Types of Mutual Funds

Mutual funds take away the most difficult decision that investors need to make that of what and when to buy and sell to meet their financial goals. By investing through the right mutual funds, your decision making is limited to picking the fund that will be able to take you to your goals in the best possible manner. Though we don't have a very detailed classification system of mutual funds in India, you can check the type of fund you are investing in by looking at its portfolio of investments. For example, the most common classification of mutual funds you will see in India is equity funds, bond funds, balanced funds, money market funds and gilt funds. A more detailed classification like aggressive growth, growth fund, small company fund, blue chip fund and so on within the equity fund category is not available. And I suggest that you don't decide on which fund to buy by just looking at the fund's name. A fund may call itself a blue chip fund but when you look at its investments, you will be surprised to find stocks that are not as blue chip as the fund's name suggests.

Irrespective of what they invest in, most mutual funds hold 5 15 per cent of their funds in cash or liquid investments. This kind of cash reserve is necessary to meet any redemptions of fund units by investors or to use in picking up bargains in the financial markets.

Money market funds or liquid funds Money market funds are as safe as your savings bank account and produce a much better return. They should be used as an alternative to savings bank accounts. You can withdraw your money within 24 hours from these funds and they allow you to write cheques on your balance. What that means is that you get a cheque book and you can write a cheque against your investment. Money market funds invest most of their money in call money, a technical term for borrowings between banks for a day, and in bank fixed deposits. And you don't have to worry about your original investment. It will remain intact because this is the overriding concern the fund has and it sacrifices greater returns by picking absolutely safe short term investments.

Bond funds Bond funds invest in all kinds of bonds government, PSU or private sector bonds. Some bond funds invest in only certain kinds of bonds. For example, gilt funds invest only in Government of India securities and are the safest type of mutual funds available in India. Certain mutual funds invest only in bonds that have the highest safety rating from credit rating agencies.

Bond funds make sense for investors who prefer a steady flow of income and don't want their original investment to fluctuate or those who may need their funds for some other purpose in the short term.

Bond funds come in many variations. A number of mutual fund families offer you a monthly income plan for regular returns on your investment.

A bond fund allows you to invest in a basket of thirty to fifty bonds which a fund manager can trade in reaction to changing market conditions like interest rates and the bond issuer's credit ratings. The biggest advantage that bond funds offer is the ability to get in and get out at any time. But unlike a bond, you don't have a fixed interest payment or a time period in which the bond issuer will pay back the loan since the fund is buying and selling bonds constantly.

When you buy a bond fund, be very careful about the average maturity of the fund's bond holdings. In other words, ask what is the average period in which the fund's bond holdings will mature or the lenders will pay back the original investment. The longer the bond fund's average maturity period, the greater the risk of volatility or fluctuations in the fund's net asset value. Bond funds from different mutual fund families or for that matter different bond funds from the same mutual fund could vary in where and in what proportion they invest their money. Since most financial newspapers and magazines don't classify debt or bond funds under separate sub categories, it is important for you to look at the fund's holdings (regulations require mutual funds to disclose their top twenty holdings) to see if the mutual fund's investments fit your financial goals. And don't take the fund's name at its face value. A high interest fund may not necessarily pay higher interest rates than the other funds.

Broadly, bond funds are of the following types:

Money market funds Though a money market mutual fund invests in safe instruments and has rarely defaulted, it gives you no guarantee that you will not lose all or part of your original investment. Money market funds first try to keep your principal intact and then try to get you interest. They manage to keep the principal intact because they invest in highly liquid investments called money market instruments. This includes lending money to banks for only a day (called call money), treasury bills and certificates of deposits.

High yield bond funds These funds pay higher returns than other bond funds, but invest all or part of their funds in riskier bonds like those that may not have the highest safety rating from credit rating agencies. The risk that a bond or bonds in the fund's portfolio could default is greater.

High safety bond funds Some bond funds will only invest their funds in the highest rated corporate bonds or risk free government securities.

Gilt funds Gilt funds invest in Government of India and state government securities and bonds that are guaranteed by the central and state governments. These mutual funds are the safest type of debt funds available since they invest in bonds backed by the full faith of the government. Your original investment is as safe as it can be though your returns may be lower than what you can get in a debt mutual fund that invests in corporate debt. Since for all practical purposes most of us cannot participate in the bond market because of the size of each trade and because most brokers cater only to very large investors, gilt funds give you an excellent opportunity to invest in the safest of all investments.

What to watch out for in bond funds Be careful of mutual funds that have a lot of money in unlisted secureness number of mutual funds invest funds in stocks and bonds that are not quoted or for which there is no secondary market. This is dicey, because it gives the fund manager the ability to cover up any losses or drop in value of quoted stocks and bonds by increasing the value of unquoted investments subjectively. Such moves could go unnoticed and explode when the mutual fund is under unusual redemption pressure. Moreover, mutual funds that have money in unlisted investments may not be as liquid or may be unable to pay investors if the redemption pressure on the bond fund increases. performance.

