Mutual funds are created when several people who wish to earn wealth (investors) combine their resources to create a huge investable amount (corpus). This large corpus is then invested into various companies across industries, operating in different sectors of the economy - depending on the type of fund chosen. All the investors of a mutual fund share in its profits, losses, incomes, and expenses in direct proportion to their level of investment.
Companies that create mutual fund schemes are called Fund Houses or Asset Management Companies (AMCs). The professionals who study the markets and pick companies to invest in are called Fund Managers. Fund managers spend a great deal of time analysing markets and studying different sectors of the economy to figure out which companies are most likely to turn a profit - in different time frames - and choose the best option.
There are thousands of mutual funds in India, under different categories, offered by hundreds of AMCs and Fund Houses. For fairness and transparency, global agencies exist that analyse and rate the performance of funds over time and make sure that investors are well informed before investing. It is mandatory for AMCs to declare a standard against which the performance of any given fund can be measured - this is called a benchmark. There are also regulatory bodies like AMFI and SEBI that ensure no investor ever gets scammed.
Mutual funds allow individuals to make their money work for them - meaning that they do not need to actively perform tasks for monetary gain. Any amount invested in mutual funds will either grow or shrink depending on market performance and the skill of the fund manager.
There are many different types of mutual funds available today, and can be categorised based on investment objective, structure and asset class. Apart from this, there are also specialised mutual funds.
1. Types of mutual funds based on asset class:
a. Equity Funds: The primary focus of equity funds is to invest at least 65% of the total corpus into equity (stocks) and equity related instruments of different companies. Stock market fluctuations affect the performance of these holdings and determine whether they make a profit or not - as such, equity funds are slightly riskier than other types of funds. Diversification of the corpus between companies operating in different sectors of the economy and hands-on expert management serve to mitigate most of the risks involved.
Equity funds are further sub-categorised based on the investment strategy (Value, dividend yield, focussed), whether the fund is managed actively or passively (Active/Index), the level of market capitalisation (small-cap, mid-cap, large-cap), or whether it’s a Sector or a Thematic Fund (that only invests in a particular sector like pharmaceuticals or petroleum or a theme such as services, healthcare, etc.).
Equity funds are recommended to those willing to wait at least 5 years to see substantial returns, and who don’t mind the inherent risk involved with equity investments. These funds operate at a higher risk, with the possibility of a greater reward.
b. Debt Funds: The primary focus of debt mutual funds is to invest a majority of its corpus into fixed-income investments, such as treasury bills, money market instruments, corporate bonds and debentures, commercial papers, gilt,, government securities, and other debt securities.
Debt funds are further sub-categorised based on how long their holdings will take to reach maturity (for example short-term debt funds, ultra-short-term debt funds, liquid funds, dynamic bond funds), instruments where they can invest (corporate bond funds, gilt funds, credit risk funds, banking and PSU funds, money market funds)
Debt funds are recommended for those who don’t want to risk their capital for a chance to earn returns higher than bank deposits, but who’d rather invest their capital in order to earn a smaller, relatively stable returns with greater liquidity.
c. Hybrid Funds: The primary focus of hybrid funds is to invest in a portfolio as balanced as it is diverse, by channeling investments proportionally into equity and debt instruments. This is done in order to create long-term capital appreciation at lower risk/ with lower volatility.
Hybrid funds can be of two major types - aggressive hybrid funds and conservative hybrid funds. An aggressive hybrid fund is an equity-oriented mutual fund will have 65%-80% of its corpus invested in stocks, shares, etc. and the remaining invested in debt instruments or money market instruments. A conservative hybrid fund is a debt-oriented mutual fund which will have 75%-90% of its corpus invested in debt instruments and the remainder in stocks, shares and other equity instruments. Hybrid funds also allow for a degree of liquidity, and divert part of the corpus into cash and cash-equivalent investments.
Hybrid funds bridge the gap between long-term capital appreciation and short-term income requirements of investors. As such, they are popular among new investors and experienced conservative investors alike.
2. Types of mutual funds based on investment objectives:
a. Growth Funds: These funds invest primarily in equities. Diversified investments in stocks and shares of various companies usually make up a good Growth Mutual Fund. The primary goal of these funds is to provide as much capital appreciation as possible during the tenure of the fund.
Most mutual funds offer growth or dividend/income as options under the same fund, meaning that an investor can choose whether to receive regular payments (dividend/income) or reinvest the money that would otherwise have been paid to him as a dividend back into the fund itself (growth).
Investors who aren’t planning to retire or pull out of their investments anytime soon, and possess the ability to take risks, are the ideal investors for this type of fund.
b. Income Funds: These funds aim to provide investors with regular income, generated through investments in government securities, stocks with high dividend potential, bonds, debentures, etc. While it’s true that no mutual fund scheme can outright guarantee results, these funds are actively managed and hence are more likely to successfully generate regular income.
