The aim of investing in equities/debt is to generate wealth over time, and mutual funds do just that. But they do it with much less risk than individual stock picking. Mutual funds are operated by professional money managers, who allocate the fund’s assets and attempt to produce capital gains or income on your behalf.
The Mutual Funds Sahi Hai campaign had a huge positive impact on demystifying mutual funds in India. This led to a lot of investors seeking Mutual Funds as an investment tool, especially through a Systematic Investment Plan. With the flexibility and options it offers, there is a fund for everyone!! Let’s explore some of the options:
Types of Mutual Funds
Equity Mutual Fund
An equity mutual fund is one which predominantly invests in equity shares or other equity related instruments. So how much should be in equities? So as per current SEBI Mutual fund regulation, for a mutual fund to be classified as an equity mutual fund, it should invest no less than 65% in equities. The fund manager has the liberty to invest the other 35%. Considering that in mind, there are various types of equity mutual funds, some are described below.
Large cap MF
The top 100 stocks by market capitalization listed in the Indian stock markets are called large caps. A mutual fund which invests in these top 100 stocks makes up the Large Cap Mutual Funds.
Mid cap MF
The next 150 stocks by market capitalization listed in the Indian stock markets (100-250) forms mid caps. A mutual fund which invests in these 150 stocks makes up the Mid Cap Mutual Funds.
Small cap MF
The stocks with rank 250+ by market capitalization listed in the Indian stock markets forms the small caps. A mutual fund which invests in these stocks usually 250-500 makes up the Small Cap Mutual Funds.
Multi cap MF
As the name suggests a Multi cap mutual fund has the freedom to invest across market capitalizations. A recent development in multi cap space is a circular by SEBI dated 11/09/2020. The circular states that a multi-cap mutual fund has to invest at least 20% each in Small, Mid and Large caps to stay true to its name.
Index Funds
Index funds, as the name suggests, is a mutual fund that tracks an Index. They are passively managed funds. That is there is no active stock picking. The role of the fund manager is mirror the respective index as closely and accurately as possible.
Because of the passive nature of such funds, fund houses need not spend huge amounts of cash for fund managers to identify and pick stocks. Hence the expense ratios for such Index funds are much lower than actively managed funds.
Index funds are often the best instruments for beginners to enter into equity markets
Besides these, there are also sectoral funds, thematic funds, international funds, focused and value oriented funds.
Debt Mutual Fund
A debt mutual fund is a scheme which invests in debt instruments such as corporate bonds, debentures, government bonds and other money market instruments. Such investments are often risk averse and provide stable and predictable income to investors, unlike equity investments.
The following are some of the types of debt mutual funds:
Liquid Funds
These mutual funds invest in debt instruments with a maturity period less than 91 days. Are often the safest funds to invest due to the low duration. Liquid funds are an excellent alternative to a savings bank account (or even FD in the current low interest situation) and often producing better post tax returns.
Average Yield: 6-7%
Corporate Bond Fund
Corporate bond funds are those mutual funds which invest not less than 80% of their portfolio in bonds of companies having a rating of at least AA+. As such a credit rating is only given to financially strong companies and history of paying back lenders on time, investment in such companies is seen with lower risk.
Average yield: 8-10%
Duration Fund
These are mutual funds which hold various debt instruments over certain durations of time. In fact Liquid funds discussed above are a type of duration fund. They are classified based on the duration to maturity of the underlying instruments that the fund is holding. Some of them are:
- Overnight
- Liquid Fund
- Ultra-short duration
- Low duration
- Short duration
- Medium duration
- Medium to Long duration
- Long duration
Gilts
Gilts are debt mutual funds that invests in government securities. These instruments have no credit risk associated with it as the borrower is the government and repayment is assured. (Indeed, if the government defaults on its interest payment, it would mean the GoI has defaulted, in such a case you would be having much bigger issues to worry about!!)
Hybrid Mutual Fund
A hybrid mutual fund is one which invests in both equity and debt to extract the best of both world. It often produces better returns than debt funds due to the allocation in equities but are more riskier than debt funds. Compared to pure equity funds, though it doesnt give returns as much as equity funds, but they are less risky and less volatile. This makes it an excellent choice for investors with medium risk capacities.
