Most preferred investment options may very well be saving money through mutual funds. Mutual funds provide the widest possible opportunity according to your financial goals, risk tolerance, and investment horizon. However, such diversities create a maze from which many fail to find an exit. This blog is an attempt to demystify mutual fund types, thus helping you choose them more prudently. We will break down each kind, the purpose, advantages, and risks, and understand which suits a particular investor.
Key Take-Away
- Mutual funds collect money from diversified investors and invest it in a pool of assets, which are managed professionally.
- Equity mutual funds invest mainly in shares so are the best for an investor who can take a long-term risk.
- Debt mutual funds will therefore be ideal for conservative investors looking for stable returns in its fixed-income securities.
- Hybrid funds combine a mix of both equity and debt to provide a balanced approach, ideally for moderate risk-takers.
- Index funds and Exchange-Traded funds mimic market indices and are the low-cost alternative investment products with a minimum management fee.
- Sectoral and Thematic funds focus on specific industries or themes, carrying higher risk but the potential for high returns.
- Solution-Oriented funds are designed specifically for retirement or possibly education for children, among others.
- Other Specialized funds include International, Fund of Funds, and Commodity Funds, diversifying across different asset classes or geographies.
Understanding these types of mutual funds will facilitate taking your investment decisions directly aligned with your financial goals, time horizon, and risk appetite.
What is a Mutual Fund?
A mutual fund is an investment plan that pools money from a large number of investors and invests in a diversified portfolio of assets, such as stocks, bonds, or other securities. Professional fund managers administer the plan, making decisions and investments to achieve a specific set of objectives-from capital appreciation and income generation to wealth preservation.
Mutual funds benefit investors in several ways: diversification, professional management, and liquidity. However, the returns will be based on which type of mutual fund you are investing in because each category has its own risk-return profile.
Types of Mutual Funds
Mutual funds can be classified into several classes, such as the asset class, investment objectives, and risk level. There are some of the principal types:
1. Equity Mutual Fund
Equity mutual funds mainly invest in the stocks of the companies. Such funds try to generate higher yields via capital appreciation over time and, therefore, suitable for long term wealth creation and growth. However they carry greater risk due to the volatilities of the stock market.
Types of Equity Mutual Funds
Large-Cap Funds: Invest in large, established companies with a stable track record. These funds are relatively less risky as compared to other equity funds.
Mid-Cap and Small Cap Funds: Smaller companies, whose growth prospects are higher but riskier and hence more volatile.
Multi-Cap Funds: Spread investments across large, mid, and small-cap companies to balance risk and reward.
Sector/Industry Funds: Sector funds are sector wise investments like in technology, health, energy, etc. These funds carry a high risk because they are heavily concentrated in one industry but promise high rewards in case the specific industry performs well.
Theme-based funds: Invests in emerging markets, artificial intelligence, or renewable energy and therefore access to a specific niche segment of the economy.
Who Should Invest?
Equity mutual fund investments are suited for investors having a long-term investment horizon of 5-10 years and more and who can absorb significant market volatility. Investments in equity mutual funds are well-suited for those who wants to build long-term wealth and are willing to take risks related to the volatility of the equity market.
Pros:
- Chance to earn high returns over the long-term.
- Spread your investment across stocks of different companies and industries.
- Handled by experts who understand the stock market.
Cons:
- Higher risk because the market can be unpredictable.
- Returns aren't guaranteed and can change a lot in the short term.
2. Debt Mutual Funds
Choosing Debt Mutual funds, allows investing in fixed income securities such as government bonds and corporate bonds, and money market instruments. Such funds are considered safer than equity funds. Conservative investors seeking reasonable income with less risk may opt for this kind of fund.
Types of Debt Mutual Funds
Liquid Funds: Invest in treasury bills or certificates of deposit. This is the best investment for up to 90 days and is highly liquid with minimal risk.
Short-Term Debt Funds: These invest in debt instruments with maturity periods of 1 to 3 years. Thus, these funds promise moderate returns with relatively low risk.
Long-Term Debt Funds: A fund that focuses on debt securities with a maturity of more than 3 years. Its returns can be affected by a change in interest rates, but returns are higher than short-term debt funds.
Credit risk funds: Invest in low-rated corporate bonds, but yield is a little better. High-risk, but the possibility of getting returns can be higher.
Gilt Funds: These invest only in government securities, thus being one of the safest debt funds. It is less risky in nature but produces moderate returns.
Who should invest?
Debt funds are apt for risk-averse investors seeking capital protection and stable returns. They would be suitable for a short to medium-term investment objective or for diversifying the risk in a portfolio dominated by equities.
Pros:
- Lower risk than equity funds.
- Steady income from interest payments.
- Suitable for short- and medium-term investment objectives.
Cons:
- Lower returns than those of equity funds.
- Sensitive to interest rate changes, which have the impact on returns.
3. Hybrid Mutual Funds
Hybrid mutual funds are also known as balanced funds as they invest both in equity and debt instruments. Balanced funds are investment schemes that find a balance between risk and return for the investor through combining the growth potential of equities with the stability of debt securities.
