Published on: 30 Dec, 2022 15:45
- An investment instrument that pools money from many investors and uses that money to invest in a diversified portfolio of stocks, bonds, or other securities.
- It is managed by a professional investment company.
- It offers diversification, professional management, and liquidity.
A mutual fund is a type of investment instrument that pools together money from many investors and uses that money to invest in a diversified portfolio of stocks, bonds, or other securities. The value of a mutual fund is determined by the value of the underlying securities it holds, and it is managed by a professional investment company.
Mutual funds offer investors a number of benefits compared to investing as individual investors.
- First, mutual funds provide diversification, which means that they allow investors to hold a variety of different securities within a single fund, rather than having to invest in each security individually. This can help to spread risk and potentially reduce volatility.
- Second, mutual funds offer professional management, which means that the fund is managed by a team of investment professionals who research and select the underlying securities for the fund.
- Finally, mutual funds are relatively easy to buy and sell, making them a convenient and flexible investment option. Mutual funds are highly liquid, meaning that investors can buy or sell shares in the fund on a daily basis.
Types of Mutual Funds
Mutual funds can be classified in different ways:
- Organization Structure – Open-ended, Close ended, Interval
- Management of Portfolio – Actively or Passively
- Investment Objective – Growth, Income, Liquidity
- Underlying Portfolio – Equity, Debt, Hybrid, Money market instruments, Multi-Asset
- Thematic/solution oriented – Tax saving, Retirement benefit, Child welfare, Arbitrage
- Exchange Traded Funds
- Overseas funds
- Fund of funds
Scheme Classification by Organization Structure
- Open-ended schemes: This type of mutual fund is a perpetual scheme which means it is open for purchase and repurchase on all business days at the current NAV.
- Close-ended schemes: This type of mutual fund has a fixed maturity. The units are issued at the time of the initial offer and redeemed only on maturity. The units of close-ended schemes are mandatorily listed to provide exit route before maturity and can be sold/traded on the stock exchanges.
- Interval schemes: Mutual funds of this type allow purchase and redemption during specified transaction periods (intervals). The transaction period has to be for a minimum of 2 days and there should be at least a 15-day gap between the two transaction periods. The units of interval schemes are also mandatorily listed on the stock exchanges.
Scheme Classification by Portfolio Management
- Active Funds: In this type of mutual fund, the Fund Manager is ‘Active’ in deciding whether to Buy, Hold, or Sell the underlying securities and in-stock selection. Active funds adopt different strategies and styles to create and manage portfolios.
- The investment strategy and style are described upfront in the Scheme Information document. Active funds expect to generate better returns (alpha) than the benchmark index.
- The risk and return in the fund will depend upon the strategy adopted.
- Active funds implement strategies to ‘select’ the stocks for the portfolio.
- Passive Funds: Passive Funds hold a portfolio that replicates a stated Index or Benchmark e.g. –
- Index Funds
- Exchange Traded Funds (ETFs)
- In a Passive Fund, the fund manager has a passive role, as the stock selection / Buy, Hold, Sell decision is driven by the Benchmark Index and the fund manager/dealer merely needs to replicate the same with minimal tracking error.
- Active v/s Passive Funds
- Active Fund –
- Rely on professional fund managers who manage investments.
- Aim to outperform Benchmark Index
- Suited for investors who wish to take advantage of fund managers' alpha generation potential.
- Passive Funds –
- Passive funds investment holdings mirror and closely track a benchmark index, e.g., Index Funds or Exchange Traded Funds (ETFs)
- it is suited for investors who want to allocate exactly as per the market index.
- Passive funds have a lower expense ratio hence lower costs to investors and better return
Classification by Investment Objectives
Asset Management Company (AMC) offers funds that cater to the different investment objectives of the investors such as –
- Capital Appreciation (Growth)
- Capital Preservation
- Regular Income
Mutual funds also offer investment plans, such as Growth and Dividend options, to help tailor the investment to the investors’ needs.
- Growth funds:
- Growth funds are schemes that are designed to provide capital appreciation.
- Growth funds primarily invest in growth-oriented assets, such as equity.
- Investment in growth-oriented funds requires a medium to long-term investment horizon, due to high volatility in short term.
- Historically, Equity as an asset class has outperformed most other kinds of investments held over the long term. However, returns from Growth funds tend to be volatile over the short term since the prices of the underlying equity shares may change.
- Hence investors must be able to take volatility in the returns in the short term.
- Income funds:
- The objective of Income Funds is to provide regular and steady income to investors.
- Income funds invest in fixed-income securities such as Corporate Bonds, Debentures, and Government securities.
- The fund’s return is from the interest income earned on these investments as well as capital gains from any change in the value of the securities.
- The fund distributes the income from the returns generated from the investment portfolio, however; there is no guarantee of income.
- The tenor and credit quality of the securities held in the investment portfolio affects the return of the fund.
- Liquid / Overnight /Money Market Mutual Funds:
- Liquid Schemes, Overnight Funds, and Money market mutual funds are investment options for investors seeking liquidity and principal protection.
- The funds invest in money market instruments with maturities not exceeding 91 days.
- The return from the funds will depend upon the short-term interest rate prevalent in the market.
- These are ideal for investors who wish to park their surplus funds for short periods.
- Investors who use these funds for longer holding periods may be sacrificing better returns possible from products suitable for a longer holding period.
Classification by Investment Portfolio
Mutual fund products can be classified based on their underlying portfolio composition
- The first way of categorization of mutual funds can be the asset class the fund invests in, such as equity/debt/money market instruments or gold.
- The second way of categorization can be strategies and styles used to create the portfolio, such as Income fund, Dynamic Bond Fund, Infrastructure fund, Large-cap/Mid-cap/Small-cap Equity fund, Value fund, etc.
- The portfolio composition flows out of the investment objectives of the scheme.