Investors with a low risk appetite who are looking for a place to park surplus funds for a short to medium term can consider these funds, as they provide a regular income. Generally, pensioners, super safe investors, and beginners in the world of mutual fund investments chose these funds.
c. Liquid Funds: The primary goal of these funds is to provide capital safety and near-instant liquidity to its investors. These funds primarily invest in debt instruments of a high credit quality and design the portfolio to mature in around three months’ time. Thus, interest rate fluctuations in the economy do not affect this fund as much as they do for other funds as the maturity of invested instruments is lined up with the maturity of the scheme itself. Even so, no mutual fund scheme can guarantee results.
These funds have a huge potential in generating income more than regular savings bank accounts which provide around 4% - 5% on average.
d. Tax-Saving Funds or ELSS:ELSS or Equity Linked Savings Schemes are mutual fund schemes whose primary aim is to generate long-term capital growth through investments in equities, stocks and shares. Investments made in ELSS are also eligible for deductions under Section 80C of the Income Tax Act, 1961.
Most Indians invest in tax saving fixed deposits, which provide earnings at a predetermined rate of interest and also serve to save a portion of income from taxes. However, tax saving fixed deposits have a lock-in period of 5 years, while tax saving ELSS have a lock-in period of only 3 years, and, historically have provided better returns.
e. Capital Protection Funds: The primary aim of capital protection funds is to protect investors’ capital in the event of economic instability, while also providing the possibility of capital appreciation and growth. These funds invest primarily in bonds and zero coupon debt although there is a small portion invested in equity as well.The Unstable movements of interest rates is countered by aligning the maturity of the debt portfolio and the maturity of the fund itself.
These funds are close-ended, and cannot be interfered with during their term - which can be 1 year, 3 years, or 5 years. It should be noted that there is no institutional coverage or guarantee that these funds will perform as advertised, but historical performance of these funds suggests that they’re mostly successful.
f. Fixed Maturity Funds: Usually compared with fixed deposits, fixed maturity funds are close-ended funds that invest primarily in debt instruments which have a predetermined maturity date. The maturity date of the debt investments are made to coincide with the maturity of the fund itself. Unlike most other debt funds, there is no constant purchase and sale of debt securities. Instead, these funds adopt a buy-and-hold strategy which helps them reduce the overall expense ratio.
These funds are very similar to fixed deposits in that they are debt instruments that lock in funds for a predetermined tenure and provide tax benefits.Unlike fixed deposits that provide assured returns, fixed maturity funds provide indicative returns at the time of buying in. This means that the real returns could fluctuate and eventually be higher or lower than what was initially indicated. As far as taxation goes, fixed maturity plans offer a dividend or growth option, and are either taxed for dividend distribution tax or capital gains tax, as the case may be.
3. Types of mutual funds based on risk factor:
a. Ultra low-risk mutual funds: Mutual funds like ultra-short-term funds and liquid funds, etc. do not present a lot of risk but generate returns above bank fixed deposits/ savings bank account.
b. Low-risk mutual funds: Funds like arbitrage funds and low duration funds favour investors with a low risk appetite.
c. Medium-risk mutual funds: Funds in this category generally have balanced investment portfolios, meaning that they divide the corpus between equity and debt instruments. Thus, the fund can provide long term capital gains, as well as stability. Medium-risk funds cannot make the most of equity, as the risk is offset by investments in debt instruments as well.
d. High-risk funds: These are funds that offer the highest potential rewards and as such carry the highest amount of risk. The primary focus of these funds is to maximise potential returns through investments in equities, which are volatile by nature.
4. Specialized Mutual Funds:
Index Funds:These funds invest their corpus into the stocks that comprise a particular index. Index funds aren’t actively managed, which means they simply replicate the index. As such, are less exposed to the negative effects of equity-related volatility. This does away with the need for active investment management. The fund returns are generally close to index returns. But, in the case of a market downturn, the index fund will also lose its market value
The benefit these funds reap by not being actively managed is that the expense ratio comes down.
a. Fund of Funds: As the name suggests, these funds invest in other mutual funds instead of directly investing in equity and debt instruments. This kind of investment management is often referred to as multi-manager investment management. These allow investors to diversify risk across various funds the fund of funds invests inInternational fund of funds (or foreign fund of funds) as the name says comprise of investments in foreign funds holding stocks/bonds of international companies or international mutual funds.
b. International Funds or Foreign Funds: The primary aim of these funds is to maximise returns and minimise losses caused by domestic market fluctuations. With a foreign fund, investors can take advantage of the burgeoning markets in other countries, even if the market in the home country is experiencing setbacks. Funds can fully invest in foreign companies, or partly invest in foreign companies and partly in domestic companies or partly or wholly in international mutual funds.
