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Mutual Funds – An Introduction to the Types of Mutual Funds

A mutual fund is a trust handled by the fund manager that pools the savings of thousands of investors who share the same financial goals. The money collected is then invested in capital market instruments such as stocks or bonds, or a combination of the two.

Investing in mutual funds is done through the provision of different types of investing options that are made available to the investors. These falls broadly into the following categories: SIP (Systematic Investment Plan), onetime payment, yearly, half yearly and quarterly payments. SIP was essentially introduced to average out the cost of investment by purchasing a particular amount of units at regular intervals irrespective of market movement. This reduces the volatility of the fund. Thus if price of the security falls, more units are bought and if price of the securities rises lesser units are bought.

To invest in mutual fund one should know the types of mutual fund available in the market. These are: equity funds, debt funds, balanced schemes, sector funds, gilt funds, index funds, MIPs (Monthly Income Plans), MMFs (Money Market Funds) ETFs etc. Each one of these schemes follows a different investment strategy. Most of the schemes have “growth oriented” or “dividend oriented” plans, which either re-invest or pay out the dividend collected from underlying stocks.

Equity Schemes: This type of fund predominantly invests in equity shares of companies. It provides returns by way of capital appreciation. This type of fund is exposed to high risk and hence return may fluctuate. As it invests only in stocks, it is riskier than debt funds. The returns will depend on the performance of the company that the fund invests in. However, on the flipside, this fund has a high return capability since equities have historically outperformed all other asset classes. There are several types of equity schemes based on different categorization parameters.

1. Large cap funds / blue chip funds – invest in large company stocks, typically from BSE 100 index. Generally low risk investment with moderate returns.

2. Mid cap / small cap funds – Mid cap & small cap funds are generally considered riskier because smaller companies have higher business risks. At the same time, they can give multi bagger returns because smaller companies can grow multi fold if they are successful.

3. Sector Funds: These funds are the riskiest amongst equity funds as these invest only in specific sectors or industries. The performance of sector funds depends on the fortunes of specific sectors or industries. This type of funds maximizes returns by investing in the sector, when the sector is expected to boom and gets out before it falls. You should invest in these funds only if you really understand the sector and its trends.

4. Index Funds: These funds track a key stock market index like BSE Sensex or NSE S&P CNX Nifty. It will invest only in those stocks which form the market index, as per the individual stock weightage. The idea is to replicate the performance of the bench marked index. The performance should ideally be better than or at least the same as the concerned index. The exit load of these schemes is usually lower than regular schemes.

Debt Schemes: Debt schemes invest mainly in income bearing instruments such as bonds, debentures, government securities and commercial paper. This type of fund basically invests in FD like instruments that pay interest based on various market factors. Its volatility depends on the economy reflected by factors such as the rupee depreciation, fiscal deficit and inflationary pressures. Broadly speaking, the returns from pure debt schemes will be in line with bank FDs. There are short term, medium term and long term debt funds based on the time horizon they cater to.

1. Gilt Funds: This is a sub-type of debt funds, which invests only in government securities and treasury bills. They are generally considered safer than corporate bonds and are more tuned towards long term investments.

2. Monthly Income Plans (MIPs): This is basically a debt scheme which invests a marginal amount of money (10%- 25%) in equity to boost the scheme’s return. This fund will give slightly higher return than traditional long term debt scheme.

3. Money Market Funds (MMFs): These are also known as liquid funds. These funds are debt schemes that invest in certificate of deposit (CDs), Interbank call money market, commercial papers and short term securities with a maturity horizon of less than 1 year. The funds objective is to preserve principal while yielding a moderate return. It is a low risk- low return investment which offers instant liquidity.

Balanced Schemes / Hybrid Schemes: This scheme invests in both equity shares and in income bearing instruments in such a proportion that balances the portfolio. The aim is to reduce the risk of investing in stocks by having a stake in the debt market as well. It usually gives a reasonable return with a moderate risk exposure. There can be hybrid funds that are more oriented towards equity (60-70% in equity) and there can be debt oriented hybrid funds (60-70% in debt).

Fund of Funds: Fund of fund is a secondary fund, which invests in different types of funds based on market conditions. E.g. if the stock markets are in a bearish mood, it might be prudent to invest in debt, and not equity. So this kind of a fund will sell its equity holdings and buy units of debt fund of the same fund house. “Asset allocation funds” is also a term used for these kinds of funds that take a macro call and invest in equity, debt, gold or some other security.

Exchange Traded Funds (ETFs): These are the funds that are traded on the market like regular stocks. You don’t need to pay Exit load to trade them, but you pay brokerage just like regular stocks. You can do intraday trading with ETFs, which is not possible with regular funds. There are ETFs that are based on Nifty (index), Gold and so on. Generally speaking, they are suitable for short term traders who want to take a position in the market using underlying security.

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