Types of Mutual Funds
Mutual funds are a must in any savvy investor’s portfolio. This is because mutual funds offer so many benefits – they enable you to diversify your portfolio, invest in equity without any pain, and enjoy the benefits of professional portfolio management. They can even invest in fixed income instruments to enjoy a steady income.
When people talk about mutual funds, many make the mistake of assuming that there is only one kind of fund and that is one that invests in the shares of companies. But the reality is that there are many types of mutual funds that meet the varying investment goals and risk appetite of investors. So let’s look at the different types of mutual funds in India.
Open ended funds
Of all the types of mutual funds, this one is the most common. An open ended fund, as the name suggests, is one that is not closed for investment. That is, it does not have a fixed tenure and investors can put their money into the scheme at any time, and redeem it at any point. Open ended funds can be either debt or equity funds. Investors pay the net asset value (NAV) to buy mutual fund units. NAV is the value of the scheme’s assets minus its liabilities per unit. It is declared each day by the mutual fund company.
Closed ended funds
Closed ended funds are those mutual funds that have a fixed tenure and amount. An asset management company comes out with a New Fund Offering (NFO) that is open to investors for a limited period of time, after which it is closed for further investment. After that, these types of mutual funds are listed on the stock exchange where they are bought and sold like equities. The price of the fund’s units is determined by demand and supply on the exchange, and not by NAV.
Equity funds are the most popular of all the different kinds of mutual funds. These funds invest in the stocks of different companies. They are managed by a fund manager, who decides when to buy and sell equities to maximise gains and minimise risks.
They are very popular with investors for several reasons. One, investors can invest small amounts in mutual funds. Two, investors are able to spread risks since they get exposure to many stocks when they invest in a mutual fund. Three, they are managed by professionals who are experts in their field. Systematic Investment Plans, or SIPs, also make it possible for investors to invest small amounts each month according to what they can afford.
While investing in equity carries market risk and no one can predict the direction of stock prices accurately, it has over the years made higher returns than most other asset classes, like gold, real estate or fixed income instruments. So if you want to get on to the equity bandwagon, you have to invest in mutual funds.
To make the most of equity funds, investors must consider a longer term horizon. For instance, to realize the true gains of equity funds, you might have to stay invested for at least five years, if not 10 or 15.
Among the different types of mutual funds in India is the debt fund. Debt funds invest not in equity, but in fixed income instruments like government bonds, corporate debentures, commercial paper and the like. Debt funds are meant for investors who want stable returns and low risk. Of course, debt funds don’t earn the kind of returns that equity funds do, but they involve far less risk.
Generally investors prefer debt funds to other fixed income instruments like fixed deposits because they’re more liquid. Debt funds are easy to invest because you can put in small amounts at your convenience. There are also some tax benefits, since debt funds are eligible for indexation if they’re held for a longer period of time. However, debt funds are not immune from interest rate risk. When interest rates go up, NAVs fall.
Large cap funds
Large cap funds are those that invest in large, well-established companies with large market capitalisation. According to the Securities and Exchange Board of India (SEBI), the top 100 companies in terms of market cap in the BSE Sensex have been classified as large cap companies. Among the different types of mutual funds in India, large cap funds are the most popular. Large cap funds are suited for investors who want regular, stable returns and less risk. Information on large cap companies is readily available and it’s fairly easy for investors to make decisions on buying or selling these stocks.
Mid cap funds
There are some mutual funds that are suitable for investors who are willing to bear more risk in order to make higher returns. Mid cap funds come within this category. Mid cap funds invest in those companies that are still in the growth stage, unlike large cap companies which are mature. Mid cap tend to 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.
Small cap funds
Small cap funds invest in shares of companies that are still in their infancy. Since most of these companies are relatively unknown, risks can be high. It needs the skills of an experienced fund manager to find shares of companies that show promise. The payoffs can be substantial from these mutual funds, if you are a risk taker.