c. Global Funds: These funds aim to generate maximum returns through investments in funds all over the world. These global funds invest in the best funds, worldwide, and in the investor’s home country as well. These are the widest and most diversified funds in the sense that currency variations, national policies, and market fluctuations of many countries need to be considered and tracked. Despite the obvious managerial challenges, these funds have provided historically high returns as they invest in the top stocks and funds, worldwide.
d. Emerging Market Funds: These funds aim to take advantage of the higher growth rate displayed by emerging and developing economies of smaller nations in order to generate higher returns. While these investments are on the riskier side, it is clear that investments through the next decade will be dependant on these emerging markets to generate returns, as their economic growth rate is far greater than that of established economies like the US and UK.
e. Sector Funds: The primary aim of these equity-based funds is to generate returns from investments in one specific sector ((for example pharmaceuticals or financial services). These funds are basically the opposite of diversified equity funds, as they focus on one specific sector rather than many. Logically, putting all of one’s eggs in one basket is a recipe for disaster, but many investment experts have an in-depth understanding of various sectors, and have historically proven that sector funds can provide massive returns, even higher than some diversified portfolios, provided market entries and exits are timed well. These funds are suitable for investors with a very high risk appetite.
f. Thematic Funds or Theme-Based Funds: Similar to sector funds, these funds focus their investments into companies that revolve around a particular theme. Unlike sector funds which invest only in companies within a particular sector, these funds invest in companies across sectors, which are united by a common theme. For example, a pharmaceutical sector fund would invest only in pharmaceutical companies, but a thematic fund in the same pharmaceutical space would invest in chemical processing companies, research laboratories, healthcare providers, etc. as well as pharmaceutical companies.
g. Asset Allocation Funds: The primary aim of these funds is to maximise returns through the perfect allocation of investments in various asset classes - like equity, debt, fixed assets, bonds, real estate, gold, etc.
These funds are basically hybrid funds tailored to the investors profiletaking into consideration everything about the investor like age, risk appetite, current net worth, investment goals and financial goals, etc. and also the current trends and condition of the market itself. Some Asset Allocation Funds are funds of funds, and as such carry a greater expense ratio.
There are two primary types of asset allocation funds - Dynamic and Static.Dynamic Asset Allocation Funds are able to adjust the number of assets that comprise the portfolio, depending on prevailing market conditions. Static Asset Allocation Funds, on the other hand, decide their investment strategy and level of investments to be made in different asset classes well in advance.
h. Exchange Traded Funds (ETFs): These funds are slightly different than other mutual funds. ETFs own stocks, bonds, commodities, etc. and ownership of the fund is held in the form of shares by shareholders. This is because ETFs are traded just like stocks in stock exchanges. Shareholders cannot directly own the underlying assets in which the fund is invested, but rather indirectly own these assets through owning shares of the fund itself. ETFs provide greater liquidity as they can be bought and sold on the stock exchange and have lower costs.
ETFs can only be bought or sold directly from or to authorized participants (APs), after an agreement has been entered into. APs are usually massive investment houses, who use creation units to conduct trades of their ETF holdings. Creation units are massive chunks of thousands of ETF shares.
The primary advantage of these ETFs is that units in the funds themselves can be traded on the stock market quickly to make the most of market fluctuations. ETF units are freely tradeable for the assets that make up the ETF, thus, the value of the ETF’s units does not vary much from the value of its owned assets. Most retail or individual investors buy ETF units from the exchange once it is listed and not creation units.
5. Mutual Funds based on structure:
a. Open-Ended Mutual Funds: As the name suggests, open-ended mutual funds allow investors to buy and sell units of the fund as per their convenience and feelings about the market. Investors in open-ended funds can also exit the fund at any time, at the fund’s current Net Asset Value (NAV). While these funds offer great flexibility, it also means that the unit capital of the fund undergoes constant changes with investors buying into - and selling out of - the fund with little to no prior warning.
b. Closed-Ended Mutual Funds: With closed-ended funds, the total unit capital, fund tenure, investment avenues, etc. are all decided in advance of the fund units being offered for purchase. Once the purchase window has closed, investors remain invested until the completion of the fund’s tenure. Units cannot be bought or sold during this time.
c. Interval Funds: These funds allow investors to enter or exit the fund at predetermined intervals, decided by the fund house. While these funds have a certain amount of liquidity, they should not be considered a liquid investment, as they cannot be redeemed at any time, only during specific intervals. Even so, they combine the benefits of open and closed ended funds, and have some added benefits like the fact that they can also invest in private assets and assets that aren’t listed on any exchange.