Different types of Mutual Funds

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Lets take a look at different types of Mutual funds.There are large number of varied mutual funds available in market created by different companies. There are funds which holds very high risk (offering higher returns if everything works in favour) to funds which holds low risk of loss. Every mutual fund has a financial objective according to which the fund manager selects various stocks to buy, defined strategies etc. Asset class under various mutual funds depends on that funds financial objective.

Now as we know there are 3 types of mutual funds basically viz

• Equity Funds,

• Debt Funds, and

• Balanced Funds.

Basic types of mutual funds are

Equity Funds

Now we are going to look in detail at various types Equity Funds available in market. Be aware that Equity funds are the riskiest of all 3 basic mutual fund categories because they invest directly in stocks. The assets under an equity fund comprises of equity from all sections Small cap, Mid Cap, Large Cap and Giant companies.

Equity mutual funds (Stock based schemes) invest a major portion of their total fund in equities. Which stocks, which industry, which business etc is decided by the fund manager. Usually you can get this data from the mutual fund investment policy or by asking the official of mutual fund providing company. Equity funds offer higher returns in long term but they fall under high risk category. If the market goes down your mutual fund will also loose in value and make loss.

Types of Equity Funds:

Growth Funds:

These funds invest in stocks of fast growing companies and in stocks that has a growth potential in long term. Most of the assets under this fund might be Large cap companies and the rest of the assets might be Mid cap funds. The objective of this fund is to produce long term capital gains for the investor rather than periodical income from dividends and capital gain distribution. Growth funds are expected to produce a sizable return in a span of 4 to 5 years. Since they offer higher returns investing in a Growth fund is risky.

Aggressive Growth Fund

This fund is considered the most risky mutual fund among all types of funds. Main objective of this fund is to give the investor maximum returns and gains by investing in Mid cap and other under researched stocks which are expected to perform outstandingly in future, say 3 or 5 years time. Most of the stocks selected under this fund are based on mere “expectation” rather than based on solid researched data. Hence this fund is highly volatile and carries a high risk. Well if things work out in favour of the fund, you can expect a very high return.

Income Equity Fund (Dividend Yield Equity Funds):

As the name suggests main objective of the fund is to provide investors a steady income (periodical, may be every month or quarter) from the assets under the fund. Assets under this fund are usually of large corporations which provide higher dividends consistently. Investments under this fund carries a less risk compared to the above 2 fu

nds. This is because not much speculative stock pickings are done under this fund which aims high capital gain. Most stocks under this fund belong to established corporations which provide high dividends consistently. In addition to steady income through dividends and capital gains distribution, this fund also grows in value in long term.

Value Fund:

These funds invests in assets that are under valued. Fund manager usually selects stocks that have low Price to Earnings ratio, low Market to Book Value ratio etc. In simple terms a value fund aims to invest in stocks that are not currently recogonised by market forces. Such stocks are traded at a low price in market than their real value. In long term these stocks are expected to rise up to their real value and produce very good capital gains.

Diversified Equity Funds:

This fund is a kind of risk mitigated fund because of diversification. This type of funds well manage the risk associated with equity investments. They do so by diversifying the asset portfolio under the fund. Such funds invest in almost all business sectors like banking, ifrastructure,hospitality,IT etc etc. They also invest in all types of companies ranging from Small to Large cap. They dont produce very high returns like a Growth fund but still they produce very attractive returns if everything works in funds favour. Risk still exists because major portion of the fund is invested in equities. Tax saving equity funds are diversified type and they are explained below.

Tax Savings Equity Fund (ELSS)

Sector Funds

Assets under this fund belong to a particular sector of the business industry, say Banking stocks alone or IT stocks alone or Infrastructure stocks alone etc. Such funds will invest only in that particular sector based on their objective. These funds carries high risk profile.

Mid Cap/Small Cap Funds

As the name suggests, assets under this fund belong to either Mid cap or Small cap or both as described by the funds investment objective.

International Equity Funds

These funds invest in stocks of international companies alone. Risk profile is high as this is a concentrated fund.

While investing in mutual funds, diversification among market capitalizations and different sectors is important, at the same time diversification across different countries also is important. India is a developing economy but still it is deeply connected with the outer world. Whatever happens globally will definitely impact the economy and markets locally. We all know how the dollar has moved in the last few years. Currency movements have its own impact on the local markets. It is a very well-known fact now that when developed economies tumbled, ours, along with other developing countries fell much harder. Keeping all these in mind it is advisable to diversify your investments internationally to have exposure to different world economies and from a currency diversification point of view too. These days there are many funds with focus on The USA, emerging economies, China, Europe etc. Invest 5-10% of your total investment into such kind of funds too

Option Income Funds

One objective of the fund is to provide periodical income to the investor by investing in stocks of companies that provide very dividends. In addition they try to maximize the income by taking advantage of Call Options on the stocks they hold.

