Types of Mutual Funds

Mutual Fund Types

In my last post, I discussed the basics of Mutual funds and told that I’ll be describing the different kinds of Mutual Funds. Thus, here it is:

Mutual Funds are fundamentally classified into three types, according asset class they invest in. The three kinds are:

  • Money-Market Funds: The money-market funds consist of short-term debt instruments like government bonds, treasury bills, certificates of deposit, and etc. A generally safer investment, but they offer lower returns than other mutual funds. Ideal for investors wanting to invest the surplus cash in short-term instruments with returns better than saving accounts. The objective of a money-market mutual fund is capital preservation and provide high liquidity, making it an ideal choice for parking Emergency Fund.
  • Debt/Income/Fixed-Income Funds (Bonds): The objective of this kind of fund is to provide a steady income. Investments are in fixed return instruments like government bonds, investment-grade corporate bonds and high-yield corporate bonds. The investors are provided cashflow on a regular basis. Even though bond funds are safer than equity funds, they are not without risk. All bond funds are subjected to interest rate risk. The value of bond funds vary inversely to interest rates. Also, the risk varies depending on the types of bonds. A mutual fund investing in high-yield junk bonds is riskier than the one investing in government bonds.
  • Equity Funds (Stocks): Funds that invest in stocks are called Equity Funds. They represent the largest category of mutual funds and aim for capital appreciation. The types of equity fund depends on the types of equities. One of the best way to understand the types of equity funds is by using a style box (popularized by Morningstar), like below:

Size

Investment Style

Value

Blend

Growth

Large

Mid

Small

The mutual fund is classified according to the size (Large cap, Mid cap and Small cap) of the company it has invested in and the investment style of the manager.

If the fund invests in large-cap companies having strong financials but low share price, is placed in the cell (Large, Value). If the mutual fund invests in companies with small market capitalization but have great growth prospects, then it is belong to the cell (Small, Growth).

So what are Growth, Value and Blend funds?

A Growth fund’s objective is to provide capital appreciation over medium to long term. Short-term volatility is a trade-off for possible long-term capital gains. These funds are ideal for investors who are seeking growth over long-term and have time on their side.

A Value fund aims for investing in high-quality companies having undervalued share prices. These companies are characterized by low Price-Earnings (P/E) ratio and Price-To-Book ratio (P/B) and high dividend yields.

A blend fund’s invests in a mix of value and growth stocks. It’s also known as ‘Hybrid’ fund.

The following two mutual fund types are based on the above three fundamental types:

  • Balanced Funds: The portfolio of a balanced fund consists of a combination of fixed income securities and equities. The aim is to provide a balanced mixture of capital appreciation, income and safety. The weightage given to each asset class have upper and lower limits. For example, a typical balanced fund portfolio comprises of 60% investment in equities and 40% in bonds.
  • AssetAllocation Fund: Similar to balanced fund, this one has no upper or lower limits on investment in any asset class. Thus, the mutual fund manager is free to change the ratio as he deems fit.

Based on the lock-in period, a mutual fund is classified as:

  • Open-Ended Fund: One invested in an open-ended fund can buy/sell units at any time at the current NAV related prices. An open-ended fund is not listed on stock-exchange. Majority of Mutual Funds are open-ended.
  • Close-Ended Fund: A close-ended fund has a limited number of shares outstanding and allows an investor to buy/sell units only during a specified period. It has a stipulated maturity period. A close-ended mutual fund is listed on the stock-exchange, so it is traded just like other stocks. Having a specified period for buying/selling units facilitates having a balance of buyers and sellers. One of the characteristics of a close-ended mutual fund is that it trades at a discount to NAV, but the discount narrows as it approaches maturity.

Based on national/international investments, the types of mutual funds are:

  • International Fund: Also known as Foreign Fund, an International Mutual Fund invests only outside unit holder’s home country.
  • Global Fund: Investments are made anywhere in the world, including the investor’s home country.

There are few other funds which don’t fall in the categories mentioned above. They focus on certain segments of the economy and specialized sections. Thus, they are called Specialty Funds. Some of them are as follows:

  • Sector Funds: Extremely volatile, these funds are sector-specific, i.e. focus on individual sectors such as health, technology and etc.
  • Regional Funds: These funds focus on a specific geographical region such as a country (say India). These funds provide an advantage in terms of ease of buying stocks of another country.
  • Socially-responsible Funds (Ethical Funds): A socially-responsible fund invests in companies that support human rights and diversity, support ecological preservation and etc. Basically, the companies, in which the fund invests, work towards the betterment of society. Thus, these funds avoid the tobacco and alcohol industries, weapon manufacturers and etc.

Some other types of funds are:

  • Tax-Saving Mutual Funds: These funds offer tax benefits to investors, for example ELSS.
  • Funds-of-funds: These funds invest in other funds and make diversification and asset allocation easier for investors. However, the disadvantage with these funds is that, they have a higher MER ratio than standalone mutual funds.
  • Index Funds: These funds replicate the performance of a market index such as the NIFTY or S&P 500. They offer a great advantage in terms of very low fees (about 0.09% only) are thus are a worthy mention when it comes to funds.

So many funds, which one to choose? One should always do a thorough research about the options he has in hand, after evaluating his goals, needs and risk appetite. That way, he can choose mutual funds wisely, keeping the stated objectives of the fund aligned with his goals. I’ll be writing about how to choose a mutual fund in my next post. Stay tuned…and spread Financial Literacy.

Financial peace isn’t the acquisition of stuff. It’s learning to live on less than you make, so you can give money back and have money to invest. You can’t win until you do this.-Dave Ramsey

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