All That You Want To Know About Mutual Funds and Types of Mutual Funds

  • Oct 16, 2019 BST
  • Team Kalkine
All That You Want To Know About Mutual Funds and Types of Mutual Funds

Mutual Fund is a pooled investment vehicle which provides investors the opportunity to subscribe to a wide range of securities via a single platform. Mutual funds are professionally managed and require investors to bear certain fees and expenses on a periodic basis. Mutual Funds are excellent instruments for long-term investor wealth creation, yet they do have certain advantages and disadvantages when compared to directly investing in stocks and other financial instruments. The main advantages of mutual funds are that they extend to the investor economies of scale, greater diversification, liquidity in comparison to direct investing and also that they are managed by expert fund managers. On the other hand, they are more expensive than direct investment in securities on account of the fees and expenses they charge.

How to Invest in a mutual fund - A mutual fund is divided into units with each unit having a predetermined face value. Investors participate in Mutual funds by buying these units, the value of which could either go up or come down depending on the performance of the mutual fund. The value of a unit at any particular time is known as its NAV or Net Asset Value and this is the price per unit which the investor has to pay in order to subscribe to a fund. An investor will be able to subscribe to a fund at the face value per unit only during the initial offer period of the fund. After that, when units are offered on a continuing basis, investors will have to purchase additional units always at the applicable NAV on any given day.

Mutual Fund classes

Mutual Funds may be classified based on their structure and the investment objectives they seek to achieve.

Structure of a mutual fund

Open-Ended Mutual Fund – In This type of a fund investors can freely enter and exit the fund as per their convenience. Owing to the above, the number of units outstanding goes up and down any number of times during a particular time period, thereby increasing or decreasing the size of the fund as a consequence. The units of the fund may be bought ad sold at the NAV (Net Asset Value) prevailing at the time of purchase or redemption.

Close-Ended Mutual Fund - In this type of fund, the fund only issues units once and subsequent buying and selling of units takes place among investors in a secondary market for these units much like shares. Since the units in this case have a secondary market of their own, they are not bought and sold at their NAV (Net Asset Value) and their prices are determined by the forces of demand and supply prevailing in the market, which may value the units at a discount or a premium to its NAV.

Types of Mutual Funds classified according to their investment objectives

Based on Investment objective, a mutual fund may be classified as Equity fund, Balanced fund or Debt Fund.

Equity Funds -An equity fund is a mutual fund that invests in equities only. Within this style of fund itself there can be many a sub-division with each seeking a differentiated objective. The most common is the plain vanilla type of fund which seeks long term capital appreciation along with dividend income. Other prominent fund types in this category are.

  • Index Funds – These funds try to emulate the performance of a particular equity index. These funds invest in all of the securities or majority of the securities represented in a particular equity index. The advantage of this type of fund is that they do not require a lot of active management and hence charge less fund management fees from the investors.
  • Dividend Yield Funds – These are funds that specifically invest in equities that give out good dividend return on investments. These funds invest in established and cash rich companies who distribute a large part of their earnings as dividend. These funds do not target capital appreciation and are less risky than funds that target capital gains.
  • Equity growth Fund – These funds have a majority of their assets devoted to growth companies and target capital gains as their main source of earnings. This fund type is the riskiest and also offers high risk to reward potential to its investors.
  • Equity Diversified Fund – These funds invest in equities across different sectors of the economy. They are generally less risky than equity growth funds and sector funds or thematic funds as the investment is diversified across sectors and across stocks of different market capitalizations and vintage.
  • Thematic Funds – These funds aim by investing in stocks which are likely to gain on an identified macro-level trend. The trend may be a certain anticipated technological change, change in consumer preferences or change in macro level economic factors like an economy coming out of a recession. These types of funds offer high risk-high return characteristics.
  • Sector Funds – These are funds that are concentrated on particular sectors like, banking, real estate, FMCG, etc. These funds are generally riskier as they are subject to the vagaries of that particular sector and cannot diversify away unsystematic risk.

Debt Funds – These funds are dedicated to debt products and invest a large portion of their funds into debt securities both the government as well as corporates. These types of funds are generally less risky than equity funds and also provide lesser returns. Within this style of fund as-well there can be many a sub-division with each seeking a differentiated objective.

  • Liquid Funds – These funds invest in highly liquid money market instruments. They are the least risky type of funds and their returns are lower compared to other types of investment fund vehicles.
  • Gilt Funds – These funds invest in Government securities of various maturities. These funds offer more safety than any other types of funds excepting Liquid funds. Yields on these types of funds are lower than other riskier class of funds but higher than those of Liquid funds.

These funds within themselves may be subdivided based on the term -horizon of securities chosen, for example Short-term Gilt funds, Long-term Gilt funds, etc.

  • Floating rate / Short term income funds – These type of funds invest in short term commercial papers and floating rate instruments. These funds offer less risk and returns on these instruments are dependent on the prevailing interest rates. If the interest rates are on the rise, then these funds will provide higher returns and vice versa.
  • Arbitrage funds – These funds earn through arbitrage opportunities occurring on account of mispricing in securities in the cash and derivatives markets. Funds are allocated between equities, derivatives and money market instruments. Higher proportion (around 75 per cent) is put in money market instruments, in the absence of arbitrage opportunities.
  • Long Term Income Funds - These funds invest a major portion of the portfolios in long-term debt papers. In a rising interest rate scenario, income funds may not give fruitful results. Interest rate risk in these funds is higher than for short-term income funds. In this fund critical factors are the outlook on interest rates, investors’ time horizon, etc.
  • FMP (Fixed Maturity Plan) - Fixed Maturity Plan or FMP in short is a fixed term mutual fund plan which invests its funds in fixed term securities having maturity periods which confirming to the tenure of the scheme itself.

Balanced Funds – These types of funds usually invest in both debt and equity, albeit in varied proportions which puts their risk profile between a pure debt fund and a pure equity fund. This characteristic makes these types of funds well suited for investors who want to diversify their risk among the two classes of securities. Within this class of Investment funds there are broadly two types of funds.

  • Debt oriented funds – These types of funds generally invest a larger proportion of their portfolio in debt securities and lesser into equities. These types of funds are less risky than equity oriented balanced funds but more than pure debt funds. During periods of market boom, they provide good returns albeit lower than equity oriented balanced funds or pure equity funds.
  • Equity Oriented Funds - These types of funds generally invest a larger proportion of their portfolio in equities and lesser into debt securities. These types of funds have higher risk than debt oriented balanced funds but less than pure equity funds. During periods of market boom, they provide good returns albeit lower than pure equity funds but more than debt oriented balanced funds.

With Bank of England reducing the interest rates to a historic low level, the spotlight is back on diverse investment opportunities. 

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