Chapter 3.3: Different Types of Mutual Funds
A mutual fund is an investment vehicle which pools money from investors and invests on their behalf in multiple assets like stocks and bonds. The profits made from the assets are then distributed to the investors.
There are a variety of mutual funds. They can also be classified into different categories on varying factors. Here’s a look at some of the types of mutual funds:
Mutual funds based on fund scheme:
There are two key kinds of mutual funds on the basis of the constitution of the fund. This basically affects when investors can buy fund units and sell them.
- Close-ended schemes:
These schemes have fixed maturity periods. Investors can buy into these funds during the period when these funds are open in the initial issue. Once that window closes, such schemes cannot issue new units except in case of bonus or rights issues.
After that period, you can only buy or sell already-issued units of the scheme on the stock exchanges where they are listed. The market price of the units could vary from the NAV of the scheme due to demand and supply factors, investors' expectations and other market factors.
- Open-ended schemes:
These funds, unlike close-ended schemes, do not have a fixed maturity period. Investors can buy or sell units at NAV-related prices from and to the mutual fund, on any business day. This means, the fund can issue units whenever it wants. These schemes have unlimited capitalization, do not have a fixed maturity date, there is no cap on the amount you can buy from the fund and the total capital can keep growing.
These funds are not generally listed on any exchange.
Open-ended schemes are preferred for their liquidity. Such funds can issue and redeem units any time during the life of a scheme. Hence, unit capital of open-ended funds can fluctuate on a daily basis.
The advantages of open-ended funds over close-ended are as follows:
- Investors can exit any time they want. The issuing company directly takes the responsibility of providing an entry and an exit. This provides ready liquidity to the investors and avoids reliance on transfer deeds, signature verifications and bad deliveries.
- Investors can entry any time they want. Thus, an open-ended fund allows one to enter the fund at any time and even to invest at regular intervals.
Mutual funds based on assets invested in:
There three kinds of mutual funds based on the assets invested in. These are as follows:
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Equity funds:
These are funds that invest only in stocks. As a result, they are usually considered high risk, high return funds. Most growth funds – the ones that promise high returns over a long-term – are equity funds.
These funds have less tax liability in the long-run as compared to debt funds. Equity funds can be further classified into types based on the investment objective into index funds, sector funds, tax-saving schemes and so on. We shall go through these in detail later.
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Hybrid funds:
These are funds which invest in both equities as well as debt instruments. For this reason, they are less risky than equity funds, but more than debt funds. Similarly, Similarly, they are likely to give you higher returns than debt funds, but lower than equity funds. As a result, they are often called 'balanced funds'.
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Debt funds:
These funds invest in debt-market instruments like bonds, government securities, debentures and so on. These are called debt instruments because they are a kind of borrowing mechanism for companies, banks as well as the government.
Simply put, you give them money, which the company returns with interest over a period of time. After which, it matures. Since the interest payments are fixed as well as the return of the principle amount, debt instruments are considered low-risk, low-return financial assets. For the same reason, debt funds are relatively safer.
They are usually preferred for the regular interest payments. Debt funds are further classified on the basis of the maturity period of the underlying assets – long-term and short-term. Some debt funds also invest in just a single type of debt instrument. Gilt funds are an example of such a fund.
Mutual funds based on investment objective:
Every investor has a different reason for investing in financial instruments. Some do so for making profits and increasing wealth, while some others do so for a regular secondary source of income. Some others invest in mutual funds for a bit of both. Keeping these requirements in mind, there are three key kinds of mutual funds based on the investment objective.
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Growth funds:
These are schemes that promise capital returns in the long-term. They usually invest in equities. As a result, growth funds are usually high risk schemes. This is because the values of assets are subject to lot of fluctuations.
Also, unlike fixed-income schemes, growth funds usually pay lower dividends. They may also prefer to reinvest the dividend money into increasing the assets under management.
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Balanced funds:
As the name suggests, these schemes try to strike a balance between risk and return. They do so by investing in both equities and debt instruments. As a result, they are a kind of hybrid fund. Their risk is lower than equity or growth funds, but higher than debt or fixed-income funds.
