Choosing among the different types of mutual funds is probably the most tedious job you have at hand after you’ve made up your mind to invest in mutual funds. To embark on a journey to financial freedom, one must invest wisely in different types of mutual funds to maintain a diversified portfolio for better returns. Now, there are different types of mutual funds to invest in which can be classified on the basis of risk appetite and goals, whether short term or long term.
How does one decide which type of mutual fund to invest in?
One can choose a mutual fund scheme based on one’s investment duration, objective and risk appetite.
Based on maturity or investment duration!
Depending on its maturity period, a mutual fund scheme can be classified into open-ended scheme or close-ended scheme.
Open-ended Fund/ Scheme
As the name suggest, an open-ended fund or scheme is one that is available for subscription and sale on a continuous basis. These schemes do not have a fixed maturity period. Investors can conveniently buy and sell units at Net Asset Value (NAV) which are declared on a daily basis. The key feature of open-end schemes is liquidity.
Close-ended Fund/ Scheme
A close-ended fund or scheme has a maturity period that is clearly specified. When the scheme is launched, the fund is open for subscription only during a prescribed period. Thereafter investors can buy or sell the units of the scheme on the stock exchanges as they would do in case of any other listed security. To enable investors to exit, some close-ended funds offer an option of selling back the units to the mutual fund through periodic repurchase at NAV related prices.
Based on objective Receiving Creating a corpus or Regular Income – Growth or Dividend
One’s investment objective may also determine the type of fund which one would have to shortlist:
Growth funds usually put a huge portion in shares and growth sectors, suitable for investors who have a surplus of idle money to be distributed in riskier plans (albeit with possibly high returns) and can wait over a period of time.
This will also require the investment horizon to be longer as volatile markets may cause adverse movement in value of these funds and hence there may not be immediate or steady returns.
For investors who seek to earn a regular income, dividend funds are best suited. However, there is a difference in the dividends that are offered by stocks and by mutual funds. In the case of stocks, dividends are earnings generated by a company (usually profits) that are distributed amongst shareholders. This is besides the appreciation in share price of a stock. Whereas in the case of a dividend mutual fund, a small chunk of the units or shares of the mutual fund are sold at a price which is higher than the purchase price to earn dividends. The dividend pay-outs can be monthly, quarterly or yearly. Depending on the fund, the dividend can also be re-invested.
Based on Risk Appetite
Risk appetite is also a function of investment goals. A retired citizen who is investing for regular monthly income would have a different risk appetite from someone who is investing with horizon of a decade for buying a house.
Index funds mirror an index.
These funds will purchase stocks in the same proportion in which they comprise an index. For instance, if a particular stock forms 2% of an index which is being followed by a mutual fund, the mutual fund will invest 2% of its investible corpus in that particular stock. The performance of an index fund will more or less mimic that of the index which it follows except for a difference that would creep up, known as tracking error. Expenses incurred by an index fund are lower as compared to other types of mutual funds.
Balanced funds are also known as hybrid funds. These are primarily of two types: Equity Oriented Funds and Debt Oriented Funds.
Equity-oriented funds invest a mix of equity (at least 65 per cent of the corpus) and debt. These funds offer attractive returns over a longer period of time but returns can be highly volatile in the short term. These funds are suitable for investors who can deal with the risk and have a longer investment horizon.
Debt-oriented funds are low risk funds that primarily invest in highly rated corporate bonds and stable government bonds. They offer steady returns and are suitable for conservative investors.
Equity Linked Savings Schemes
Equity Linked Savings Schemes make it possible for investors to claim uptoRs 1.5 lakhs as tax deduction under Section 80C of the Income Tax Act while creating a corpus! However, an investor cannot withdraw money before 3 years as this scheme has a mandatory lock in period.
Largecap funds invest mostly in big companies. Funds identify these companies by their market capitalisation. These companies are well established and have immense credibility. They are most likely to be among the top names in their respective sector. Although there is no fixed nomenclature, a company whose market cap is more than Rs 10,000 crores is considered to be a large cap company in India. Conservative and risk averse investors can start investing in large cap funds. These funds carry less risk and offer modest returns.
Midcap funds invest mostly in medium-sized companies. Their rise and fall, both could occur at a scorching space. But these companies may successfully grow over a period of time and provide handsome returns to investors. Investors with the ability to take considerable risks should bet on these funds.
Smallcap funds invest in small companies. Investing in these companies over short term could be perilous unless backed by substantial research and credible experience. However, they can also offer phenomenal return over a longer duration of time. They are appropriate only for investors with a significantly high-risk appetite.
Sector funds invest only in businesses which are operating in a particular sector. For example, a Pharma themed fund will only invest in Pharmaceutical companies. As investments are directed towards a specific sector or theme, sector funds are considered extremely risky. Timing the entry into and exit from these sectoral funds is imperative as some of these sectors are cyclical. They are meant for investors with deep knowledge about a specific sector. It is advisable for investors to only take marginal positions in these funds.
As the idiosyncrasies of different individuals vary, everyone has a different set of goals to meet. Thankfully, there are ample mutual fund types available to the people that cater to their different needs.