A Mutual Fund is a pool of money provided by a number of people, investors and/or organisations
We’ve all heard of Mutual Funds. They’re among the first things people seem to talk about when discussing investments. The ads on TV from many companies advertising their mutual funds, and how easy it is to buy a mutual fund, are pretty much a part of daily routine. You, I and nearly everybody else knows this line by heart – “Mutual fund investments are subject to market risks.”
So what are these popular, and regularly well marketed, things called mutual funds?
A Mutual Fund is a pool of money provided by a number of people, investors and/or organizations. Mutual funds might just be the easiest, least stressful way of investing in the stock market. The general consensus is, more new money has been introduced into funds in stock markets across the globe during the past few years than at any time in history. This pool of money is invested and managed by a fund manager. This fund manager’s goals depend on the type of mutual fund.
According to Investopedia, almost $28 trillion is invested in mutual funds worldwide. As the number of mutual funds has grown, their scope and strategies have expanded too. By 2013, in the United States alone, there were 1,329 American equity funds, 1,345 global funds and 1,866 total return funds, 594 investment grade bond funds, 225 high-yield bond funds, 270 global bond funds, 214 government bond funds, 143 multi-sector funds, 560 state and national municipal bond funds, 382 taxable money market funds and 173 tax-free money market funds. It is estimated that more than half of all American households invest in mutual funds. Another interesting bit of trivia is that the first modern mutual fund, the Massachusetts Investors Trust, was established in 1924. In just one year, the fund grew to from $50,000 to $392,000 in assets. That is around $4.6 million in 2017 American dollars. The fund went public in 1928 and eventually became known as MFS Investment Management.
One basic thing to remember is investing in a share of a mutual fund is different from investing in shares of stock. Mutual fund shares, unlike stock, do not give holders any voting rights. A share of a mutual fund represents investments in many different stocks instead of just one holding.
Many investment products are not one single product, but are instead a collection of individual products. For example, we wear different pieces of clothing that make up our wardrobe. Financial products like mutual funds function in a similar manner, by investing in a collection of stocks and bonds to comprise the entire fund.
Now that we have some idea of the basics of Mutual Funds, let’s look at the types of these funds. There are various types of mutual fund schemes. These schemes are categorized based on their utility and features.
Based on their maturity periods, mutual funds are split into three broad categories:
Open-ended Funds, Close-ended Funds, and Interval Funds.
An open-ended mutual fund scheme is one in which investors can buy and redeem the units at any time. These schemes do not have any maturity date. The price at which an investor buys and sells the units will be based on the net asset value of that scheme. Net asset value or NAV s the value of one unit of the scheme. NAV is the aggregate value of all the assets of the scheme, divided by the total number of units issued by the scheme.
Liquidity is the key feature of an open-ended fund. Liquidity, to put it simply, means to get your money whenever you need it, or how quickly you can get your hands on your cash. Since Open ended funds buy and sell units on a continuous basis and, they allow investors to enter and exit as per their convenience.
A close-ended fund, on the other hand, has a predefined maturity period like 3 or 6 years. These funds are generally open for subscription for a specific duration. Unlike open ended funds, close-ended funds are traded on the stock exchanges. The prices at which they are traded are based on the NAV, but there is a catch. Close-ended funds trade at a discount to their NAV. That is because unless the investor is able to find another buyer, he will have to wait till the maturity date to redeem his units.
Interval funds are the combination of Open-ended and close-ended funds. These funds may trade on the stock exchange and open for sale and redemption at predetermined intervals on the prevailing Net Asset Value.
Depending on the investment objective of investors, mutual funds are classified into various types. And this is where it can get confusing, so we’ll try to keep things simple and to the point.
Typically, mutual funds are named for the type of investment objective and the underlying investments. For instance, if the fund invests primarily in equity, it is called an equity fund.
