A mutual fund is a trust managed by the fund manager that pools the savings of thousands of investors who share the same financial goals. The money raised is then invested in capital market instruments, such as stocks or bonds, or a combination of both.
Investing in mutual funds is done by providing different types of investment options that are made available to investors. These are broadly divided into the following categories: SIP (Systematic Investment Plan), single payments, annual, semi-annual and quarterly payments. SIP was essentially introduced to average the cost of investing in purchasing a particular number of units at regular intervals, regardless of market movement. This reduces the volatility of the fund. Thus, if the price of the security falls, more units are purchased and if the security price rises, fewer units are purchased.
To invest in mutual funds one must know the types of mutual funds available in the market. These are: Equity Funds, Debt Funds, Balanced Plans, Sector Funds, Gilt Funds, Index Funds, MIPs (Monthly Income Plans), MMFs (Money Market Funds), ETFs, etc. Each of these schemes follows a different investment strategy. Most schemes have “growth-oriented” or “dividend-oriented” plans, which reinvest or pay out the dividend collected from the underlying shares.
Stock Plans: This type of fund efficiently invests in company shares. It provides returns through capital appreciation. This type of fund is exposed to high risk and therefore returns may fluctuate. Because it invests only in stocks, it is riskier than debt funds. Returns will depend on the performance of the company in which the fund invests. However, on the other hand, this fund has a high return capacity as stocks have historically outperformed all other asset classes. There are various types of equity schemes based on different categorization parameters.
1. Large-Cap Funds/Blue-Tan Funds: Invest in shares of large companies, typically the BSE 100 Index. Generally low-risk investment with moderate returns.
2. Small and Mid Cap Funds: Small and mid cap funds are generally considered riskier because smaller companies have higher business risks. At the same time, they can generate multi-packer returns because smaller companies can grow multiple times if they are successful.
3. Sector Funds: These funds are the riskiest of the stock funds as they invest only in specific sectors or industries. The performance of sector funds depends on the fortunes of specific sectors or industries. This type of fund maximizes profitability by investing in the sector, when the sector is expected to grow and exits before it falls. You should invest in these funds only if you truly understand the industry and its trends.
4. Index Funds – These funds track a key stock index like the BSE Sensex or the NSE S&P CNX Nifty. You will invest only in those stocks that make up the market index, based on the weight of the individual stock. The idea is to replicate the performance of the index marked in the bank. Ideally, the performance should be better than or at least equal to the index in question. The output load of these schemes is usually less than that of regular schemes.
Debt Schemes: Debt schemes invest primarily in income generating 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 depreciation of the rupee, the fiscal deficit and inflationary pressures. Generally speaking, returns from pure debt schemes will be in line with bank FDs. There are short, medium and long-term debt funds depending on the time horizon they serve.
1. Gold Funds: This is a subtype of debt funds, investing only in government securities and treasury bills. They are generally considered safer than corporate bonds and are more geared towards long-term investments.
2. Monthly Income Plans (MIPs): This is basically a debt scheme that invests a marginal amount of money (10% – 25%) in capital to increase the yield of the scheme. This fund will give a slightly higher return than the traditional long-term debt scheme.
3. Money Market Funds (MMFs): Also known as liquid funds. These funds are debt schemes that invest in certificates of deposit (CD), interbank call money market, commercial paper, and short-term securities with a maturity horizon of less than 1 year. The objective of the funds is to preserve principal while earning a moderate return. It is a low risk, low return investment that offers instant liquidity.
Balanced Schemes/Hybrid Schemes: This scheme invests in both equity equities and income generating instruments in a proportion that balances the portfolio. The objective is to reduce the risk of investing in shares while also having a share in the debt market. It usually gives a reasonable return with moderate risk exposure. There may be hybrid funds that are more equity oriented (60-70% equity) and there may be debt oriented hybrid funds (60-70% debt).
Fund of Funds: Fund of Funds is a secondary fund, which invests in different types of funds depending on market conditions. For example, if the stock markets are trending down, it might be prudent to invest in debt rather than stocks. So this type of fund will sell its equity holdings and buy units of debt funds from the same fund house. “Asset allocation funds” is also a term used for these types of funds that accept a macro call and invest in stocks, debt, gold, or some other security.
Exchange Traded Funds (ETFs): These are funds that trade on the market like regular stocks. You don’t need to pay the exit charge to trade them, but you do pay brokerage just like regular stocks. You can trade intraday with ETFs, which is not possible with regular funds. There are ETFs that are based on Nifty (index), Gold, etc. Generally speaking, they are suitable for short-term traders who want to take a position in the market using underlying securities.