Balanced funds Balanced funds are essentially a mixture of stocks and bonds and do better than equity funds in times of economic downturn since shares are usually poor performers during such times. They do better than bond funds in times of economic upturns since the stock investments in these funds help them post better.

Balanced funds are ideal for diversifying Your investments without spending time on the process. They also allow investors to limit their exposure to shares.

Equity funds Equity funds invest in stocks but usually follow different investment strategies. Equity funds may look for value in stocks or invest in the most actively traded stocks. If you buy an equity fund or a mutual fund that invests in stocks you must clearly understand that the price of its units will fluctuate with the price of the stocks it owns.

Equity funds from the same mutual fund family could be different in where and in what proportion they invest their money. Since most financial newspapers and magazines don't classify equity funds under separate subcategories, it is important for you to look at the fund's top twenty holdings to see if the investments fit with your financial goals. And don't take the fund's name at its face value. A fund could be called a blue chip fund, but you need to see its holdings to determine if the holdings are truly blue chip. Equity funds could be of the following types:

Index funds are equity funds that invest in exactly the same stocks (and in the same proportion) that make up the market indices like the BSE Senses or the NSE Nifty Index. So what's the advantage of an index fund? For those of you who follow the markets but have no time to pick and choose, just buy into an index fund. Then just look at how the BSE Senses or the NSE Nifty is doing and you will know how your index fund is doing. Index funds have two distinct advantages. The fund manager can programme a computer to just follow the index and pick stocks without putting in hours of his time in research and stock picking. So the cost to the mutual fund for managing an index fund is low. The other advantage is that you cannot do worse than the BSE Senses or the NSE Nifty. Simply because the index fund is replicating the movements of the index.

Sector specific funds Sector specific funds invest in particular industry sectors like information technology, pharmaceuticals or consumer goods. Keep away from sector funds because they provide no diversification and in most cases they tend to be more volatile than most other mutual funds. That's because most stocks in the same industry sector usually suffer from the same problems or gain for the same reasons. But if you are really optimistic about a particular sector, it may not hurt to put up to 5 10 per cent of your investible funds in a sector specific fund.

Blue chip funds These funds invest in stocks of very well respected companies. The purpose is to build a stock portfolio of conservative stocks so that it does not do worse than the stock market indices. Such funds return less than funds that invest in growth oriented companies.

Growth funds A number of mutual fund families use this word to describe their equity funds. But growth funds are funds that invest in companies which are growing at a rate faster than the rest of the economy and industry.

The goal is to capitalize on the increase in stock prices. The risk is that many growth companies are not very big and may not be able to absorb bad news as easily as blue chip companies. Shares bought by such funds are usually more volatile than blue chip stocks.

Commodity funds Commodity funds are new to India and offer you an opportunity to invest in the outlook for commodities like gold. But funds of these types have not done well globally and are best avoided.

International stock and bond funds Even though regulations allow Indian mutual funds to invest in foreign securities, nothing much has happened as yet primarily because a number of mutual funds don't have the expertise and there is not much interest among investors to buy mutual funds that invest in international stocks or bonds. But mutual funds that invest in foreign stocks and bonds provide an excellent opportunity to diversify your portfolio. They also reduce the country risk or the risk that all Indian investments could be affected by changes in Indian economy, politics, etc. Expect international stock and bond funds to pick up in the near future.

Mutual funds with tax benefits You can reduce your taxable income by 20 per cent of your investment up to a maximum of Rs 2,000 by investing in mutual funds schemes that are authorized to offer such a benefit. These schemes are just like any other equity or bond scheme except that they give you this 20 per cent tax break. The condition is that you cannot withdraw your funds from the scheme for a certain number of years.

A mutual fund from the Unit Trust of India (UTI) The Unit Trust of India (UTI) is India's oldest mutual fund it has been around since the 1960s. As such, it has a head start over other funds (most of which began in the 1990s). It manages more money than any mutual fund in India (in fact many times more), has the largest number of mutual fund investors and has the largest distribution network out of all the funds. And there is hardly a publicly listed company in India of any standing in which UTI does not have a significant shareholding.

I haven't come across a middle class household that does not have funds invested in some UTI scheme. But just because your father invested in UTI, you may not be making the most prudent decision by doing the same. Investment choices were limited till the late 1980s, UTI being the only player. Moreover, UTI does not operate in a monopoly situation any more and the practice of giving you fixed returns on your units is dying out. Till the late 1980s, UTI was the largest player in the market and could move the markets if it wanted. In such a scenario, it was easy to pay assured dividends and continue to churn out spectacular dividends and bonus shares/units year after year. Look at the scenario now. To match UTI's might, you have tens of mutual funds and hundreds of foreign institutional investors with deep pockets. And UTI's size in itself is becoming a liability. The funds UTI has are becoming too large to manage.

Remember, UTI is just another mutual fund and its schemes brace the same ups and downs of the financial markets as any other mutual fund. It does have thirty years of investment experience in Indian financial markets but experience counts little against a nimble competition.

So invest in UTI if any of its schemes is performing better than the other mutual funds. But invest because it's the smart thing to do and not because of emotional reasons or because your dad invested in it.