Equity funds make money for their investors by investing in equities, also commonly known as shares. Equity funds are further classified into large cap funds, mid-cap funds, small-cap funds and sector/thematic funds. There are further types called multi-cap funds and balanced funds too, which are basically just variants.
So what are Large-cap funds? These are funds that invest a large part of their corpus in shares of very large companies. Large cap funds invest in companies which have a large market capitalization, hence the name large. These typically are very large, established players with a large workforce. Think Unilever, Reliance, Infosys. The big boys. Large cap companies have a market capitalization of more than INR 10,000 crore.
Large cap funds are a good option for investors with a long term investment horizon and also those who do not want to take too much risk. Since blue chip companies are financially strong, these funds tend to give stable returns over other equity funds. These are low risk and the returns from large cap mutual funds can be lower than those from midcap and small funds. But bear in mind that mid and small cap funds are high risk-high return bets, while large cap funds are likely to be more consistent in performance. Usually, large cap companies withstand economic crises better and recover faster. Therefore, investors looking for an investment with low risk but moderate returns can consider large cap mutual funds.
Next are Mid-cap Funds.
Mid-cap funds invest in shares of mid-sized companies. Because they are smaller in size, these companies’ growth rates are quite high in the initial years. There are various definitions of mid-caps funds. For our purposes, let’s go with conventional wisdom that companies with a market capitalization of 500 Cr to 10,000 Cr. Another way to define them is companies beyond the first top 50 companies in the Nifty 50, all the way to the 250th. Returns from a midcap fund can be volatile since shocks to the economy affect them more than they affect the bigger companies. However, in boom times, midcap companies tend to do better than their larger counterparts, since the growth is on a small base.
Because large cap companies are more reliable, most investors chase them. When too many buyers put money in the same set of large caps, they become expensive. Investors then start looking for companies which are relatively cheaper compared to large caps. That is when midcaps start looking attractive.
The third type of equity funds are Small-cap funds.
Small cap companies include firms that are in their early stage of development with small revenues. Small caps are typically defined as firms with a market capitalization of less than INR 500 Crore. Since small cap stocks give high growth potential and are companies in early stages of development, they have a chance of giving higher returns. But, understandably, the risk of failure is higher with such small companies compared to the large and mid-cap organizations.
Many small cap companies serve niche markets with sound consumer demand for their products and services. They also serve emerging industries with the potential for substantial future growth. Small cap firms have the potential to generate good returns. However, the risks involved are much higher. You need to stay invested for longer durations to get the best returns.
Thematic Funds invest in shares of companies that belong to a particular sectoral or based on a particular investment theme. These could be pharma, banking, auto, infrastructure, information technology, to name a few. A pharma focussed fund may invest only in shares of pharma companies, while a multinational companies-focussed fund may invest in such companies irrespective of the sector they belong to.
Theme-based funds are considered high-risk, high-return bets. The performance of these funds depends on the performance of the limited number of companies/sectors invested in. Theme-based funds are best suited to mature investors and those who follow market trends closely.
Next are ELSS funds or Equity Linked Saving Schemes, commonly known as Tax Saving Mutual Funds. These are equity funds with a 3 year lock-in period. Investments in ELSSs qualify for tax deductions of up to Rs 1.5 lakh under 80C. ELSSs are equity schemes that invest their corpus mostly in equity
ELSSs lock-in period of three years is a blessing in disguise as it helps many investors, especially the new ones, weather the volatility in the stock market.
Investment experts recommend that tax-payers link a long-term financial goal to their ELSS investments. They believe that such a strategy helps investors stay focused on their investment objective. You don’t have to sell your ELSS investments after the lock-in period. If it is performing well, you can hold to it to achieve your financial goal.
Another type of equity fund is the International Equity Fund. These are usually preferred by investors who want to invest in securities across geographical barriers. Investors usually invest in International Mutual Funds to diversify their portfolio, and take advantage of the stock market rallies in global markets. International Mutual Funds are generally not recommended for those new to investing, considering the currency fluctuation risk.