Even within hybrid mutual funds, there are subcategories such as
Aggressive Hybrid
Aggressive funds can hold up to 75% of the portfolio in stocks and the remaining 25% in fixed income options such as debts and FD like instruments.
Dynamic
A dynamic fund offers the fund manager complete freedom as to the accocation towards debt and equity. There is no fixed maximum and minimum percentage for the asset class and the manager is free to choose an allocation he deems fit according to the market condition.
That is if the manager feels that the stocks are overvalued and a crash is eminent, he can completely exit and invest in debt and vice versa.
Multi Asset
All the mutual funds discussed til now either invested in equities or debt. A mutli asset mutual fund can have a third asset class such as gold or real estate.
Multi asset funds are required to have a minimum of 10% in each of the respective asset classes at all times.
ELSS
Equity Linked Savings Scheme or ELSS is an equity mutual fund that helps you save tax under Section 80C by investing up to a maximum of Rs 1,50,000 per financial year.
ELSS mutual funds have a lock-in period of 3 years. Since the on-set of the new tax regime, exemptions under 80C have been removed. This makes ELSS scheme unattractive for such investors, opting for the new tax regime as it does not offer much benefit and their investments are locked away for 3 years.
FOFs
Fund of Funds (FOF) is a mutual fund that invest in other mutual funds for managing risk, volatility, ease, etc. But FOFs usually have higher expense ratios and tend to dilute the portfolio.
Things to consider
Open vs Close ended funds
99.99% investors should only invest in open-ended mutual funds because of the peculiarities of how closed-ended mutual funds work and how it might not be the right option for most investors. Read more…
Direct Plan ONLY
Mutual funds offer 2 ways through which you can purchase them. One is directly from the fund house (Direct Plan) or through an intermediary, usually the brokers (Regular Plan). The key difference between the 2 is that through the regular plan, usually the brokers take a commission for themselves out of our total fund value. This reduces our returns by over 1% each year and is not worth it, as you will see in the example for expense ratio.
Zero commission direct mutual fund investing has caught up even through brokers such as Zerodha and other offerings such as Groww, ET Money, Paytm Money.
Expense Ratio
There is literally zero direct cost of owning mutual funds at the hand of the investor. However, the fund house charges you a percentage of your total holding for running and maintaining the fund.
Expense ratio though doesn’t seem like much, but over years and compounded becomes an enormous amount in itself. A simple additional percentage over long periods can have huge repercussions.
Example:
10 lakh lump sum at 15% for 25 years grows to Rs 4,15,44,120
Add 1% expense ratio to that equation, the net return becomes 14% and the total investment becomes only Rs 3,24,51,308
That’s a humongous difference of nearly 90 lakh rupees over 25 years!!
Exit Load
Again, certain mutual fund houses charge a small percentage of holding if you exit the fund within a specified time period. This is in fact to discourage people from shuffling around with the funds too often and will not be a point of concern if your investment horizon is long term for most funds.
AUM
AUM stands for asset under management. It refers to the total value of investment a mutual fund house is holding under that specific fund. A general rule of thumb is to ensure the mutual fund has at least a couple of thousand crores as AUM so that the fund faces no liquidity pressure while redeeming.
FAQs
Mutual funds offer a plethora of advantages including but not limited to: diversification, easiness, professional portfolio management, low entry point as low as Rs 500, Automation using SIPs etc.
Some of the disadvantages of mutual funds include: Over diversification, excessive fees via regular option, selection becomes tedious, fund manager risk, etc.
There is no right or wrong time to invest, the best strategy is to have a disciplined and systematic approach to investing. Time in the market is more important than timing the market.
Too many mutual funds are bad for the portfolio, one should ideally hold a maximum of 2-3 funds only, more than that there will be too much diversification and end up owning the entire market.
Depends on the expectations and needs of the individual, there is no right or wrong here.
There is no single best mutual fund type, only the one that’s best for you and your needs
In the initial years of one’s investing journey especially at a young age, one’s risk appetite would be higher, aiming for higher returns. However, risk management plays a huge role and having low volatility in your portfolio becomes a blessing even at the expense of a couple of percentage of returns.
I hope the article covered enough to provide a bird’s eye view of the mutual fund space. If you have any doubts or comments feel free to let me know in the comments or through any other mediums, will be happy to discuss.
My other articles on Investing: Investing: Why should you start now?, What I learned after 5 years of Investing
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