Mutual Funds and Their Types. A Mutual fund is a pool of money representing the saving made by a number of investors. The funds so collected are managed by professionals by investing in equity as well as debt instruments like stocks, debentures, bonds, money markets, and other financial instruments. The job of the fund manager of a mutual fund also known as the portfolio manager includes making investments out of the funds entrusted by various investors to the mutual fund, booking capital gains/losses, periodically collecting interest/ dividend income, and payment of interest/ dividend to investors, etc.
Types/ Classification of Mutual Funds
On the basis of their investment pattern and other characteristics, mutual funds can be classified into two broad categories, which are further sub-categorized as depicted below :
General Classification of Mutual Funds :
Mutual funds under this category are classified into various sub-categories as indicated above. The individual sub-category has been discussed below in detail.
1) Open-Ended Schemes of Mutual Fund:
Under the open-ended schemes, mutual funds make their units available on an- going basis (on-tap) at the Net Asset Value (NAV) based rates. They are not listed on any of the stock exchanges. Such schemes do not have any ‘lock-in period'(which means your money will remain locked in with the mutual fund company for a period of certain years), and they offer repurchase facilities immediately after the allotment. ‘US-64 scheme’ of Unit Trust of India is a typical example of an open-ended scheme.
Other salient features of open-ended schemes launched by MFs are as under:
- During the lifespan of an open-ended scheme of a fund, the investors are free to enter or come out of such scheme at any point in time.
- The Corpus of an open-ended scheme is not fixed; its level keeps on increasing or decreasing with the entry/exit of investors.
- Such schemes do not have a fixed redemption/maturity period. The redemption price of units, in the form of NAV, is always on offer by the fund, at which an investor can get his/her units redeemed and exit the fund.
- An investor desirous of re-entering the scheme can do so by purchasing units at the prevailing NAV rates; such funds notify sale and purchase prices at periodical intervals.
2 ) Close Ended Schemes of MF:
Close-ended schemes do not provide redemption of their unit on an ongoing basis. They are characterized by the following features:
- The corpus of a close-ended scheme is fixed, and its maturity period is between two and five years;
- Investors have the option to invest in such schemes only during the time of their launch when they remain open for subscription for a limited period (generally 45 days);
- Once the limited offer period is over, investors cannot buy the units under a close-ended scheme directly from the fund. However, as the units are listed in the stock exchanges, they can be traded (bought and sold) in the secondary market;
- Some of the close-ended schemes give an opportunity to the unit holders for selling their units directly to the fund from time to time at the prices linked to their NAV;
- Investors directly receive dividends, bonuses, etc. periodically from the fund.
3 ) Interval Schemes:
They are hybrid schemes having some characteristics of open-ended schemes, and some characteristics of close-ended schemes. They give an option to their existing unit-holders for the redemption of their units at NAV-based prices at predetermined periodicity.
4 ) Load Funds:
There are certain common overheads incurred by almost all the mutual funds, e.g. marketing, distribution, advertising, portfolio churning, fund manager’s salary, etc. Such expenses are recovered by many mutual funds from their investors in the form of various loads, e.g. entry load, exit load, etc. Such funds are termed ‘Load Funds’. Various kinds Of loads are levied on the investors, which are as follows:
i) Entry Load or Front-end Load:
Charges under this load are imposed on an investor right at the time, when he/she joins the scheme. The amount of entry load is subtracted from the amount of contribution to the fund by the investor.
ii) Exit Load or Back-end Load:
Charges under this load are levied on an investor at the time of his/her exit from the scheme by way of redemption of units held by him/her. The amount of exit load is recovered from the redemption proceeds payable to such unit holders.
iii) Deferred Load:
Deferred load represents the charges recovered during the period spread over a wide range of time.
5) No-Load Funds:
Mutual funds, which do not charge any of the above loads, are aptly termed ‘No-load Funds’.
