short term instruments. They are also flexible about investing in High grade and high yield bonds, subject to the investment objective specified by them.
Some more types of funds
Fixed Maturity Plans (FMP) :
These funds are very similar to capital protection funds. They also invest in high-quality debt. However, to avoid market risk arising from a change in interest rates, the fund invests the amounts in those fixed income securities that mature along with the maturity of the fund. This ensures that by the time the fund is due for redemption, all the amount invested in various securities is received back by the fund. Thus, this fund also ensures the protection of capital. FMPs are normally passively managed.
A MIP, or Monthly Income Plan, is essentially a debt fund, with maximum exposure to equity to the extent of 15%. They are marketed as Monthly Income Plans wherein a conservative debt fund would not be able to earn the returns that are required to pay a monthly amount. Thus, a small proportion of funds is invested in equity to earn a little extra return, making it easy for the fund to make a monthly payment.
ELSS funds :
ELSS stands for Equity Linked Savings Scheme. A scheme is essentially a Diversified Equity fund. However, these funds are specifically introduced to provide an incentive for investors to invest in mutual funds by offering a deduction in their taxable income. Thus, an investor investing in an ELSS scheme can claim a deduction u/s 80C of the Income-tax Act. This reduces the total taxable income and therefore, the tax payable by the investor. ELSS schemes were specifically launched to encourage long term investment in equity mutual funds. As per current rules, ELSS funds have a lock-in period of 3 years from the date of investment. Dividend from schemes is currently tax-free. The Dividend Distribution Tax is also 0%. These fund schemes will have the word “tax” in their name.
Value funds :
Value funds invest in “Value” stocks. Value stocks are stocks that the fund manager believes are trading at a price that is much lower than their intrinsic value, based on criteria such as future earnings potential, return on capital, free cash flows, dividend yield and other fundamental measures of value. A Value fund manager believes that value stocks are created when the market (investors)overreact to negative news flow such as disappointing earnings, negative publicity or legal problems, which may not have a huge impact on the company’s long-term prospects. Markets eventually recognize the true worth of such companies resulting in the stock price bouncing back. This results in huge gains for the value investor. Thus, Value funds are essentially looking for bargains. They are looking at fundamentally good stocks that are currently available at low prices.
Fund of Funds :
Mutual funds that invest in other mutual fund schemes offered by different AMCs, are known as Fund of Funds. Fund of Funds maintains a portfolio comprising of units of other mutual fund schemes. It is similar to a normal mutual fund maintaining a portfolio comprising of different securities. Fund of Funds provides investors with an added advantage of diversifying into different mutual fund schemes with even a small amount of investment, which further helps in diversification of risks. However, the expenses of Fund of Funds are quite high on account of compounding expenses of investments into different mutual fund schemes.
Interval Funds :
Interval funds are funds which have the features of both open-ended and closed-ended funds. They are basically closed-ended funds but are open for subscription during specified intervals. Investors can purchase or redeem units during these specified intervals from the fund. If investors want to invest or sell units at any time which is outside the specified intervals, then they may do so by purchasing or selling from the stock exchange.
Regular Vs Direct Funds
Every fund scheme has two variants, namely Regular and Direct. Regular funds are the variants sold to you by bankers. brokers, commission agents, independent Financial Advisors, etc. Direct funds imply funds directly bought by investors from the AMC, without the support of a broker. Thus, direct funds save recurring commission expenses for the investor. Over a period of time, the impact of these commissions is huge. There is no difference in the way the money is managed, whether one opts for the Regular or the Direct variant of a mutual fund scheme. Hence, investors should ALWAYS opt for Direct funds, unless they need a lot of regular hand-holding, for which they are willing to pay a significant amount.
Investors must understand the fund in which they are investing and ensure that the investment objective of the fund matches their investment objective. however, irrespective of the fund, one should ALWAYS opt for Direct funds.