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Fixed-income funds:
These are schemes that promise regular income for a period of time. For this reason, fixed-income funds are usually a kind of debt fund. This makes fixed-income funds low-risk schemes, which are unlikely to give you a large amount of profit in the long-run.
They pay higher dividends than growth funds. As with debt funds, they may be further classified on the basis of the specific assets invested in or on the basis of maturity.
Some special funds:
These are funds which invest in a specific kind of assets. They may be a kind of equity or debt fund.
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Index schemes:
Indices serve as a benchmark to measure the performance of the market as a whole. Indices are also formed to monitor performance of companies in a specific sector. Every index is formed of stock participants. The value of the index has a direct relation to the value of the stocks. However, you cannot invest in an index directly. It is merely an arbitrary number. So, to earn as much returns as the index, investors prefer to invest in an Index fund. The fund invests in the index stock participants in the same proportion as the index.
For example, if a stock had a weightage of 10% in an index, the scheme will also invest 10% of its funds in the stock. Thus, it recreates the index to help the investors earn money. Such schemes are generally passive funds as the managers need not research much for asset allocation. As a result, the fees are lower. They are also a kind of equity fund.
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Real estate funds:
These are not a sector-specific fund which invests in realty company shares. Instead, these funds invest directly in real estate. This may be by buying property or funding real estate developers.
That said, they can also buy shares of housing finance companies or their securitized assets. Risk depends on where the fund is investing the money.
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Gilt funds:
These schemes primarily invest in government securities. Government debt is usually credit-risk free. Hence, the investor usually does not have to worry about credit risk.
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Interval schemes:
These schemes combine the features of open-ended and closed-ended schemes. They may be traded on the stock exchange or may be open for sale or redemption during pre-determined intervals at NAV based prices.
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Sector funds:
These are a kind of equity scheme restrict their investing to one or more pre-defined sectors, e.g. technology sector.
Since they depend upon the performance of select sectors only, these schemes are inherently more risky than general schemes. They are best suited for informed investors, who wish to bet on a single sector.
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Tax-saving schemes:
Investors are now encouraged to invest in the equity markets through the Equity Linked Savings Scheme (ELSS) by offering them a tax rebate. When you invest in such schemes, your total taxable income falls. However, there is a limit of Rs 1 lakh for tax purposes. The crutch is that the units purchased cannot be redeemed, sold or transferred for a period of three years.
However, in comparison with other tax-saving financial instruments like Public Provident Funds (PPF) and Employee Provident Funds (EPF), ELSS funds have the lowest lock-in period. An example of ELSS scheme is the Kotak ELSS scheme.
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Money market schemes:
These schemes – a kind of debt fund – invest in short-term instruments such as commercial paper (CP), certificates of deposit (CD), treasury bills (T-Bill) and overnight money (Call).
The schemes are the least volatile of all the types of schemes because of the short-term maturities of the money-market instruments. These schemes have become popular with institutional investors and high-net worth individuals having short-term surplus funds.
What are Hedge Funds:
While reading up about mutual funds, you may hear about hedge funds. They are quite similar to mutual funds as they are an investment vehicle too. They too pool money from investors, and then invest on their behalf in different securities. That’s where their similarities end.
Here are some differences between mutual funds and hedge funds.
- Mutual funds are open to all investors, while hedge funds are not. They are only available for high-net worth investors.
- Mutual funds invest in regular financial instruments like stocks, bonds. Hedge funds, on the contrary, invest in complex and riskier financial instruments like mortgage products.
- Hedge funds can borrow additional amounts. They can also bet on twice the total worth of their assets. This is not applicable for mutual funds, which have limited borrowing capabilities.
- Mutual funds have lower charges than hedge funds. This is because hedge funds have a high amount of reliance on the asset manager’s expertise.
- Even a small-investor can opt for a mutual fund, as it allows investment of small sums of money. This is not possible for hedge funds, which have a high investment threshold.
- As a result, mutual funds are less risky than hedge funds. They also cannot use complex investment strategies like hedge funds.
