Mutual Fund Categories | Simple Explanation for Beginners
There exists a mutual fund for each of our financial goals. But then that's also the problem. There are around 7000 mutual fund schemes available in the US and around 2500 in India. And we need to pick only 3 or 4 from these. That's tricky and to do that efficiently we need to know what options are available out there for us as investors. So in this blog, we will go through the different types of mutual fund schemes.
Mutual fund schemes can be classified based on a wide variety of factors. But the most important one is based on where the money is invested.
Where the money is invested
In the Mutual Fund Basics blog, we discussed Equity and Debt. To refresh, equity refers to stocks of both listed and unlisted companies, and debt is a common term for all financial products that are based on borrowing, like a bank fixed deposit or a bond. If you are not familiar with stocks and bonds, I highly suggest watching this video where I have covered this topic in detail.
Equity Mutual Funds
Equity mutual funds are those that mainly invest in stocks of companies to benefit from high returns. This could be in the form of regular dividends or capital gains. But why do we need to invest in equity mutual funds? Why can't we just buy stocks of companies directly? Of course, we could do that. But how would you know which stocks to invest in? When you buy a mutual fund, you outsource that decision to an expert. They analyze the market trends, read the financial reports of companies, and integrate a portfolio of stocks into a fund.
Now, equity funds can be further classified based on market capitalization
Market capitalization is simply the total number of a company's stocks in the market multiplied by its price. This provides a rough estimate of the company's value. Based on market cap, stocks can be classified into three categories: large, medium, and small.
Large-cap stocks are those that belong to well-established companies with a huge market capitalization. In the US, these are companies typically valued at over $10 billion. Mid-cap stocks are those of companies with a market cap between 2 to 10 billion and small-cap stocks have less than 2 billion in market cap. In Indian stock market terms, large caps are the stocks of the first 100 companies listed in the stock exchanges based on market cap., mid-caps are between 101st and 250th and beyond that are small-cap stocks. Mid-cap and small-cap companies are fast-growing ones that have the potential to one day become a large-cap if they can keep growing.
When it comes to funds, large-cap funds invest at least 80% of their total assets in large-cap stocks.
On the other hand, mid-cap funds invest a significant portion of their assets in mid-sized companies, and small-cap funds in stocks of small-cap companies. In India, the average 10-year return of large-cap funds is around 12%, whereas it is around 15-20% for mid and small-caps.
Now these were the main categories based on market capitalization, but we can also find a few other combinations. Large and Mid Cap Funds, Mid and Small Cap Funds, Multi-Cap, and Flexi Cap funds. Large and Mid-cap funds focus mainly on large-cap and mid-cap stocks with a minimum allocation of 35% in each and Mid and Small Cap funds do the same with mid and small-cap stocks.
Multi Cap Fund is an equity scheme investing across all three market caps and has to allocate at least 25 percent in each. And with the flexi-cap category, the fund manager has complete freedom to invest funds across market caps. In the US, this is called an All-Cap fund.
If we come out of market cap-based classification, there are sectoral equity funds that invest predominantly in a sector or a theme. A sector can be information technology, infrastructure, pharma, and so on. For example, an energy fund would only mainly invest in stocks of energy companies. Since these funds have complete exposure to one sector or theme, they are riskier investments than other Equity Funds.
Another fund category similar to sector funds is the focused fund. This is a type of mutual fund scheme that invests in a small number of stocks in a limited number of sectors that are each related in some way.
Equity funds are the best option to build wealth. But if we want more stability, safety, and liquidity for our investment we need debt funds.
Debt Funds
To understand debt funds we need to understand debts. The core of every debt-related product is a loan. When governments and corporations want to raise money, they issue bonds. And by buying a bond, you're giving the issuer a loan, and they agree to pay you back along with interest after a fixed duration called the maturity period. So these are products where two things are fixed – how much you will get back and when you will get it back. So these are also called fixed-income securities and they can be broadly classified based on their maturity period.
Cash management bills (CMBs) are issued by the Government with a maturity period ranging from a few days up to three months. Governments across the world also issue Treasury Bills or T-Bills for a period of 91, 182, and 364 days. Then there are Treasury notes and Treasury bonds. These are medium and long-term government securities, ranging from two to 10 years.
Commercial paper is an unsecured, short-term debt instrument issued by corporations with a maturity from a day to 270 days.
Certificates of Deposits (CDs) are for funds deposited in a bank for a specific period. Typically, CD terms range from three months to five years and they offer better interest rates than Fixed deposits.
We don't have to go through them in detail, but just keep in mind that debt funds mainly invest in the above-mentioned assets or a combination of them. A term you will encounter the most when it comes to debt funds in Average maturity. It simply means the average holding period of all the assets in the fund. Similar to debt, debt funds can also be classified based on their average maturity period.
