According to some estimates there are close to 2000 different mutual funds schemes in India. Wouldn’t it be nice if there was some way to structure all these schemes into different types of mutual funds. Not only it would reduce the mutual funds universe to much smaller set but also help us gain insights about a particular scheme.
So what are the different types of mutual funds?
Categorization of Mutual Funds can be done based on different parameters. Generally one would find different types of mutual funds based on structure, asset class, investment objectives, Speciality.
Types of Mutual Funds Based on Structure
When we talk about classifying different types of mutual funds based on structure, it basically means when can units (of that particular mutual fund) be purchased or redeemed. Hence it gives us an idea about liquidity. There are 3 types of mutual funds based on structure –
- Open-Ended Funds: In this type of mutual funds, units can be purchased and redeemed anytime during the year. All transactions are done on the prevailing NAV of the fund. Therefore these types of mutual funds allow for maximum liquidity. An investor can enter into a scheme anytime and exit from it without any restrictions. Here units are sold back to the mutual fund company.
- Close-Ended Funds: As the name suggests, the freedom to walk in and walk out is restricted in close-ended mutual funds. An investor can purchase units only during the initial offer period (referred to as NFO or New Fund Offer) and can redeem only at maturity period. However these schemes are often listed on exchanges to provide for liquidity where they can be traded. But units are sold back to the mutual fund company only after the maturity period.
- Important point to note here is that generally an investor would trade his units on the exchange for liquidity. Therefore any buyer would want to buy them at a discount.
- Interval Funds: These types of mutual funds combine best of both the worlds. The fund management company offers to repurchase units (from existing shareholders) at different intervals thereby providing liquidity to some extent.
Types of Mutual Funds Based on Asset Class
Every mutual fund follows a mandate to invest in certain types of financial assets for example – equity, gold, corporate bonds etc or combination of these. Therefore one often finds classification of mutual funds based on the asset class they invest in. There are 3 types of mutual funds based on this criteria –
- Equity Funds: As the name suggests, these types of mutual funds invest in equity stocks of the companies. Since as an asset class, equity is considered as risky, these funds also carry the same risk profile. Their returns are generally higher and are linked to market performance. These kinds of funds are good for those who are willing to stay invested for long duration of time i.e. 5+ years. There are different types of Equity Funds based on Investment Objective and Speciality.
- Considered Risky but Higher Returns
- Best for Long Term Investors as it is seen that equity does outperform other asset classes over long durations of time.
- Debt Funds: These types of mutual funds invest their corpus in debt instruments like corporate bonds, government bonds, commercial papers etc. These are considered to be less risky than equity mutual funds hence might suit to those investors who are little risk averse.
- Considered less risky as compared to equity mutual funds.
- Debt Funds can further be divided into –
- Money Market Funds/Liquid Funds: What would you do if you want to invest your money for 5 days? Though it might seem preposterous for a retail investor to deploy his/her capital for only 5 days but for a large corporate, it makes perfect sense. And here is where money market funds come into the picture. These types of mutual funds invest their corpus in highly liquid financial instruments like commercial papers, T-Bills etc.
- Suited for big corporates, HNIs, business houses and active retail investors to deploy their extra money for short duration of time
- GILT Funds: These funds invest in central and state government securities. Since these securities are assumed to carry ZERO default risk, they are considered super safe.
- Best suited for investors with very low risk appetite
- Money Market Funds/Liquid Funds: What would you do if you want to invest your money for 5 days? Though it might seem preposterous for a retail investor to deploy his/her capital for only 5 days but for a large corporate, it makes perfect sense. And here is where money market funds come into the picture. These types of mutual funds invest their corpus in highly liquid financial instruments like commercial papers, T-Bills etc.
- Important Note: In debt, there are 2 kinds of risks – Credit Default Risk and Interest Risk. Credit Default Risk arises when the borrower fails to deliver on its payments. Read more about it here. Since debt instrument prices move in the opposite direction as interest rates, every debt oriented mutual fund run the risk of interest rate fluctuation. Read more about interest rate risk here on wikipedia.
- Therefore in GILT Funds, though default risk is ZERO since the borrower is the central or state government, an investor still runs the risk of interest rate.
