Mutual Funds: Common Types and Terminologies
Investing in mutual funds is an ideal option for those who want to diversify their portfolio and minimize risks. A mutual fund takes money (investments) from individuals and institutional investors who have a common investment objective. This pooled sum of money is managed by a fund manager that invests in various securities or asset classes to generate returns for investors. It offers professional money management, transparency, and liquidity.
In this article, we discuss some of the basic categories and terminologies related to mutual funds.
Basic Categories of Mutual Funds:
Equity Mutual Funds
Equity Mutual Funds (EMFs) generate returns by investing in stocks of public listed companies across market capitalisation (small-cap, mid-cap, and large-cap). They are typically known to generate better returns than fixed deposits or debt-based funds. EMFs can be based on a particular theme such as emerging markets, dividend yield, energy funds, tax-saving, etc. It can also be based on different sectors such as financial services, automobiles, and fast-moving consumer goods (FMCG). The profits and losses generated from EMFs depend solely on the performance of the shares included in them.
Debt Mutual Funds
These funds invest in fixed income securities such as corporate bonds, treasury bills, commercial papers, and government securities. Such debt instruments have a pre-determined maturity date and interest rate that the buyer can earn at the time of maturity. It can be a preferred choice for passive investors that have a low-risk appetite. However, movements in interest rates pose a risk to debt fund investors. [Interest rate risk is the potential investment loss that results from a change in interest rates.]
Liquid Funds invest in short-term fixed-income instruments with a maturity of up to 91 days. These funds carry the lowest interest-rate risk in the debt funds category. Liquid funds are an alternative to depositing your money in a savings bank account as it offers better returns.
An Index Mutual Fund invests in a portfolio of stocks that track or imitate stock market indices such as the NSE NIFTY and BSE Sensex. They are passively managed funds that have exposure to securities present in the underlying index in the same proportion. It aims to match the returns offered by the underlying index. Index funds could be opted by those who prefer predictable returns without taking a lot of risks.
Balanced Funds (also known as Hybrid Funds) are financial instruments that invest in a mix of both equity and debt segments in specific ratios. Fund managers keep changing the allocation/ratio based on market risks. These funds often provide the best risk-reward balance and help to maximise the return on investment (RoI).
Fund of Funds
Fund of funds (FoFs) is a type of mutual fund that utilises the money pooled from its clients to invest in various other types of mutual funds available in the market. Thus, the returns of an FoF depend on the performance of the target fund.
Tax Saving Funds (ELSS)
An Equity-Linked Savings Scheme (ELSS) is a category of mutual fund that helps in saving taxes. It provides the dual advantage of wealth creation and tax saving under Section 80C of the Income Tax Act. By investing in ELSS mutual funds, you can claim a tax exemption of up to Rs 1.50 lakh from your annual taxable income. To learn more about ELSS, click here.
Asset Management Company
An AMC is a company registered with the Securities and Exchange Board of India (SEBI) that handles asset management and investment decisions for mutual funds. The top AMCs in India include SBI Mutual Fund (MF), ICICI Prudential MF, HDFC Mutual Fund, Aditya Birla Sun Life MF, Nippon India MF, and Axis MF.
New Fund Offer (NFO)
Asset Management Companies launch New Fund Offers (NFOs) to issue units of their new mutual fund schemes. Units are similar to shares issued by companies during an initial public offering (IPO). Through an NFO, investors can purchase units of a mutual fund at the subscription price. The offer price is usually set at Rs 10 per unit. Funds are launched via NFOs for a limited time period, following which they are traded in the market based on their corresponding net asset value.
Before applying to an NFO, make sure to review the past performance of the AMC and the fund manager. Also, ensure that the fund matches your investment strategy and risk appetite.
Net Asset Value
Net Asset Value or NAV is the price of each unit of a mutual fund. It is the weighted average value of the stocks and other assets in the scheme/portfolio. NAV is calculated by deducting the liabilities from the total asset value and dividing it by the number of shares. It is calculated at the end of each trading day.
NAV is not an indicator of the future prospects of a scheme. Moreover, a mutual fund with a lower NAV does not mean that it is not performing well when compared to a fund with a higher NAV.
Open-Ended and Closed-Ended Funds
Open-Ended Funds are mutual funds whose units are open for purchase and redemption at any time. There are no limits on the duration and amount a person can invest. All transactions of such fund units are done at the prevailing NAVs. Open-ended funds are ideal for those who want liquidity in their investments as they are not bound to any maturity period.
Closed-Ended Funds are those funds in which units can be purchased only during the initial offer period (NFO). The units can be redeemed at the specified maturity date.
Interval mutual funds are a cross between open-ended and close-ended funds. It allows transactions at specific periods. Investors can choose to purchase or redeem their units when a trading window opens.
As the name suggests, expense ratio is the annual maintenance charge levied by mutual funds to finance its expenses. It includes the annual operating costs, including management fees, allocation charges, and advertising costs of the fund.
Entry Load and Exit Load
Entry Load is the amount payable by an investor while joining a mutual fund. As per recent SEBI regulations, the entry load is removed from the calculations of the total expense ratio of a mutual fund.
Exit load is the amount payable when an investor chooses to withdraw from a mutual fund. This charge is payable on the total investment of an individual, usually standing at 1%. It is used as a tool to discourage people from withdrawing funds from a mutual fund and keep investing for the long term.
We would like to remind our readers to invest in mutual funds only after a thorough understanding of the objectives, theme, expenses, and risks involved. Also, ensure that the strategy deployed by the fund manager aligns with your investment goals. HAPPY INVESTING!