Overnight fund is a sub-category of debt funds with an average maturity of one day. The liquid fund invests in securities with a maturity period of up to 91 days, Ultra-Short Duration Funds with a duration of 90 to 180 days, and low-duration funds, with an average maturity of between six months and a year.
These are the important ones and all that we need. There are other categories of debt funds such as medium-term bond funds, long-term bond funds, corporate bond funds, credit risk funds, G-Sec funds, floater funds, and more. But for someone starting with mutual fund investments, it is better to keep things simple in the beginning.
But one thing you need to remember is that even though they are less riskier than equity funds, debt funds are not completely risk-free. There are two types of risks that we need to watch out for, interest risk and credit risk.
The value of a mutual fund is simply a representation of the value of the assets included in the fund. A major part of debt funds are bonds issued by Governments and corporations that can be traded in the bond market. Interest rate is the risk of new bonds getting issued at higher interest rates in the market thereby reducing the demand for the existing bonds in our fund portfolio. Then there is the risk of the borrower not returning the due interest and principal of the bond to the lender. This is more the case with corporate bonds and less with government bonds. But if we want the best of both the equity and debt world, there are hybrid funds.
Hybrid
These funds mix stocks, bonds, and sometimes other assets to give investors the chance for high returns while also offering a stable portfolio.
Hybrid funds can also be classified further based on the allocation of equity and debt. A conservative hybrid fund is a debt fund with 75 to 90 percent in debt and the rest in equity. The balanced hybrid fund goes with a balanced approach and has debt and equity in almost similar proportions. An aggressive hybrid is more tilted towards the equity part with an allocation between 65 percent and 80 percent.
Bases on Entry and Exit
Mutual funds can also be classified based on when you can buy and sell them. There are open-ended funds, close-ended funds, and interval funds.
Open Ended
Open-ended funds are the ones in which an investor can enter and exit at any time. They always remain open for sale and repurchase. The fund house can create an unlimited number of units over the lifetime of the scheme as more and more investors buy into that scheme
Close Ended
A closed-end fund is a type of mutual fund that issues only a fixed number of units through one initial public offering. Its units can then be bought and sold on a stock exchange, but no new units will be created, and no new money will flow into the fund. At the close date of the scheme, investors redeem their units to the fund house and get their money back.
Interval Funds
Interval funds are a combination of both open-ended and closed-ended funds. They become open during pre-specified periods when investors can redeem their units.
Based on Investment Strategy
Mutual Funds can also classified based on the investment strategy of the fund manager into Growth and Value funds.
Growth funds
A growth fund invests in stocks of companies with higher-than-average growth potential. They are popular with investors because of their potential to deliver higher returns over time, but they do come with some drawbacks, especially greater volatility, due to the stocks they own.
Value Funds
Value Funds invest in value Stocks which are stocks of larger, well-established companies that are currently selling at a “discount. Fund managers find value stocks by analyzing various factors of a company such as its growth, Price to Earning ratio, Dividend yield, and others.
Based on how funds are managed
Mutual Funds can also classified based on their management strategy into Active and Passive funds.
Active Funds
An active fund is where the fund manager analyses the market and decides what stocks, bonds, or other assets to buy, hold, and sell. So the performance of an active fund depends a lot on the knowledge and expertise of the fund manager.
Passive Funds
The simple definition of a passive fund is a type of fund that just buys the index and stays with it. So they are also called index funds. But what is an index? It is simply a number that is used to track the performance of a group of assets in a standardized way. If the tracked assets are stocks, we get a stock market index, for bonds, there is the bond price index.
For example, the S&P500 is an index that tracks the performance of the 500 largest companies in the US by market capitalization.
Similarly, Sensex is a stock market index that tracks thirty top stocks listed on the Bombay Stock Exchange (BSE).
A passive fund just mimics an index and aims to give investors an easy way to buy all the stocks or bonds in a given index instead of having to buy them separately. Since the role of fund manager is restricted to a minimum, the expense ratio of passive funds or the cost to manage the fund is very low. So they are great options for cost-conscious investors. Another category of passive funds is called Exchange Traded Funds or ETFs. An ETF also tracks an index but is listed on the stock market and is available for trading all day. While you can buy and sell an index fund straight from the AMC, you have to open a demat account to buy an ETF.
Others
Then there are fund categories that aim to provide customized solutions, such as helping investors plan for retirement and their children's education, REITS that allow one to invest in income-generating real estate assets, Equity Linked Saving Scheme (ELSS) for tax exemption and funds of funds that hold shares in other funds. But as I said for beginner investors it's better to keep things simple.
In the next blog in the series, we will have a look at how to use all the things that we learned so to find the best-performing funds that match our goals.
Disclaimer: The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. It is important to do your own analysis before making any investment.