Precious Metal Funds

These funds invests in precious metals like Gold and mining companies involved in mining precious metals

Debt Funds

Debt mutual funds invest in debt instruments (debt papers issued) like government bonds, fixed deposits, approved private deposits , corporate debentures, private companies, treasury bills, Commercial papers etc. There are rating agencies that grade the debt instruments. Based on the fund philosophy, the fund manager will choose the instruments with different risks. Asset class varies for different types of Debt funds. These mutual funds carries very less risk compared to Equity funds. Most of the debt funds aim to generate a fixed income to the investor so they usually distribute their surplus. Assets under a debt fund are those types which pays reasonable interest on the invested capital. They focus on steady revenue as interest rather than capital gains resulting from growth of assets.

Benefits of investment in debt funds

• Current income

The debt mutual fund is primarily focused on getting a regular return. The investments of the fund are in deposits/bonds with different maturing tenures and different interest rates. We need to take care to match our time frame for investment to the time frame of these. The current income from these funds will be in the range of 8 to 10 per cent. Generally, the current income is received format the debt mutual funds in the form of dividend. Hence, this cash flow is tax free in our (investors') hands.

• Capital appreciation

Through investing in debt instruments only, there is a possibility for capital appreciation in debt funds. This is a major advantage that we get from investing in mutual funds rather than directly in a bank deposit. This capital appreciation is possible because debt instruments that mutual funds invest in are market tradable. Thus, when the market interest rates come down as in the current scenario, the debt mutual funds get much higher bond yield. The average return from the top 15 debt mutual funds in the year 2009 has been 25.96 per cent.

• Risk

When the interest rates go up in the general market, the bond yield comes down, leading to capital erosion when debt instruments are traded. This can lead to very low or even negative returns from debt instruments.vSo no financial tool can be said to be risk free. However in the short term, debt instruments are a good place to preserve capital.

• Liquidity

Debt funds have high liquidity. They can be converted to cash between 2 to 4 days. The high liquidity and conservation of capital are key benefits for temporary parking of funds. Many companies make use of these features for the cash management of their corporate funds.

• Tax treatment

Debt mutual funds like the debt instruments are taxed higher then the equity mutual funds. The short term capital gains are taxed at 20% and the long term capital gains tax is 10%. The tenure for long term capital gains is an investment period of over 1 year (365 days). (Similar to equity mutual funds)

• Convenience

Like any mutual fund, the debt mutual fund also gives the 4 conveniences:

• • Convenience of knowledge

  • Convenience of time

  • Convenience of small investments and

  • Convenience of payment frequency

Summary

• Debt mutual funds score better than the debt instruments directly because of the tax benefits that we get from their dividends compared to interest from the debt instruments.

• Preservation of capital is a major advantage that we get from the debt mutual funds. The potential for capital appreciation and higher returns that the traditional debt instrument can be maximized from these funds.

• By nature of their investments and the tax treatment, these are for investment for the short term only.

Different types of Debt funds arise based on difference in investment objective.

Types of Debt Funds are:

Capital Protection Plans

These are a type of debt funds which guarantee investors capital. They invest a small portion of the fund in equities with a hope of generating more wealth. Main attraction of such scheme is that you need not fear loss of capital due to market downsides. You can invest in equities with out much risk and still take advantage of it.

Fixed Term Plans:

Fixed term plans are generally closed-end funds for short term period, say 1 year or low. Unlike normal closed-end funds these fixed term plans are usually not listed on stock exchange. They aim to generate short term returns by investing in debt instruments for short periods.

Gilt Funds

Gilt funds invests in Govt. debt papers, papers issued by State governments, Govt. securities, papers issued by RBI etc. These funds are considered very safe of all types of mutual funds but still it holds risk. When interest rates goes up, debt funds will loose in value, means their NAV can go down. Alternatively their NAV goes up when interest rates falls down. Gilt funds are of Short term (3 to 6 months) and long term.

