We often discuss about how wonderful mutual funds are and the returns that they give. Have you wondered about the risks entailed in a mutual fund? Remember mutual funds can be small cap mutual funds or they can be large cap mutual funds or they can be flexi cap funds or any other category, but they do carry some degree of risk. Large cap mutual funds carry macro risk, mid cap mutual funds carry client concentration risk and the list can go on. The risk varies with the type of mutual fund and hence they are discussed together.
The moral of the story is that in all the types of mutual funds in India, there is an element of risk involved. It is not like debt funds are risk free. Even they carry risks like interest rate risk, inflation risk, duration risk etc. And, of course, if you are holding hybrid mutual funds, then they carry the risk of equity funds and debt funds, to some extent. How does that sound? Let us start with our types and classes of mutual funds 101.
Fund classes – Open ended funds and closed ended funds
Before we get into types of mutual let us understand the 2 important fund classes viz. Open-ended mutual funds and closed-ended mutual funds.
• Open Ended Mutual Funds are the most popular type of mutual funds. In an open-ended mutual fund, investors can invest and redeem fund units on tap directly from the AMC. These investments and redemptions are done at a price pegged to the NAV, which is announced by the fund daily. Open-ended fund is open for entry and exit always.
• Closed Ended Mutual Funds are open for a fixed period of time and are then closed for subscription. Once the closed-ended fund subscription closes, fresh investment are not permitted. The tenure of the close ended fund can be 1 year to 3 years. Closed-ended funds have to be mandatorily listed on the stock exchanges.
• There is a third category called interval funds, that are not too popular.
Today, more than 95% of the AUM of mutual funds in India is in the open ended mutual funds category. ETFs are a form of closed ended fund, that are widely traded.
Table of Content
Major types of Equity Funds in India
We first look at the various types of equity funds in India.
• Equity Diversified Funds are equity funds that hold a diversified portfolio of equity assets. They are the most popular among equity funds. In last few years, flexi caps or multi caps have emerged as a distinct class of diversified equity funds which goes beyond large caps and invests in mid-caps and small caps too. Equity funds get favourable tax treatment on capital gains (both short term and long term). Equity diversified funds are more risky than balanced funds but less risky than sectoral and thematic funds.
• Equity Linked savings schemes (ELSS) funds are also like a regular equity fund but qualify for tax exemption under Section 80C of the Income Tax Act on investments up to Rs1.50 lakhs per year. Due to the tax exemption, there is a statutory lock-in period of 3 years for ELSS funds, but this tax exemption enhances the effective yield on ELSS funds.
• Sectoral Funds are focused on industry groups like banking, IT, FMCG, healthcare etc. They run high concentration risk. For example, if an investor is holding a Healthcare Fund and if the US FDA comes out with a negative announcement, then it is a risk of the entire pharma sector. They are high on the risk scale.
• Thematic Funds are also concentrated like sector funds but focus is on themes and not on industry groups. Thematic funds include mid-cap funds, small-cap funds, dividend yield funds, turnaround funds, commodity funds etc. These funds are risker. Mid-cap and small-cap funds run liquidity risk while turnaround funds have low success ratios.
An equity fund, to be classified so for tax purposes, must have more than 65% invested in equities.
Major types of hybrid funds in India
Hybrid funds are a combination of equity and debt and try to find a middle path.
• Balanced Funds can be aggressive balanced funds or conservative funds depending on whether equity or debt predominates. There are also dynamic funds like the Balanced Advantage Fund (BAF), where the fund manager has discretion on equity/debt allocation. These balanced funds are classified as equity or debt funds based on equity ownership percentage.
• Solution Funds are designed for specific long term solutions like retirement, children’s education etc. They normally delivery results only in the very long term.
• Arbitrage Funds go long on equities and short on stock futures of equal amount. This creates riskless arbitrage profits. The returns are in the range of 4-5% on an annualized basis. While they are classified as a hybrid fund, arbitrage funds are actually treasury products.
The popularity of hybrid funds has been growing in the last few years.
Major types of Debt Mutual Funds in India
Here are some of the major debt fund categories available in the Indian market.
• Income Funds essentially invest in government securities and corporate debt paper. The longer term income funds of 5 to 10 year maturity are impacted more by rate changes. There are also shorter term income funds that invest in shorter term G-Secs, treasury bills, call money, Commercial Paper (CP), certificates of deposit (CD) etc. These are less susceptible to interest rates changes.
• Credit Opportunities Fund takes on credit risk. Investing in high quality AAA rated bonds is the safest but yields are too low. Hence, Credit Opportunity Funds add bonds that are AA rated for higher yields. as they give higher yield. While this is a good idea to enhance yield, it comes with higher default risk.
• Floating Rate Debt Funds invest in floating rate bonds that pay variable interest that fluctuates with a market benchmark. They are useful in a rising interest rate scenario. Normally benchmarks used are MCLR or Bank rate. Floating rate funds can invest in floating rate bonds of longer maturity or shorter maturity. However, in India, the choice of floating rate bonds is quite limited.
• Ultra-Short Term Funds or liquid-Plus Funds invest in short term paper with maturity of less than 1 year. Since the yield on such paper is very low, ultra-short Term Fund adds long term paper to its portfolio to enhance yields. Unlike liquid funds, Ultra-Short Term Funds have an exit load.
• Gilt Funds are a class of debt funds that invest purely in government bonds issued by the central government. Some gilt funds also invest in state government bonds to enhance yields. Gilt Funds come in 2 categories. Short term gilt funds invest in government bonds with a residual maturity of less than 1 year. On the other hand, long term gilt funds invest in bonds of a longer maturity. Gilt funds are more vulnerable to yield shifts.
• Monthly Income Plans (MIPs) is often a misnomer. They do not assure any monthly income. Instead, they are closed ended debt funds that invest in bonds where the duration matches that of the fund to minimize the rate risk. In an Aggressive MIP, proportion of equities can be as high as 25-30%. A conservative MIP restricts equity to just about 5-10% of the portfolio. In an MIP, the purpose of equity is not for long term wealth creati
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