Types of Hybrid Mutual Funds
Aggressive Hybrid Funds: It invests heavily in equities up to 75% and the balance in debt. These funds are advisable for those who seek equity-like returns with some protection against the vagaries of the market.
Conservative Hybrid Funds: Indulge in higher allocation to debt, up to 75% and marginally in equities, which ensures stability while limiting exposure to market volatility.
Balanced Advantage Funds: The proportion of equity and debt is managed dynamically based on the assessment of market conditions-continuously maintaining a balance between risk and return.
Who Should Invest?
Hybrid funds are suitable for moderate risk-takers who would want to get exposure to a combination of equity and debt through one fund. They fit well with investors seeking growth plus income and with people looking to diversify their portfolios.
Pros:
- Balanced risk return profile.
- Diversified exposure to both equity and debt.
- Best suited for medium-term investment horizons.
Cons:
- Returns are moderate, not as high as pure equity funds.
- Some risk due to equity exposure, more so in aggressive hybrid funds.
4. Index Funds and ETFs
Index funds and exchange traded funds (ETFs) try to track the performance of a particular index, whether S and P 500 or Nifty 50. They tend to buy the same stock in the same proportion as suggested/ distributed in the particular index in a relatively low cost.
Types of Index Funds and ETFs
Broad market index funds: This fund track major stock market indices, giving investors access to the entire market.
Sectoral Index Funds: Invests strictly in specific sectors, such as healthcare, technology, or financials, while imitating a sector-specific index.
International Index Funds: It can offer access to international markets and invest in international indices like the MSCI World Index.
Who Should Invest?
Index funds and ETFs are ideal investment options for cost-conscious investors who happen to prefer a passive investment strategy. Such funds are fabulous for long-term investors looking to effectively mirror the general market performance at the minimal costs of actively managed funds.
Pros:
- Low expense ratios due to passive management.
- Broad market exposure with minimal effort.
- Lower opportunity of lagging the market in comparison to other actively managed funds.
Cons:
- Limited potential for outperforming the market.
- Subject to market fluctuations.
5. Sectoral and Thematic funds
Sectoral and thematic mutual funds look for specific sectors, such as technology, energy, or pharmaceuticals or themes (e.g. digital transformation, clean energy, or healthcare innovation). Such funds are very focused and are considered riskier as this is more concentrated within one particular industry or theme.
Type of Sectoral and Thematic Funds
Sectoral Funds: Investment in specific industries such as Banking, IT, or Real Estate.
Thematic Funds: Focuses more on the bigger investment themes-like infrastructure development, ESG (environmental, social, and governance), or demographic changes.
Who Should Invest?
These types of funds are suitable for aggressive investors who are well aware of their respective industry or theme. Additionally, they may be helpful to investors who would like to cash in on the short-to-medium-term sector and theme plays.
Pros:
- Potential: very High returns if sectors or themes perform well.
- It allows investors to target high-growth industries or emerging trends.
Cons:
- High risk because it has concentrated exposure towards a particular sector or theme.
- Performance is extremely sensitive to the success of the sector/theme.
6. Solution-Oriented Mutual Funds
Solution-oriented mutual funds are also created for specific savings requirements, such as retirement or funding one's child's education. Such funds usually carry a lock-in period after which investments can be withdrawn, hence holding the investment for as long as is required to reach the desired financial end.
Types of Solution-Oriented Funds
Retirement Funds: They are meant to offer steady income after retirement. Invest for the long term during working years and invest in safer funds closer to retirement.
Children Education Funds: These are long-term saving tools for funding the education of your child. Most of these funds invest in an equity and debt mix with the objective of securing wealth appreciation through early years and then moving toward capital protection as the child approaches the age when the funds will be required for education.
Who Should Invest?
Solution-oriented funds are best suited to those with specific financial goals and long investment horizons. It can develop a pool of resources systematically put aside for specific milestones-like your child's education or your retirement-through these funds.
Pros:
- Targeted towards specific long-term financial goals.
- It encourages saving discipline through a lock-in period.
- Managed to consistently balance growth and capital protection over the long term.
Cons:
- Limited liquidity due to the lock-in period.
- Returns depend on market conditions, particularly for funds with significant equity exposure.
7. Other Specialized Mutual Funds
In addition to debt, hybrid, and solution oriented funds, there are specialized mutual funds which cater to still more niche investment preferences. It also helps investors to diversify across geographies, asset classes, or even other funds.
Types of Specialized Mutual Funds
International or Global Funds: Invest in international markets, providing exposure to foreign companies and industries. These help diversify beyond the domestic market and can give exposure to global growth opportunities but carry currency and geopolitical risks with them.
Fund of Funds (FoF): These invest in other mutual funds and not in stocks or bonds directly. They do this hoping to further diversify their investment by packing many mutual funds into one fund, but the management fees on the FoF and the underlying funds can send the expense ratio up.
Commodity Funds: These funds invest in commodities, like gold, oil, or agricultural products. These provide investors with protection against inflation and a way to diversify into another asset class, though generally these funds are a bit more volatile than traditional equity and debt funds.
Who Should Invest?