Moving on from equity funds, another category is Hybrid Funds
Hybrid funds are mutual funds with a mix of debt and equity. The proportion of debt and equity changes. There are broadly two types of hybrid funds, Balanced funds & Monthly Income Plans.
Balanced Funds are for investors with a long term view in mind, i.e. more than 3 years.
Investors saving for goals that are roughly 5-6 years away are usually advised to go for balanced funds. These funds invest in a mix of equities and debt, giving the investor the best of both worlds. The fund gains from a healthy dose of equities but the debt portion fortifies it against any downturn. Taxes on these funds are as per equity mutual funds because balanced funds allocate more than 65% to equity.
As you might have guessed, there are two types of balanced funds – equity oriented and debt-oriented, depending on the mix.
Equity-oriented schemes
These schemes are more volatile due to the higher allocation for stocks. But gains are tax-free if the investment is held for more than one year.
On the other hand, debt-oriented balanced funds are less volatile and suit those with a lower risk appetite. However, this relative safety means lower returns and any gains you make are not eligible for tax exemption.
Keeping the risks involved in mind, here’s an interesting bit of information: The five-year returns of the top five equity-oriented balanced funds are higher than those of debt-oriented balanced schemes. This statistic should be kept in mind if you plan to remain invested for an average of 5 years.
The second type of hybrid fund is the Monthly Income Plans or MIP
These funds are generally recommended for retirees and ultra conservative investors looking to invest a small part of their corpus in stocks. There are various kinds of MIP or Monthly Income Plans. The difference is in the percentage of equity in the funds. MIPs started off as a means to provide monthly income. They were seen as annuity products in the Indian market.
A Monthly Income Plan is basically a debt-oriented hybrid mutual fund scheme investing around 70-80 per cent of the total corpus into debt instruments like debentures, government securities, etc. The remaining part is invested into equity. The objective of these schemes is to provide steady income at regular intervals.
According to industry experts, MIPs are best suited for retirees, housewives and people seeking some additional income or extra returns over and above what they are earning through fixed deposits. Returns are in the range of 10-12%. However, many MIPs in the market invest as high as 32 per cent in equities. Investors should be sure that they are okay with the equity exposure because a very large exposure may result in high volatility.
Since these schemes invest most of their corpus in debt, they are categorized as debt schemes for the purpose of taxation.
Besides Equity and Hybrid funds, the third large category of Mutual Funds is the Debt Fund.
Investopedia defines a debt fund as an investment pool, such as a mutual fund or exchange-traded fund, in which core holdings are fixed income investments. A debt fund may invest in short-term or long-term bonds, securitized products, money market instruments or floating rate debt. The fee ratios on debt funds are usually lower, on average, than equity funds because the overall management costs are lower.
Debt funds are mutual funds that invest in fixed income instruments. They mainly invest in a mix of debt or fixed income securities like Government securities, Treasury bills, Corporate bonds, etc. Debt funds are preferred by those who are looking for steady income with relatively lower risks. There are various types of debt funds :
The first type of debt fund is the Gilt Fund
Gilt funds are mutual funds that invest in government securities issued by the RBI. Depending on their maturity profile, gilt funds carry interest rate risk.
That’s one reason this year is not looking good for Gilt funds. Gilt schemes invest mostly in government securities and government securities are extremely sensitive to interest rate changes. They suffer the most when the rates start going up, and benefit when rates go down.
Long-term gilt funds have been going through an extended bad phase since the Reserve Bank changed its monetary stance in February 2017. Long-term debt funds, especially the gilt schemes, had taken a hit after the RBI stopped easing policy rates in 2017.
Another variety of debt fund is the Long-term Income fund. Long term income funds invest in Corporate bonds and Government of India bonds that have a long-term maturity period. Long-term income funds usually benefit when the interest rates are moving downwards. These funds seek to generate returns both in declining and rising interest rate scenarios by managing their portfolio actively. They either generate interest income by holding the instruments till maturity or manage gains by selling them in the debt market if the price of the instrument rallies well.
