Mutual funds – know your type

A mutual fund is an avenue that enables a retail investor with a corpus of even few hundreds to participate in investment avenues, which are otherwise inaccessible to individual investors. It is set up as a trust and pools together the small savings of individual investors and invests the entire corpus to achieve a common goal.

While mutual funds are normally considered risky, investors are not aware that there are varied kinds of mutual fund schemes. Each scheme has a separate risk profile and there is an investment option for each and every kind of investor. Mutual funds also have few inherent advantages:

Before we dwell on the risks associated with mutual funds, let us first take a look into the different types of mutual funds available for a retail investor. These can be broadly classified as debt schemes, equity funds and hybrid funds:

Debt schemes – investment horizon (0 – 36 months)

Liquid funds – (0-3 months):

These schemes generally invest in safer, short term instruments such as treasury bills, certificates of deposit (CD), commercial paper (CP) and interbank call money. They aim to provide easy liquidity, preservation of capital and moderate, steady income. They are ideal for an investment horizon of three months. Corporates and individual investors use these as a means to park their surplus funds for short periods or while awaiting a more favourable investment alternative.

Ultra short term funds – (3-9 months):

Similar to liquid schemes, ultra short term funds also invest in short term papers like T-bills, CDs, CPs and also pass through certificates (PTCs). The average maturity of these papers is generally for a period of three to nine months to a year. They are ideal for an investor who seeks stable returns and has an investment horizon of less than nine months.

Short term funds – (9-18 months):

These funds invest primarily in corporate debentures, bonds issued by public sector undertakings and to some extent in CDs  and CPs. They are ideal for an investor with an investment horizon of nine to 18 months.

Medium term funds – (18-24 months):

These funds hold papers like PTCs, corporate debentures and structural obligations. They are ideal for an investor with a horizon of 18 – 24 months.

Income funds – (24 months and above):

These schemes will invest in a mix of government and non-government securities. These funds hold longer maturity papers like government securities, corporate debentures etc. and are ideal for an investor with a horizon of more than 24 months.

Gilt funds – (24 months and above):

Gilt funds invest only in government securities, which do not have any credit risk. Mostly these papers are also long term and require an investment horizon of at least 24 months.

Equity funds

Equity funds invest at least 65 per cent of their portfolio in equity funds. Since investment is made in equity markets, an investment in the same should be made with a horizon of at least three years.

Diversified equity funds:

Diversified equity funds invest in a diverse mix of securities that cut across sectors. They provide equity participation to a retail investor with an objective to provide capital appreciation. They also enable access to a diversified set of stocks, which would otherwise have been out of reach of an individual investor.

Sector funds:

Sector funds have the mandate to invest in only one type of sector, which is already mentioned in the investment objective. For example, a banking sector fund will invest only in the shares of banking companies.

Thematic funds:

Thematic funds invest with a particular theme as their objective. For example, an infrastructure thematic fund might invest in shares of companies that are into infrastructure construction, infrastructure toll-collection, cement, steel, telecom, power etc. The investment is more broad-based than a sector fund; but narrower than a diversified equity fund.

Equity linked savings schemes (ELSS):

ELSS schemes invest in a style similar to that of a diversified equity fund but offer tax benefit to investors under Sec 80C. However, these schemes have a lock-in period of three years.

Arbitrage funds:

Arbitrage funds take contrary positions in different markets/securities, such that the risk is neutralised, but a return is earned. For instance, by buying a share in BSE and simultaneously selling the same share in the NSE at a higher price. Most arbitrage funds take contrary positions between the equity market and the futures and options market.

Hybrid funds

Balanced funds:

A balanced fund invests in a mix of debt instruments and stocks. Most balanced funds available in the market keep a minimum of 65 per cent in equity. This qualifies them as equity oriented funds and they are eligible for tax benefits on long term capital gains tax.

Monthly income plans:

Monthly income plans primarily invest in debt securities but have a small percentage of their funds (10 – 25%) in equities also. This is to give an extra kicker to the returns generated by the schemes. These schemes come with a dividend option on monthly, quarterly, half yearly and yearly basis.

Important Terminologies

Net Asset Value – Net Asset Value is the market value of the assets of the scheme minus its liabilities.

“NAV = Net Assets of the Scheme / Number of outstanding units”

Load – Load is a charge on the NAV and is defined as a percentage. Exit/Entry loads are subject to SEBI regulation and vary depending on industry practice.

The tax factor

Mutual Funds are also an attractive proposition when we take taxation into account. Equity funds enjoy a distinctive advantage when it comes to taxation. The long term capital gains tax (i.e. investment period of more than one year) is nil. Similarly, the dividend earned from equity mutual funds are also tax free. However, there is a 15 per cent short term capital gains tax.

In case of debt funds, short term capital gains are taxed as per the investor’s tax slab. The long term capital gains enjoy indexation benefit. The table provided below provides the comprehensive view of taxation on mutual funds.