We have frequently emphasised the usefulness of Mutual Funds as an investment option for young investors in these pages. In fact, apart from Senior Citizens, who are naturally extremely risk-averse, mutual funds should be a part of every investor’s portfolio.
Fundamentally we need to understand what are Mutual Funds. Simply put, it is a pooling of assets of investors, managed by a Trust (Asset Management Company) which invests the money into different asset classes including equity, debt and gold.
While there are many bases of classification, the most rational way to do this is on the basis of the type of assets invested in.
Therefore, the broadest classification of Mutual Funds is as follows:
Equity-linked Mutual Funds
These are Mutual Funds which invest in shares of companies, or equities, listed on stock exchanges. It is not necessary that all the funds are invested in shares, since the AMC will typically reserve the right to invest a portion of the funds into debt and hold a portion in cash in order to hedge against market fluctuations.
These are further divided into:
- Large-cap funds : These funds put most of their money into mature businesses already having a large market capitalisation – think of the Reliance, Tata group companies, Infosys and similar. These are seen as less risky and less prone to fluctuation (though nothing is certain in the world of equity shares).
- Mid-and-small cap funds : These are riskier than Large-cap funds, investing the money into smaller companies that are not so large or mature, but are likely to be in a growth stage. If the strategy pays off, such funds can rise dramatically in rising markets, giving much better returns. At the same time, in a downturn, these are likely to do worse.
- Sector / Thematic funds : These are more interesting. Sector funds invest in shares of companies engaged in similar businesses. E.g a Power-Sector Fund would invest in companies involved in activities from power-generation to last-mile distribution. A Banking sector funds invests in the shares of different Banks. Thematic funds look at broader divisions, binding together multiple sectors into a ‘theme’ such as ‘consumer spending’, ‘infrastructure’ and so on.
- Index Funds : These are funds that attempt to mimic a popular index like the BSE Sensex or the NSE Nifty. The AMC manages these funds on a passive basis, only adjusting to the extent the composition of the index being tracked changes. Theoretically index funds give returns exactly the same as the benchmark being tracked. If you are confident of overall trend in the market or a particular sector you can opt for an Index fund or sectoral index fund.
Non equity-linked Funds
The second type of funds is commonly called the Debt funds, though not all such funds strictly invest in Debt securities. There are many divisions within Debt funds, such as:
- Bond Funds : These invest in corporate bonds. They can be long term or short term in nature. Typically the longer the term the riskier the investment in case of Bonds. These are typically recommended investments in scenarios where the interest rates in the market are on a falling trend.
- G-sec funds: These funds invest in government securities. Like Bond funds these are also long or short-term in nature. While considered to be safe in the long term, since they are issued by RBI and backed by the Government of India, their returns can fluctuate considerably in the short term.
- Liquid and Cash-management Funds : These funds are for the very short term, investing in government securities and corporate bonds with rapidly-approaching maturity dates. They are meant to be a better way of keeping your funds than lying in your savings back account. These are considered the least risky option.
- Gold funds : Though not debt funds, strictly-speaking, these are classified as non-equity. They either mimic the price of gold itself (like an index funds) or invest in the shares of gold-mining companies. These are to be seen as an alternative to buying physical gold as an investment.
Apart from these, there do exist another category known as ‘Hybrid Funds’, but these are essentially a combination of Debt and Equity in a pre-defined ratio. Similarly you may hear of ‘Income’ Funds, which are nothing but Debt funds that pay out a regular dividend or ‘Tax Saver’ Funds, which are just mutual funds that are eligible for tax-benefit under section 80C of the Income Tax Act.
We have tried to cover here the categories of Mutual Funds that give you an idea of what you are buying when your agent tries to sell a fund to you. Always remember, though – ultimately, in a Mutual Fund, the risk is all your own.