Remember how you split your restaurant bills among friends who are part of the meal? Here are possible reasons why you do it:
- It reduces an individual’s burden of bearing the entire cost
- It spreads the cost across each of them
- It offers benefits to every participant
Mutual funds also work in a similar fashion. Don’t know much about mutual funds? Fret not because we have compiled a comprehensive guide on what is a mutual fund and what are its types.
This article covers
What is a mutual fund?
A mutual fund is a form of investment where several investors park their funds to form a pool or corpus. A fund manager, in turn, invests this pool of funds in various instruments such as equity and debt, depending on the investment objective (mentioned in the offer document). Unlike equity, when you purchase a mutual fund, you are not allotted individual shares but a unit of the mutual fund in proportion to your investment. As such, profits or losses on investing in a fund are shared by all the investors in the scheme proportionately.
How does a mutual fund work?
A mutual fund is managed by a professional manager who is responsible for investing the pool of funds in select instruments based on the fund’s objective. The fund manager also monitors the performance of the mutual fund. As mentioned, when you invest in a mutual fund, you don’t own the entire fund but only part of it called a ‘unit’. Nevertheless, the value of a unit increases or decreases as per the value of the underlying assets of the fund. And profit is distributed accordingly.
Types of mutual funds
Mutual funds are of various types and can be broadly categorised based on two parameters:
- Maturity period
- Underlying asset
1. Based on the maturity period: under this category, a mutual fund can be classified as follows:
a. Open-ended funds: these types of mutual funds are known for the liquidity that they offer. These are open for subscription (buy/purchase) and redemption (sell) at all times as there is no fixed maturity period. You can buy and sell units of an open-ended fund at the NAV or net asset value, which is ascertained daily when the market closes.
b. Close-ended funds: as the name suggests, close-ended funds have a fixed maturity period, typically ranging from 3 to 7 yrs. Here, a fixed number of units are issued and listed on a stock exchange. Unlike an open-ended fund, you cannot enter or exit from this fund as you wish. You can only invest in a close-ended fund during the initial period regarded as the New Fund Offer (NFO) period. If you wish to invest in this fund at a later point in time, you can do so by purchasing the units listed on a stock exchange, either at a premium or a discount on NAV. This feature makes a close-ended fund very much like an exchange-traded fund (ETF). Since the fund has a fixed maturity period, your investment will automatically be redeemed on the maturity date.
c. Interval funds: This type of mutual fund is a combination of an open-ended and a close-ended fund. You can invest or exit from an interval fund only at specific intervals at the discretion of the mutual fund house. Once you invest in an interval fund, your money is locked in until its maturity.
2. By asset class or underlying asset: under this category, a mutual fund is classified based on the underlying asset or nature of investment as follows:
a. Equity or growth funds: These types of funds allow you to indirectly invest in stock markets, i.e. shares or related instruments. The aim here is to offer capital appreciation over medium- to long-term. Since equity, the underlying asset, has a considerable risk element, growth mutual funds also carry high risk. Nonetheless, the risk is mitigated as the funds are spread across equities of various industries.
Just like equity, a growth scheme also has the potential to generate high returns in the long-term. You can consider investing in equity funds if you are looking for capital appreciation, have a high risk appetite, and a long-term investment horizon in mind.
Equity funds can further be divided into three types:
- Sector-specific funds: as the name suggests, these mutual fund schemes invest in a specific sector such as banking, mining, and infrastructure or segments such as mid-cap, small-cap, and large-cap. Sector funds carry high risk and have the potential to generate high returns.
- Index funds: this type of mutual fund invests in equity based on an index. As such, the index fund also replicates the direction or the movement of the index it is based on. Let us understand this with an example. Assume that a mutual fund follows an NSE index, where Stock X and Y have 75% and 25% weightage, respectively. Following this, the index fund also invests 75% of the corpus in Stock X and 25% in Stock Y. Index funds carry a medium-risk because here loss is limited to the proportionate loss of the index.
- Tax-saving funds: This type of mutual fund scheme offers tax benefits to investors. Since the underlying asset here is equity, the fund is also called Equity Linked Saving Schemes (ELSS). Tax-saving funds have a lock-in period or fixed maturity period of 3 yrs and are eligible for tax deduction under section 80C of the Income Tax Act, 1961.
b. Debt or income funds: These types of funds majorly invest in debt or fixed-income instruments such as gilts, bonds, debentures, and money-market securities. As such, a debt fund offers a fixed rate of interest and is relatively less risky than an equity fund. This fund offers capital security and moderate growth and is therefore suitable if you want to receive a stable income by assuming a low risk.
c. Balanced or hybrid funds: In these types of funds the corpus is invested in both equity and debt instruments as per the fund’s investment objective, which is mentioned in the offer documents. Ergo, a balanced fund offers high growth via equity and a regular income through debt avenues. A typical hybrid fund invests 60% in equity and 40% in debt instruments.
d. Money market funds or liquid funds: as the name suggests, liquid funds are invested in the money market or short-term debt instruments having a tenure of up to 91 days. The main objective of money market funds is to offer a reasonable return to investors in the short-term. Money market funds are highly liquid and relatively less risky, which makes it suitable if you wish to park your surplus for a short. You can only invest up to Rs 10 lakh in a liquid fund and the NAV is calculated daily.
e. Monthly Income Plans (MIP): these are best suited for retirees as the majority of the funds are invested in debt mutual funds, thus reducing the exposure of equity. These carry low risk and offer a regular monthly income.
f. Fixed Maturity Funds (FMP): these types of funds have a fixed maturity period between 1 and 5 yrs and invest in fixed-income securities.
g. Gilt fund: these types of funds only invest in government securities and are best suited for risk-averse investors.
h. Fund of funds: these invest in other mutual funds or other schemes of the same mutual fund. The benefit of such a scheme is that you can enjoy a greater diversification, which spreads the risks across multiple schemes.
i. Foreign funds: these types of schemes invests in funds of other nations. That way, you can enjoy decent returns when domestic stock markets don’t perform well.
j. Real estate funds: these types of schemes allow you to be an indirect participant in the real estate sector. Here, the fund invests in established property firms and not projects. You can consider investing in these funds for the long-term.