For those unwilling to trust their finances to the mercies of a fund manager, the index fund could be right choice. Index funds invest in the shares of companies that make up an index, like for example the Sensex or the Nifty. Returns will therefore depend on the way these indices move. If the stock market moves up, index funds will go up in a similar proportion. Among the various mutual funds, these fall in the lower risk category. But investors can miss out because there are funds that do outperform the Sensex or Nifty.
A diversified fund invests across companies regardless of market capitalisation or sector. These funds enable investors to reap the benefits of diversification and reduce the risks involved in investing. Of course, this category includes a wide variety of schemes and risk profiles. While some may lean in favour of large cap companies, others may have a lot of mid cap and small cap shares in their portfolios. The risk profile of a diversified fund may be somewhere between a large cap fund and a mid cap or small cap fund.
Sectoral funds are those that invest in specific sectors of the economy, like banking and finance, fast moving consumer goods (FMCG), infrastructure etc. Of course, exposure to one particular sector involves a higher level of risk because there is no diversification. This kind of fund is for those who know a particular sector well and are willing to place their bets on it.
Some types of mutual funds are eligible for tax benefits. Section 80C of the Income Tax Act has something called equity linked savings scheme (ELSS) that allows a deduction in taxable income. Most asset management companies have ELSS funds that allow you to invest a maximum of Rs 1.5 lakh and get a reduction in taxable income. For example, if you have an income of Rs 10 lakh and you invest Rs 1.5 lakh in ELSS, your taxable income will be Rs 8.5 lakh, leading to a considerable saving in income tax.
Hybrid fund/ Balanced fund
A hybrid or balanced fund invests in multiple asset classes to meet the need for varying investment objectives and risk appetite. A balanced fund may invest in a mix of debt and equity. This is a fund that is preferred by conservative investors who want to enjoy the steady returns and low risk that a debt fund involves, combined with the high-return-high-risk profile of an equity fund. Generally, balanced funds in India invest 60 per cent of their corpus in debt and 40 per cent in equity. A conservative fund may invest less in equity and more in debt.
Arbitrage funds are a kind of mutual fund that many investors may be unfamiliar with. These mutual funds take advantage of price differences between the derivatives and cash segments of the stock market. However, arbitrage opportunities are not available all the time, so to ensure steady returns to investors, arbitrage funds place part of their corpus in fixed income instruments.
Fixed maturity plans
Fixed maturity plans or FMPs are among the types of mutual fund that are close ended. Which means that they invest for a certain fixed period of time. FMPs invest in fixed income instruments and offer stable returns for risk-averse investors. They are available for varying periods of time, ranging from 30 days to several years. FMPs have some tax benefits compared to fixed deposits. If you hold them for over three years, you get indexation benefits and could end up saving some tax. Of course, returns in FMPs, unlike a fixed deposit, are only indicative and may not always be what you expected.
This is one of the types of mutual funds that are suitable for investors who want to park funds for short periods. Investments could be as short as a day! Liquid funds invest in fixed income instruments with very short maturities of up to 91 days, like treasury bills, certificates of deposit and commercial paper. The focus of these funds is basically capital protection, rather than ensuring high returns. So fund managers tend to err on the side of caution and invest only in those instruments that have a high credit rating. Mutual fund companies try to keep costs to a minimum so that investors don’t have to pay high expense ratios and reduce their returns.
Ultra short term funds
These funds are similar to liquid funds. These funds invest in fixed income instruments of a very short duration with a certain portion in longer-term securities. Generally, the instruments do not have a residual maturity of over a year. Ultra short term funds are aimed at investors who want to park money between one and six months.
Gilt funds invest in central and state government securities that have a medium and long term tenure. These funds are aimed at investors with a longer-term perspective. Since the securities these funds invest in are guaranteed by the government, there is no risk of default. So to that extent they are free from risk. However, gilt funds are not immune from interest rate risk. When interest rates rise, yields go down as do the net asset values (NAVs) of gilt funds. Higher the maturity profile of these instruments, higher the risk.
Among the more popular type of fund is the income fund, which is preferred by investors who do not want to take much risk and enjoy a stable income over the longer term. Income funds invest in a mix of government securities and corporate paper with maturities of around five years. Of course, like gilt funds, income funds too are subject to interest rate risk.