- Mutual and hedge funds differ in the very objective of the fund. For a mutual fund, the objective is to protect investor's money through diversification. For hedge funds, however, diversification is not a must. They can extremely concentrated investment decisions.
- Since mutual funds are open to retail investors, they are more regulated than hedge funds.
What is a Systematic Investment Plan:
Sometimes, we may wish to invest a big some of amount, but won’t have the entire sum at once. A systematic investment plan (SIP) comes handy in such a situation. It helps you spread your investment over time through fixed payments either on a monthly or quarterly basis. This also helps inject discipline into your investment habit, as many who wish to invest regularly forget to do so. Thus, you may end up spending more than you should, and not investing enough. SIPs help you avoid this.
Under SIP, you automate your monthly mutual fund investment activities. You, thus, invest small sums at regular intervals to buy mutual fund units. Many prefer an SIP over investing in lump sum in mutual funds. This is because SIP offers some benefits that a lump sum investment doesn’t. Here’s a look:
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Cost averaging:
SIP helps you lower your average cost of investment. This principle is called rupee-cost averaging. Every month, the value of the MF scheme changes. Units are thus available at a different price every month. So, when you invest a fixed amount every month, during different market cycles, you buy varying amounts of MF units. So, on the whole, the average cost falls.
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Power of compounding:
As you keep investing, you also earn returns on the interest or profits you make. Moreover, you can also earn more by reinvesting your profits.
Thus, the longer you invest, the higher your total return.
For this reason, it is advisable to start investing as early as possible, and thus earn more profits through continuous reinvestment. This is called the power of compounding. SIP helps you tap into the power of compounding.
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Timing:
Getting your timing right is of great essence. That said, it is not easy to do so. With an SIP, you invest across time, irrespective of the market timing. This increases your overall probability of getting your timing right.
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Tax-saving schemes:
In an SIP, your investment process is automated. So, you never miss a single investment. This instills discipline in your investments and helps you to meet your financial goals.
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Discipline:
These schemes – a kind of debt fund – invest in short-term instruments such as commercial paper (CP), certificates of deposit (CD), treasury bills (T-Bill) and overnight money (Call).
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Small investors:
SIPs can be started even with the small amount of Rs 500 or Rs 1,000 whereas some mutual funds may have a higher investment threshold.
What is Systematic Transfer Plan:
An SIP helps you enter a mutual fund investment. But, what if you want to switch to another scheme within a fund family after you have invested in it? The STP or Systematic Transfer Plan may come handy here.
When you opt for STP, also called the Systematic Switch Plan, you allow the mutual fund to transfer a certain amount of money or units to another scheme periodically. Thus, your mutual fund portfolio will regularly be rebalanced.
For example, suppose you have invested Rs 50,000 in an equity fund. You expect that a few months later you would start needing a secondary source of income. However, you also want to earn high returns due to the rise in equity markets. So, you can opt for an STP plan through which Rs 5,000 is shift to a debt scheme on a monthly basis. So, this way, you earn some returns through your equity fund and also start building your debt fund portfolio for your future income needs.
What is Systematic Withdrawal Plan:
A Systematic Withdrawal Plan or SWP is for withdrawal what an SIP is for investment. It allows an investor to withdraw a fixed amount of money or units from your fund portfolio at regular intervals. This would come handy for those wishing for a regular source of income. The key requirement is that you have a sizeable portfolio of funds. Without that, you would not be able to withdraw any funds.
An SWP helps you meet your liquidity needs. It is, therefore, usually used by retired investors.
An SWP comes handy when you are unsure about the correct time to exit investments. You thus get your money irrespective of market conditions. So, when the market is up, you sell less number of units for the fixed amount, and when the market is down, you sell more units.
Another key advantage of an SWP is it spreads your tax liabilities across time too. You will have to pay capital gains tax over a period of years, instead of paying it in lump sum in one year. In the meanwhile, you may also enjoy further appreciation in the value of your mutual funds.
WHAT NEXT?
We are almost at the end. Before you start investing in mutual funds, there are a few more important points to keep in mind like taxation. This can affect your total financial returns. To know about these factors, Click here
- Snapshot of profit/loss
- Reflects performance of your portfolio
- Helps compute taxes
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