Different Types of Mutual Funds
Now that we have understood how a mutual fund basically works, we will now move on to the different types of mutual funds that are available to invest in. Mutual funds are classified in a variety of ways, based on factors like when an investor can invest more or redeem part of his investment, what type of securities the fund manager will invest in, how the fund will be managed etc.
When a scheme is first launched to the public, it is called a New Fund Offer (NFO). The investors are allowed to buy units at their face value, i.e. the basic value that the unit is offered for. Following the NFO, the units are valued at the Net Asset Value (NAV) of the Scheme. The NAV is the market value per unit of the fund. It can be logically deduced that the NAV of a scheme would change each day as the value of the securities in the scheme portfolio changes.
The first classification is on the basis of the time when an investor can add or redeem units from the Mutual Fund:
- Open-Ended Funds
These funds are open for investors to enter or exit at any point in time, even after the NFO. Even though some investors may exit from the scheme, the scheme continues to function with the remaining investors. In this type of fund, the investor has complete freedom to enter or exit from the fund at any time.
- Close-Ended Funds
These funds have a fixed maturity. A close ended scheme offers units to the investors only at the time of the NFO. The mutual fund is required by regulations to make arrangements for the units to be traded post-NFO in a stock exchange. Thus an investor who wants to buy units will have to find a seller on the stock market and vice versa. Here, the units can be redeemed from the mutual fund only after the schemes maturity.
- Interval Funds
These are a sort of mix of both open-ended and close-ended funds. Such funds act as a close-ended fund for the majority of the time but become open-ended at pre-specified intervals, called ‘transaction periods’. The period between two transaction periods is called ‘interval period’. The units of the mutual fund have to be compulsorily listed on the stock exchange during the interval period of such funds.
Mutual funds are also classified on the basis of portfolio management of the fund:
- Actively Managed Funds
These are funds where the fund manager is given the flexibility to change the basic portfolio of the scheme, i.e. the proportion of assets allotted to each security, within the broad parameters of the investment objective. As it can be expected, the running costs of such a fund turn out to be higher. Investors expect such a fund to consistently outperform the market.
- Passive Funds
These funds invest on the basis of a specific index. For example, a passive fund tracking the Nifty 50 will buy only the shares that are part of Nifty 50 Index. The proportion of each share in the scheme would also mirror the index. The performance of such funds naturally mirror the performance of the concerned index. Such schemes are also called Index Schemes. The fund manager of such a scheme has no role in deciding the investments and thus, such funds have relatively lower running costs.
Exchange Traded Funds (ETFs) are also passive funds. Their portfolio replicates an equity or commodity index such as BSE Sensex or Gold ETFs. The units of these funds are issued during the NFO. Post this, the units are available for sale and purchase on the stock exchange.
The third classification of mutual funds is done on the basis of the securities which the fund invests in:
- Equity Schemes
Schemes that invest largely in equity shared and equity related instruments seek capital appreciation through the investments in such growth assets. Such schemes are called Equity Schemes. The returns of such schemes are volatile as the securities listed in the portfolio are also listed on the stock exchange where their value changes through the day. Such schemes are superior when one looks at a long term investment horizon.
- Debt Schemes
Such schemes mainly invest in debt securities like Treasury Bills, Government Securities, Bonds and Debentures. The main source of income from a debt instrument is regular income in the form of interest. Such schemes are less volatile and are the investment of choice when the investment horizon is short.
- Hybrid Schemes
Hybrid funds invest in a combination of securities such as equity, debt or gold. The ratio of this combination will depend on the investment objective of the fund. Logically, the risk will be higher if the equity component is higher.
We will discuss the further classification of the funds in a later article.