- Hybrid funds: As the name suggests, Hybrid Funds try to balance the risk and return by investing in a mix of equity and debt. Depending on the ratio of equity to debt split, these are further classified into –
- Balanced Mutual Funds: They have a mandate to allocate minimum of 65% of their corpus to equity with remaining to be invested in debt. This is done to attain equity taxation rules which means that long term capital gains tax is ZERO i.e if an investment is held over 1 year, returns will be tax free.
- Equity Savings Funds: They also have a minimum equity allocation of 65% to maintain equity taxation rules. But their equity allocation is sub-divided into
- Naked Equity Allocation which hovers around 30-35%
- Matching Sale Position in stocks in the Future Segment. This constitute around 30-35%.
- Monthly Income Plans: These types of mutual funds invest around 15-20% of their corpus in equity and rest goes in debt. Important point to note here is that they are treated as debt as far as taxation is concerned which means long term capital gain tax is 20% after indexation.
Types of Mutual Funds Based on Investment Objective
Everyone needs a purpose and mutual funds are no different. Whenever a fund fund gets launched, it comes with a definite investment objective. Therefore one would also find classification of different types of mutual funds based on the investment objective.
- Growth Funds: Primary objective of these funds is to grow the capital which means higher returns. Therefore growth funds essentially invest in equity stocks and are another name for equity mutual funds.
- Risky as they invest in equity
- Ideal for long term investors
- Tax Saving Funds (ELSS): These types of mutual funds provide tax rebate to the investor under section 80C of the Income Tax Act, 1961. They invest their corpus in equity. At the moment, their lock in period stands at 3 years
- Risky
- Ideal for long term investors
- Example – Axis Long Term Equity Fund
- Pension Funds: These funds primary investment objective is to help investors plan for their retirement and invest with a view of very long investment periods. They invest in both equity and debt with more aggressive ones investing greater portion in equity.
- Ideal for really long durations of time
- Example – Tata Retirement Savings Fund
Types of Mutual Funds Based on Speciality
There are various segments within each asset class and mutual funds follow a mandate as to which segment they can invest in. Here are different types of mutuals funds when classified on speciality.
- Index Funds: As the name suggests, these funds invest in the same pattern as various indices do like Nifty. Naturally their value varies in proportion of the underlying index
- Example – ICICI Prudential Nifty Index Fund
- Sectoral Funds: There are various sector specific funds which invest in companies belonging to a particular sector. Since they take a call on one sector, a big part of their performance is dependent on how does the sector perform.
- Example – UTI Banking Sector Fund – they invest in companies involved in financial sector
- Market Capitalization: Companies on any exchange is classified into different categories based on their market capitalization. Common categories are
- Micro Cap
- Small Cap
- Mid Cap
- Large Cap
- Generally funds restrict their investment in 1 or 2 category and are known likewise. However there are funds which distribute their corpus across categories. Such funds are called multi cap funds.
- Example – DSP Blackrock Micro Cap fund – It invests in small cap companies
- Example of Multi Cap – ICICI Prudential Value Discovery Fund
- Exchange Traded Funds: These types of mutual funds track a commodity, basket of assets or an index as closely as possible and are traded on stock exchanges like shares. They give the flexibility to buy and sell throughout the day just like shares.
- Important Point: One needs to have a Demat Account to hold ETF units.
- Example – Reliance ETF Gold BeES
Few Important Closing Notes
- Tax Treatment of Equity and Debt
- It is important to understand different tax treatments of equity and debt mutual funds. Long Term Capital Gains Tax for Equity is ZERO i.e. if any equity mutual fund unit is held for more than 1 year, returns would be tax free. Short Term Tax on Equity is 15%
- Long Term Capital Gains Tax on Debt is 20% after factoring in indexation. In short term, income from debt mutual funds are added to your income and taxed accordingly.
- Regular vs Direct: We could also classify mutual funds basis from where we have bought it. If we buy it directly from the AMC then it is called Direct whereas if there is any broker (distributor) in between then that plan is called Regular Plan. It is advised to go for Direct plans as returns are higher (because there is no distribution cost to be paid out to broker)
- One doesn’t need any demat account to buy mutual funds units. But for ETF, demat account is required.
If you have any questions, feel free to ask in comments below.
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