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Understanding the Types of Mutual Funds

To make the readers understand the various types of mutual funds in a detailed and simple manner, we have divided the blog in four parts. The first blog will speak about broader categorisation and its understanding. The second one will on be an equity oriented mutual funds scheme. Third blog of the series will be focused on debt oriented schemes. And the last one in the series would focus on hybrid mutual fund schemes and other schemes. While it may sound very theoretic, it is advisable to understand all the options available for investment.


When novice investors plan to begin their investment journey towards wealth creation or financial independence – the first advice from stalwarts is to start with mutual funds. The primary reason being, it is possible for mutual funds to structure a scheme for different kinds of investment objectives. In other words, mutual funds through various schemes make it easier for investors different objectives to achieve their financial goals.


Definition of mutual funds and why different kinds of mutual funds schemes are required?


Mutual fund is a financial instrument in the form of a ‘trust’ to mobilise money from investors, to invest in different markets and securities, in line with the common investment objectives agreed upon, between the mutual fund and the investor.


Mutual funds seek to collect money from all possible investors. Various investors have different investment preferences and requirements. In order to accommodate these preferences, mutual funds try to mobilise different pools of money. Each pool of money is called a mutual fund scheme. Every scheme has a pre-announced investment objective. Investors invest in a mutual fund scheme whose investment objective reflects their own needs, preference and most importantly risk profile. So, to make the right choice of investment in mutual funds one must understand what different mutual funds schemes are available.


Types of funds – Broad Categorisation


Mutual funds can be classified in various different ways, depending upon the structure and the nature of investments they make. However, the first broad categorisation happens on the basis of taking entry and exit from any mutual fund scheme. It can be divided into three major categories vis-à-vis, open ended scheme, close ended scheme and interval funds.


Open ended funds are open for investors to enter or exit at any time, even after the new fund offer (NFO). When existing investors acquire additional units or new investors acquire units at net asset value (NAV) from the open ended scheme, it is called a sale transaction. When investors choose to return any of their units to the scheme and get back their equivalent value (in terms of units), it is called a repurchase transaction. Even after your exit, the scheme continues operations with the remaining investors.


In the case of close ended funds there is a fixed maturity. One can buy units of a close ended scheme, from the fund, only during its NFO. The fund makes arrangements for the units to be traded, on a stock exchange. Listing of such close ended mutual funds schemes on stock exchange is compulsory. In this case, the buying or selling can happen on the exchange. With no new allotment post the NFO the unit capital of the scheme remains stable or fixed.


As the fund is not involved in the exchange-based transaction, the price is likely to be different from the NAV. Depending on the demand-supply situation for the units of the scheme on the stock exchanges; the transaction price could be higher or lower than the prevailing NAV.


The interval funds combine features of both open ended and close ended schemes. Such schemes are mostly close ended, but eventually become open ended at pre-specified intervals or prescribed dates. Unlike in a purely close ended scheme, they are not completely dependent on the stock exchange and hence investors may not have to pay higher prices in case of higher demand. However, between these intervals, the units are compulsorily listed on stock exchanges to allow investors an exit route.


Second categorisation – fund management style


The second categorisation happens on the fund management style, vis-à-vis, actively managed funds, passively managed funds and then exchange traded funds.


Actively managed funds are funds where the fund manager has the flexibility to choose the investment portfolio. However, only within the broad parameters of the investment objectives of that scheme. The returns in such schemes are dependent on the positions taken by the fund managers based on the research they do. Since this increases the role of the fund manager, the expenses for running the fund turn out to be higher. Further the churning of portfolio happens on a regular basis adding to the transactional cost of securities. The goal of active fund management is to beat the stock market’s average returns and take full advantage of short-term price fluctuations. It involves a much deeper analysis and the expertise to know when to pivot into or out of a particular stock, bond, or any asset the scheme invests in. It is usually suitable for those who are ready to take some risk and outperform the broader market. General perception is that actively managed funds perform better than the market or outperform the markets. There are many counter arguments regarding the same and hence this can become a different topic of blog with few examples.


Passive funds invest on the basis of a specified index, whose performance the mutual fund scheme seeks to track. Thus, a passive fund tracking the S&P BSE Sensex would buy only the shares that are part of the composition of the S&P BSE Sensex. The proportion of each share in the scheme’s portfolio would also be the same as the weightage assigned to the share in the computation of the S&P BSE Sensex. Thus, the performance of these funds tends to mirror the concerned index. They are not designed to perform better than the market. Such schemes are also called index schemes. Since the portfolio is determined by the index itself, the fund manager has no role in deciding on investments. Therefore, these schemes have low running costs. It is best suited for those investors who are a bit risk averse but want to generate higher than the risk free returns in long term. Historically, it has been seen that few benchmark equity indices generated a compound annual growth rate of more than 12 per cent in the long run. So, passive funds are seen as a good investment instrument in the long run for those who are ready to take moderate risk.

Exchange traded funds (ETFs) are also like passive funds. Just that, in ETFs, the portfolio replicates an index or benchmark such as an equity index or a commodity index. To name a few, Nippon India ETF Nifty BeES is one ETF that tracks the Nifty 50 index. Motilal Oswal MidCap 100 tracks Nifty MidCap 100 and Motilal Oswal NASDAQ 100 tracks stocks listed in the NASDAQ.


In the debt series Nippon India ETF Liquid BeES is available. A few like HDFC Gold Exchange Traded Fund and UTI Gold Exchange Traded Fund track Gold. As for investing, the units in such ETFs are issued to the investors in a NFO after which they are available for sale and purchase on a stock exchange. Units are credited to the investor’s de-mat account and the transactions post-NFO is done through the trading and settlement platforms of the stock exchange. The units of the ETF are traded at real time prices that are linked to the changes in the underlying index.


 

Conclusion: Based on the broader bifurcation investors can opt for actively managed funds or passively managed funds according to the risk taking capabilities. Eventually, all the equity related investments are subject to face volatility. It is always advisable to opt for a plan that suits your pocket and time horizon.



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