6) Tax-Exempt Funds:
Mutual Funds investing their corpus in such financial instruments, which are exempted from the payment of tax, are termed as. Tax-exempt Funds. All the equity-oriented funds, which are open-ended, are exempted from the payment of distribution tax (distribution tax is a tax levied on income distributed to investors). Other examples of the tax-exempt category are long-term capital gains and dividend income (in the hands of investors).
7 ) Non-Tax-Exempt Funds:
Mutual Funds investing their corpus in such financial securities, which attract payment of tax, are termed as ‘Non-Tax-exempt Funds’. In our country, all mutual funds, other than the ‘open-ended equity-oriented funds are required to pay distribution tax.
Any profit made by an investor on account of the sale of units, within twelve months of their purchase, falls under the category of short-term capital gains and is taxable. Similarly, in the case of an ‘equity-oriented fund’, the sale of its units attracts Securities Transaction Tax (STT). The amount of STT is recovered from the redemption proceeds payable to an investor.
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Broad Classification of Mutual Funds
Various sub-categories of the broad classification of mutual funds are as follows.
1 ) Equity Funds:
Equity funds are those funds that invest their corpus exclusively in the equity market.
2) Debt/Income Funds:
Debt funds or income funds are the funds with the policy of investing their corpus in the debt papers having medium or long-term tenure, issued by the companies belonging to diverse sectors like banking, financial institutions, infrastructure, Government companies, etc. The risk exposure of such funds is at a low level, and their endeavor is to ensure a stable stream of current income, rather than capital appreciation, for their investors.
In a view of achieving the above target, a major chunk of the available surplus is distributed amongst the investors. Even though the debt securities, which form the main constituent of debt funds portfolio, are in general much less risky as compared to the equities, they are exposed to the specific risk of default in the payment of interest and/or principal (credit default) by the issuer.
As part of risk-mitigating/risk-management exercise, debt funds make their investments in the securities/issuers with better ‘investment ratings’ by credit rating agencies, like CRISIL, CARE Ratings, ONICRA Credit Rating Agency, Fitch Ratings, ICRA, Moody’s Investors Service, etc. Debt funds looking for higher returns should be ready to be exposed to higher risks.
Debt funds may be classified into the following categories on the basis of their investment objectives:
i) Diversified Debt Funds:
Debt funds, which invest in the debt instruments issued by various sectors of the economy, are termed diversified debt funds.
ii ) Focused Debt Funds:
Focused debt funds belong to a category altogether different from diversified debt funds. Such funds investment strategy focuses and invests and investing in carefully chosen debt instruments issued by companies belonging to the particular sector of the economy. They are very selective in their investment decisions.
iii ) High Yield Debt Funds:
The investment objective of high yield debt funds is to maximize their earnings, for which they are prepared to take the highest level of risks. Their choice of the investment may include even the debt instruments rated by rating agencies as “below investment grade”.
They are willing to go to any extent in order to achieve their objective of higher returns. As a result, they tend to be more volatile in nature and are exposed to higher default risks.
3) Liquid Funds/Money Market Funds:
Liquid funds, also termed money market funds have the policy to invest exclusively in money market debt instruments, which are characterized by their high liquidity and short-term maturity period (within 12 months). The only risk they are exposed to is interest rate risk; other risks are minimal, i.e. they belong to the lowest risk-bearing category of instruments, and are considered safest amongst other categories of mutual funds. Money market instruments of choice for a typical liquid fund are Government of India Treasury Bills of different maturities, Commercial papers issued by companies, Certificates of Deposit issued by banks, etc.
4) Hybrid Funds:
Hybrid funds invest in different financial instruments like equities, debts, and various money market securities. Their portfolio is, thus, an assortment of diversified financial papers. The ratio of debt and equity in a hybrid fund’s portfolio is generally 50:50, which may be fixed or variable.
5) Sector Funds:
Sector Funds are those funds, which restrict their investments in a particular sector or interlinked sectors (e.g. energy, power, technology, infrastructure, etc.) of the economy. Such funds are variable in a significant manner as far as market capitalization, investment objective (i.e., growth and/or income), and a class of securities within the portfolio are concerned. They are known for their volatile nature and moderate dividend distribution.