Monthly Income Plans (MIP)

These are debt funds which aims to generate a monthly income for its investors. Risk profile is usually low to moderate. If you have a large sum of money to invest in (within the set risk profile), you can generate a reasonably good monthly return from this debt fund, if everything works in favour. These debt funds usually do not guarantee a fixed monthly income. They say they will pay dividends and distribute it if they are profitable at that particular point of time.

Liquid Funds (Money Market Funds)

These are the most liquid mutual funds available in market. Such funds are relatively short duration funds for 3 to 6 months. Usually they return investments at a rate of 5% (it may vary) and investments are made in safe debt instruments like Certifcate of Deposit, Certificate of Paper, Treasury bills etc. These types of investments are better than Savings Bank account which offer only 3.5% rate of return.

Funds which do not invest any part of assets in securities with a residual maturity of more than 91 days are liquid funds. Currently, the average portfolio maturity of this category ranges between four and 91 days. These funds invest in short-term debt instruments with maturities of less than one year. Investments are mostly in money market instruments, short-term corporate deposits and treasury. The maturity of instruments held is between 3 and 6 months.

Why invest in liquid funds?

These funds provide good liquidity, low interest rate risk and the prevailing yield in the market. Liquid funds have the restriction that they can only have 10 per cent or less mark-to-market component, indicating a lower interest rate risk. While liquidity is one factor of these funds, safe investments make them the preferred parking option for HNIs and corporates. Moreover, the maturity makes them relatively less sensitive to interest rate fluctuations, compared to other debt funds. For all these reasons, liquid funds are used as an alternative to short-term fix deposits. Most schemes have a lock-in period of a maximum of three days to protect against procedural (primarily banking) glitches, and offer redemption proceeds within 24 hours. The minimum investment size in a liquid fund varies from Rs 25,000 to Rs 1 lakh.

The tax advantage

Short-term capital gains tax applies on liquid funds that are held for less than a year at the income tax slab that one falls in. However, there is tax efficient strategy that you can adopt. Dividends from liquid funds are tax-free in the hands of investor, which makes them more attractive than bank fixed deposits. Consider opting for dividend reinvestment when investing in a liquid fund because dividends stripped will be reinvested as units and will be considered as fresh investments. This way the capital gain will be very low. In case you do plan to hold the investment in liquid fund for over a year; opt for the growth option to benefit from the indexation benefits.

Floating Rate Funds

These are funds which invests in debt instruments that offer floating rate interest. They also invests in Govt.debts and securities. Returns are usually in the range of 5 to 6% for short term floating rate funds and 6 to 8% for long term floating rate funds.

Diversified Debt Funds

These are type of debt funds which invests in all possible types of debt instruments and hence spread the risk to a broad level. These types of debt funds reduce risk to a low level by diverifying assets under management. Though low, these funds still holds risk.These are mutual funds which invests in debt papers issued by Government authorities, corporate debentures, private companies, treasury bills etc. It varies for various types of Debt funds. These mutual funds carries very less risk compared to Equity funds.

Income Funds

Balanced funds are mutual funds that invest in both equities and debt instruments.They normally keep their equity component in the range of 60%-75% and the rest in debt products or cash.Some balanced mutual funds are considered to be more aggressive in that they have a larger equity component.For example, HDFC Prudence keeps its equity allocation around 75% in most of the cases and rest 25% in debt or cash. However,others like Reliance Regular Savings Balanced are considered less aggressive and have a lower equity component around 60-65% .

From the taxman’s point of view, any mutual fund which has equity component more than 65% is considered as an “Equity Fund” and so long term capital gains from sale of balanced mutual fund units too are exempted from tax after one year just like in the case of pure equity mutual funds .

As balanced funds have to maintain their ratios between equity and debt by a fixed percentage, they have to periodically adjust their asset allocation.So, if a balanced fund has a ratio of 70:30 (Equity: Debt) and suppose it reaches 77:23, the fund manager will make sure that he sells the excess equity portion to rebalance the fund back to 70:30.This asset allocation by balanced funds leads to superior returns over the longer term. But in the short term, balanced funds will not out perform pure equity based funds especially in bull runs. So you always have to give balanced funds a long time to see the performance.

As balanced funds are not exposed to equity in the same way as regular equity diversified funds whose equity exposure is generally 95% or more in an average scenario,their fall in case of market crash is lower than pure diversified funds.This is why these funds do better in downturns than diversified equity funds. For example in CY 2008, balanced funds lost 37.88% against a fall of 53.08% in large-cap equity funds and 59.01% in case of mid- and small-cap equity funds.And a similar performance was recorded in CY 2011, when balanced funds lost 13.47%, whereas large-cap diversified equity funds lost 24.33% and mid- and small-cap funds lost 24.99%.Thus balanced funds are a great choice for people who find the fall in the value of their portfolio tough to handle.

