5 Categories to Determine Types of Mutual Funds
Mutual Funds are generally considered the same as share market or stocks. For those who understand something about mutual funds, they mostly consider it to be risky as they invest in equities.
Historically, mutual funds have been marketed as an equity product and hence the misconception is valid and expected. However, the recent campaigns of “Mutual Funds Sahi Hai” has attempted to eliminate such misconceptions by designing a few TV commercials which also talk about the other category of funds.
Having said that, the different kinds of mutual funds still remain many. And so does the confusion of a potential investor. The recent changes brought about by SEBI only added to the confusion as more categories were added. But what was done well was that each category was better defined so that the investor could take a more informed call about which funds are suitable to the policyholder.
There are various ways in which mutual funds can be classified. The following ways which have been listed are not mutually exclusive and the same fund can be categorized in multiple ways. It is akin to how a woman can be a wife, a mother and a daughter – all at the same time.
- Asset Category – Determined by which asset class the fund invests in.
- Sub – Asset Category – Within each asset category, there are further bifurcations which define the investment philosophy of each fund.
- Based on structure – Each of the funds in the above categories can also be classified as per the structure in which they are designed.
- Tax Saving Funds – These funds are equity funds with a lock-in period of 3 years. They provide tax benefit under section 80C of the IT Act.
- Specialized Funds – Several other categories will be detailed out here.
#1. Asset Category
Funds under asset category are classified basis the asset class in which they invest in. There are three primary categories here:
Primarily invest in stocks of companies listed on the exchange. The performance of these funds is determined by how these shares perform (price-hikes or price-drops) in the stock market. These funds offer complete liquidity – which means that you can come in and out of it at any point in time. This also makes this asset class very volatile in the short term.
Since companies tend to perform only in the long run, equity as an asset class is suitable for only long-term investors. They are therefore suitable for those who are looking for long-term wealth creation and have the ability to survive through the short-term volatility. They are also suitable for people who are looking for equity exposure for the long term but are not experts at picking stocks.
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Debt funds invest in fixed-income securities like bonds, government securities, and treasury bills. They are therefore not linked to the stock market. Debt funds have various subcategories too and each category has a different risk level. But in simple terms, debt funds are suitable for those who are looking to park surplus funds for a few years and prefer the safety of capital over short-term volatility. The returns from debt funds are usually much lower than equity funds. Since their returns match or just beat inflation, they are not a sufficient instrument for wealth creation in the long run.
Balanced or Hybrid Funds
These are funds that invest in a mix of debt and equity. In some cases, the proportion of equity is higher than debt while in others it is the other way round. Risk and returns are balanced out this way. These funds are suitable for first-time equity investors and those who want to invest for the medium term.
#2. Sub - Asset Category
Mutual Funds can be further subdivided within Equity and Debt. Following are the common categories:
Common categories within Equity Funds
Large Cap Funds
These funds invest at least 80% of their portfolio in large-cap stocks. Large-cap stocks are the top 100 listed stocks basis their market value (market capitalization)
These funds do not have a fixed mandate of market capitalization. The fund manager, therefore, is free to decide how much he wants to invest where. These funds are suitable to moderate to high-risk investors who have an investment horizon of more than 5-7 years
Mid Cap Funds
These funds invest at least 80% of their portfolio in mid-cap stocks. Midcap stocks are the next 150 listed stocks after large-cap stocks basis their market value (market capitalization)
Small Cap Funds
These funds invest at least 80% of their portfolio in small-cap stocks. Small cap stocks are the smaller companies after large and midcap stocks
Large & Mid Cap Funds
These funds invest at least 35% of their portfolio each in large and midcap stocks.
Common categories within Debt Funds
- Liquid Funds - They invest in debt instruments and money market with a tenure of up to 91 days. They are suitable for people who need to park money for a few days or weeks.
- Ultra - Short Term Debt Funds - Typically, these funds invest in securities that mature within a week to about 18 months. If you wish to park your cash for 1-9 months, then this one is for you. Liquid funds and Ultra Short Term Debt funds are the lowest risk funds
- Income Funds – These are long-term debt schemes that invest in corporate bonds, government bonds, and money market instruments. They are highly vulnerable to interest rate changes and are suitable for investors who have a long-term investment horizon and medium risk-taking ability. Entry and exit from these funds have to be timed properly. The best time to invest in these funds is when the interest rates are poised to fall
- Gilt Funds – These funds invest in securities of the central and state governments. Since they are backed by the government, the credit risk is Nil. These securities generally have a maturity of over 3 years and hence an investor of a Gilt Fund should have a similar time horizon.
- Fixed Maturity Funds – These are debt funds which need you to lock in your money for a certain time period. The instruments they invest in have a maturity similar to the lock-in period. These are suitable for people who are in 20-30% tax bracket and otherwise invest in long-term fixed deposits.
#3. Based on Structure
This category basically defines the funds based on how they are structured/designed. They are not related to where these funds actually invest.
These are funds in which units are open for purchase or redemption through the year. All purchases/redemption of these fund units is done at prevailing NAVs. They are an ideal investment for those who want investment along with liquidity because they are not bound to any specific
maturity/lock in periods. This means that investors can withdraw their funds at any time they want thus giving them the liquidity they need.
These are funds in which units can be purchased only during the initial offer period. Units can be redeemed at a specified maturity date. Sometimes, to provide for liquidity, these schemes are often listed for trade on a stock exchange. Unlike open-ended mutual funds, once the units or stocks are bought, they cannot be sold back to the mutual fund, instead, they need to be sold through the stock market at the prevailing price of the units.
These are funds that have the features of open-ended and close-ended funds in that they are opened for a repurchase of units at different intervals during the fund tenure. The fund management company offers to repurchase units from existing unit holders during these intervals. If unitholders wish, they can offload the units in favor of the fund.
#4. Tax Saving Category
Each Fund House / Asset Management Company can have one tax saving fund. These are equity mutual funds with an added benefit that they provide your tax savings in the form of deduction under section 80C of the Income Tax Act. Since these funds provide tax benefits, unlike normal equity funds, they have a lock-in period of 3 years. In every other way, they are same as any other equity fund. A tax saving fund can, therefore, be a Large Cap fund, a Multi-Cap fund or even a Mid Cap fund. These funds are also known as ELSS (Equity Linked Saving Scheme) Funds.
#5. Specialized Mutual Funds
These funds basically mimic an index like Sensex or Nifty 50. So if you are investing in an index fund, it basically means that your money is getting invested in all the constituents of the index in the same proportion. Your returns will, therefore, be the same as that of the index. These are passive funds which means that the fund manager does not need to make decisions of his investment holdings on a daily basis. Therefore, the expense ratios of these funds are lower which also makes them a good substitute to large-cap funds.
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Funds which invest in stocks of a particular sector or theme are known as thematic/sectoral funds.
Infrastructure funds, Pharma funds, Consumption funds are examples of a few such funds.
So now if someone says that mutual funds only represent markets and risk, you know it better than they do!
What were the types of Mutual Funds you knew before? Share in comments.