The next type of debt fund, is, you guessed it, Short term Income fund
Short term funds invest in Commercial Papers, Certificate of Deposits, Money Market instruments, etc. The average maturity period of their portfolio is rarely over two years. These funds even pick up long-term bonds which have only 1 -2 years left to mature. Short-term income funds are designed to generate income from interest on short to medium term bonds. This accumulated interest, referred to as accrual income, adds up in the net asset value. Steady income makes returns less volatile.
That said, short-term funds are a good option if you have a 1-2 year timeframe, and do not need the funds in the near future. Since these schemes invest in higher interest-bearing papers, they deliver higher returns than the trusted old fixed deposits. While most short-term funds tend to invest only in papers with strong credit ratings, some of them do invest a portion of their portfolio in low-credit instruments to increase returns. Such funds require a higher risk appetite though the horizon required is still 2 years. Else, short-term funds suit all risk profiles.
The last of the debt funds is the Dynamic Bond.
This is a hybrid category of debt funds that invests in fixed income instruments of various maturities depending on market conditions. Dynamic bonds can be short term or long term instruments.
Dynamic funds can give higher returns than short-term debt funds but they also come with higher risks. Buy these funds only if you can handle the volatility.
Dynamic bond funds are aggressive income funds where a fund manager can change the underlying portfolios drastically. Every debt fund is supposed to invest as per its mandate: therefore, short-term funds invest in shorter-tenured securities and long-term funds invest in longer-tenured ones. However, dynamic bonds, by definition, don’t have such restrictions. They can be long-term bond funds in one month and short-term in another, depending on where the interest rates are headed.
If you can handle the volatility of dynamic bonds, market data has shown that over 3-year time periods, dynamic funds outperformed short-term bond funds around 60-70% of the times. And, according to Livemint, over 5-year periods, dynamic funds outperformed short-term funds by almost 80-90%.
That’s the end of Debt Funds.
Which brings us to the next type of mutual fund – Money Market Funds.
Money market funds also known as liquid funds. These funds invest in safer short-term instruments like Treasury Bills (T-Bills); Certificates of Deposit (CD) and Commercial Paper (CP) for a period less than 91 days. The objective of money market funds is to provide easy liquidity, preserve the capital and moderate income. These funds are good for corporates as well as individual investors, though with a caveat that I’ll speak about in a minute.
While they count as a subcategory of debt funds, money market funds invest in instruments of very short tenor/maturity, from a couple of months to less than 91 days. Much like other commodities that are traded in designated commodities exchanges, money is traded in a designated exchange termed the money market.
A money market fund’s purpose is to provide investors with a safe place to invest in easily accessible cash-equivalent assets characterized as a low-risk, low-return investment. Because of their relatively low returns, it might not be feasible to use money market funds as a long-term investment option.
And now, that caveat I spoke about: Kotak Bank recommends that if you don’t have a large amount of cash in your savings bank account, then this option may not be not of interest to you. If, on the other hand, you do have large cash surplus, then money market funds can give better returns than savings accounts.
And that about covers the main types of mutual funds that a majority of investors look to put their money in to. There are other funds of course, like Gold Funds, that one could invest in. But these have become obsolete since the introduction of sovereign gold bonds, which are a better investment option if you want to invest in the yellow metal.
One final bit, before I close on mutual funds. As a recap, here is how, according to Investopedia, a mutual fund makes money for an investor.
Investors typically earn a return from a mutual fund in three ways:
1) From dividends on stocks and interest on bonds held in the fund’s portfolio. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution. Funds often give investors a choice either to receive a check for distributions or to reinvest the earnings and get more shares
2) If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution.3) If fund holdings increase in price but are not sold by the fund manager, the fund’s shares increase in price. You can then sell your mutual fund shares for a profit in the market.
So that then, is the long and short of the thing called a mutual fund.
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