Moreover as equities are attractively valued with limited downside, and interest rates are at their peak, and likely to fall,leading to capital gains on bonds,now is a good time to buy balanced mutual funds.

And BTW a SIP in a balanced fund or a long term lump sum investment in a balanced fund might even be a good idea. Over the 14 yr period from Jan 1997 to Mar 2011 a SIP investment of Rs. 1,000 per month in HDFC Prudence would have become Rs 13.6 lacs i.e. a return of 25.93% CAGR.The same 1,000 per month invested in HDFC top 200, would have become 13.9 lacs i.e.a return of 26.20% CAGR, marginally more … Which shows that despite having much lower equity exposure, HDFC Prudence has given almost equal returns like HDFC Top 200, can be called out-performance.

Arbitrage Funds

These funds are best bet in volatile stock markets. Well in my view volatility is a basic behavior of stock market, so for those who actually are interested in decent risk adjusted returns with less volatility should consider arbitrage funds. Arbitrage strategy takes advantage of price inefficiencies arising out in cash and derivative segments. Derivatives are those instruments which are used to hedge risk in stock price movements. It may sound complicated but expert market players play in these products with ease. When markets are volatile smart fund managers spot the price differences in different market segment and make money out of it. Investors have to understand that where arbitrage strategy limits the losses, it limits the gains too. When things are certain every fund can make you the money, but this fund will generate you the money in uncertain times

The other advantage of arbitrage fund is that it comes under equity taxation. This means, the long term capital gain and dividend distribution does not attract any taxation. Thus you can expect the safety of debt and taxation of equity from arbitrage funds.

Debt funds are attractive because of their stable returns and easy liquidity. But the problem arises when you sell them within 1 year, wherein you are taxed 30%. Moreover, we have seen that even Debt funds including the so called "safe" liquid funds could give negative returns (June 2013)

This is where Arbitrage Funds come into picture.

• WHAT IS ARBITRAGE FUND?

Arbitrage is the price difference between the Cash Market and Derivatives Market due to Market inefficiencies.

Let us take an example :

1. ACC is quoting at Rs.980 in NSE and Rs.990 in BSE

2. ACC is quoting at Rs.980 in NSE Cash and Rs.995 in F&O (next month)

Here, the Fund buys ACC @ 980 in NSE cash and sell in BSE @ 990 and the resultant difference is the profit.

In Scenario 2, the Fund sells ACC at 995 in F&O and buys at Rs.980 in NSE cash. So, on Expiry day (settlement date), the fund has made risk free profit, because the Cash price and F&O tends to coincide.

This Arbitrage (price difference) could be due to multiple factors like Dividend payout, rights issue, Buy back,etc.

Arbitrage Fund is the fund which is designed to capatilise on this mispricing and generate returns.

ADVANTAGES

1. Tax treatment like Equity funds without the risk associated with Equity.

2. Safer than Equity Funds

3. Income funds too are volatile and carry “interest risk” too which Arbitrage funds carry no such risk

4. Very little chance of “negative” returns as evidenced by the returns seen in 2008, where all kinds of Equity funds gave Negative returns, but bucking the trend, Arbitrage funds gave positive returns.

5. Arbitrage Funds tones down an investors risk.

6. Dividend recd from Arbitrage Funds are TAX FREE.

7. Acts as an “hedge” against volatility.

DISADVANTAGES

1. In a falling interest scenario, Debt funds can easily outperform Arbitrage funds by a wide margin.

2. Only in a volatile market with its attendant fluctuations, arbitrage opportunities are created and hence in a flattish and stable markets, the Arbitrage funds tend to underperform.

3. Fund Manager has to be extra vigiliant to spot and grab opportunities whenever they arise. Failing which, the returns are affected.

4. Since Arbitrage Funds tend to have large number of transactions, the result is the rise in cost of managing funds due to Brokerage and Security Transaction Tax (STT).

5. Arbitrage Funds tend to have a higher Exit Load compared to Debt Funds.

6. Even Expense Ratio is almost always higher in an arbitrage fund compared to Debt fund.

7. Arbitrage Funds are not allowed to “SHORT” in Cash Markets, hence in a Bearish market, their performance can suffer.

Hegde Funds

More details -From Morning star