In my previous article, “What the hell are Mutual Funds
“, I have tried to explain what are mutual funds, and the rationale behind investing in them. In this article, I would try to explain different types of mutual funds
available in market, and fundamental differences between them.
Mutual Funds can be broadly classified into 3 categories:
1. Equity Based funds: These funds primarily invest in stocks and equity of companies. These offer the highest returns, and carry highest risk. In simple terms, they try to make money by buying and selling stocks in stock market, and hence carry the same risks associated with normal stock trading.
2. Debt based funds: These funds primarily invest in bonds, government and corporate securities and Treasury bills. These carry the lowest risk and offer lowest returns. The returns are almost fixed in nature.
3. Balanced Funds: These funds invest in both equities as well as debts. These funds try to maximize returns while keeping the risks at a minimum.
Equity Funds can further be classified into following types:
1. Equity Diversified: These are the truly diversified equity funds. These can invest in any sector and any stocks. They can be overweight on any sector and underweight on any sector. They keep on churning their portfolio in accordance with the latest market conditions. These happen to be my personal favorite as they completely mirror the concept of diversified portfolio.
2. Equity Sector: These are sector based funds. These funds can invest in stocks of only a particular sector. For example, an Equity Auto sector fund can invest only in stocks of auto sector. This aspect makes these funds most risky. If the sector tumbles, then these funds don’t have an option to move on to some another sector. To take care of this shortcoming, nowadays sectoral funds are coming which have option of investing in a group of sectors instead of sticking to a particular sector. These funds are meant for the most risky investor, and should never constitute more than a fraction of your portfolio.
3. Index Based Funds: These funds investing in stocks that form index of a stock market. Such stocks are the biggest stocks and mirror the general direction of market as a whole. These funds offer the best way to invest in all the index stocks in one go. Among the equity fund categories, these are the ones that offer lowest risk.
Balanced Funds can be classified into following types:
1. Balanced Funds: As explained previously, these are the funds that invest in a combination of Debt as well as Equities. The ratio of investments in debt and equity vary from fund to fund. They may chose to invest anywhere from 40% to 70% in Equity, and remaining in Debt. As only a portion of your investments is subjected to equities, so they offer lesser risk than the pure equity funds. Also, the returns happen to be lower than equity funds but higher than debt funds.
2. Monthly Income Plans: These are an interesting class of Mutual funds. These invest in both equity as well as Debt. The main objective of these funds is to preserve the principal, while maximizing the returns. In all the categories of equity based funds that I have mentioned above, there is a probability that investor can incur so high losses that he loses even his original principal amount. However, monthly income plans don’t let that happen. They invest that portion of portfolio in debt instruments which can earn enough interest to maintain the original investment. Rest of the portion is invested in equities. So, these funds offer the stability of debt funds with returns that are just a notch above them.
Debt Based Funds can be classified into following types:
1. Income Funds: These funds can invest in complete array of debt instruments, ranging from government securities and t-bills to corporate debentures. Most of these funds park a majority of their corpus in corporate bonds and debentures as they offer a higher return than fixed income securities.
2. Gilt Funds: These funds invest only in government backed securities and treasury bills. The interest on these is almost fixed in nature, and carries almost zero risk as these are assured by government.
3. Liquid Funds: These invest in money market instruments of duration up to 1 year. These can invest in call money, treasury bills, commercial paper and certificates of debt. These are ideal for investors who want to park their surplus money for a short period of time.
As is apparent from above, there is a whole gamut of mutual funds available to suit needs and style of each investor. If you are risk taking investor, you may go with equity funds and if you are risk averse you may go with Debt funds. If you lie somewhere in between then Balanced funds are you. Go and find your fund, there would be definitely one made for you.