As the investment portfolio of ‘sector funds’ generally consists of one specific sector (or two/ three closely linked sectors),’ their success is entirely dependent upon the future of those sectors. They are, therefore, considered the riskiest funds out of all the mutual funds. During their initial offering itself, they are required to disclose the name/s of the sector in which they plan to invest, and they have to abide by the disclosure by restricting their investment in that particular sector. The success of such funds is linked with the successful performance of that particular sector. If it performs well, then the returns may be much more than that of an equity diversified fund or an index fund. However, if that particular sector underperforms, the returns would be adversely affected.
6) Technology Funds:
Technology funds may be considered as one of the sector funds, as they have a strategy to invest exclusively in the technology sector, which comprises hardware and software companies, viz. manufacturers of computers and other electronic items, as well as developers of information technology related applications.
A technology mutual fund may be defined as a mutual fund, which invests in the companies engaged in the business of designing, creating, and distributing technology-driven products and services. Such funds are characterized by the diversification of the highest level. Certain classes of technology funds are viewed by market participants to be so distinctive that they need to be kept in a separate category.
7 ) Exchange Traded Funds (ETF):
Exchange Traded Funds are known for being traded like a single stock on stock exchanges at a price linked with the indices of those stock exchanges. Their investors get the benefits of both – close-ended as well as open-ended mutual funds. Other advantages offered by such funds include diversification coupled with the benefits of holding a single share, which can be traded at index-linked prices. Exchange-traded funds are of recent origin in our country, and they have gained popularity within a short span of time, even in the global market.
8 ) Commodity Funds:
Commodity funds, as the nomenclature itself suggests, have the policy of investing their corpus in various commodities (like metals, agricultural products, crude oils, etc.) directly or indirectly (through commodity companies or commodity futures contracts). Typical examples of commodity funds are ‘precious metals funds’ and ‘gold funds, which are known to invest their corpus in gold, gold futures, and/or shares of gold mines.
Commodity funds may be classified as ‘specialized funds’ (investing their corpus exclusively in a single commodity or a single group of commodities), and ‘diversified funds’ (investing their corpus in various commodities available in the market). The specialized fund’s risk exposure is, for obvious reasons, at a higher level as compared to that of diversified funds.
9 ) Fund of Funds (FOFs):
A mutual fund that invests in the units of other mutual funds/hedge funds, instead of investing directly in different financial instruments (equity or debt) available in the market, is known as a ‘Fund of Funds (FOFs). FOF is also referred to as a multi-manager investment.
On the basis of their investment pattern, FOFs may be categorized into the following two groups:
a ) Mutual Fund FOFs:
Mutual Fund FOF invests its corpus in the units of other mutual funds. Its ‘ portfolio comprises of units of various mutual funds and not the financial securities, as in the case with other mutual funds.
b) Hedge Fund FOFs:
The investment strategy of a hedge fund FOF is to exclusively invest in various hedge funds. An exposure to the hedge fund industry ensures diversification of risks involved in a single investment fund.
10 ) Real Estate Funds:
Real estate funds are those funds, which have the policy of investing their corpus exclusively in real estate developers directly or indirectly (i.e. through the shares/securitized assets of housing finance companies). They constitute a highly specialized category of mutual funds having the objective of generating a regular flow of income and/or capital appreciation for their investors.
Advantages & Disadvantages of Real Estate Funds :
Real estate funds may either be growth-oriented or income-oriented or both. However, an investor may reap the benefits of regular income in the form of dividends during the period of holding the units of such funds, and book capital gain from the sale of those units.
As compared to Je diversified growth funds or income funds, the real estate funds are inherently more volatile in rate. It is, therefore, suggested by experts to invest in such funds with a long-term horizon in view, and remain invested therein. In the event of any adverse development, the real estate market tends to decline sharply, and investors of real estate funds are likely to suffer financially.