These specialized funds are suitable for investors looking for diversification beyond traditional asset classes or geographic boundaries. They are also suitable for people hoping to hedge against certain risks, such as inflation or currency fluctuations, or who wish to gain exposure to global or commodity markets.
Pros:
- Investment access to global markets, commodities, or multiple funds through one investment.
- Diversification across asset classes, industries, or geographies.
- Potential to hedge against particular risks, such as inflation or currency devaluation.
Cons:
- Higher management fees, especially for the Fund of Funds. Increased complexity and risk compared to traditional mutual funds.
- Volatility, especially for commodity funds, is generally caused by shifts in world market conditions.
Conclusion
In that respect, mutual funds provide plenty of avenues of investment that match varied financial objectives, preferences, and horizons. From wealth creation over the long term, stable income, diversification into thematic sectors, or global markets, there is a mutual fund for you.
Knowing different types of mutual funds such as equity, debt, hybrid, index, sectoral, thematic, solution-oriented, or specialized may help you make wiser choices and match your investment to your financial objectives.
It is important to assess your risk appetite, time horizon, and investment goals when selecting a mutual fund. Equity funds offer high return potential, but they also come with higher risks and volatility.
On the other hand, debt funds give stability, while hybrid funds balance between the two. Specialty funds offer unique exposure, perhaps to international markets, commodities, or even other mutual funds, but this often comes with higher risks or costs.
Working with a financial advisor will help you consider your choices and know your investments are working in concert with your long-term financial plan.
Frequently Asked Questions (FAQs)
1. How do I choose a mutual fund that is best for me?
Choosing the right mutual fund depends on your financial goals, risk tolerance, and investment horizon. If you’re aiming for long-term wealth creation and can tolerate high risk, equity funds may be suitable. For conservative investors, debt funds may be better. Hybrid funds balance risk and reward, while sectoral or thematic funds suit those looking for targeted growth opportunities.
2. Distinguish between the equity mutual funds and the debt mutual funds.
Equity mutual funds majorly invest in the stock market, which are hence potentially riskier but offer higher returns over longer periods. Debt mutual funds invest in fixed-income securities like bonds, offering stable returns with lower risk.
3. Discuss any six benefits of investing in mutual funds.
For diversification, ease of management, and high yield on investment, mutual funds offer that. One can also come in with relatively small amounts compared to direct investments in stocks and bonds.
4. Describe the risks associated with mutual funds.
Risks vary for each type of fund. Equity and debt funds expose themselves to volatility and changes in interest rates, respectively, while sectoral/thematic funds risk concentration. Hybrid funds invest in equity and debt to balance risks.
5. What is Index Investing and How is it Different from Actively Managed Investing?
Index funds are managed on a passive management basis and try to replicate the performance of some particular index, like Nifty50. Typically, they have lower fees than those managed on an active basis, where decision-making by a fund manager over investments attempts to achieve better performance than the market.
6. Can I make losses in mutual funds?
Yes, mutual funds do come with a market risk; one can really lose money. Even equity funds are quite volatile, and debt funds might lose out if interest rates increase. You should ensure that your risk appetite matches the kind of fund you invest in.
7. What minimum investment amount is required in Mutual Funds?
This does vary, of course, in terms of what is the minimum amount of investment for mutual funds. Indeed, many funds allow the possibility that one can invest as low as 500 or less through what is called Systematic Investment Plans (SIPs).
8. Define SIP or Systematic Investment Plan.
SIP stands for Systematic Investment Plan, meaning investments in mutual funds of fixed amounts but made at regular intervals. It averages out the cost of investment and brings down the impact of market volatility over time.
9. Are mutual funds taxed?
Yes, mutual funds returns are chargeable to tax. Returns from equity funds are charged to tax depending on capital gains (short-term and long-term). Returns from debt funds are charged to tax according to your income tax slab for short-term gains and charged at a lower rate for long-term gains. Index funds and ETFs also have similar tax treatments.
10. What is a mutual fund expense ratio?
Expense Ratio: The fee that a mutual fund company charges investors for administering the fund; includes administrative and management fees. Lower expense ratios generally mean a higher net return for investors.
11. What is a Net Asset Value (NAV)?
NAV is the per-unit price of a mutual fund. It is calculated by dividing the total assets of the fund minus liabilities by the number of outstanding units. NAV changes daily based on the value of the underlying assets.
12. What is the ideal holding-period for mutual funds?
The period of investment would be determined by the type of mutual fund and your personal financial goals. Normally, equity funds are long-term funds ranging from 5 years and above, with debt funds and liquid funds going in for much shorter periods, possibly 1-3 years. Solution-based funds like mutual funds for retirement or education are designed within that specific time frame.
13. What are sector funds and thematic funds, and how risky are they?
The sectoral and thematic funds focus on single industries or investment themes like healthcare, technology, ESG, and artificial intelligence. From this, these funds appear to be riskier since they are concentrated in an area, which can be more volatile compared to diversified funds.
14. How do I redeem or transact units of my mutual fund?
You can redeem your units of a mutual fund by putting a request for redemption either on the website, the application, or in the office of the fund house. The redemption results in the money being credited to the bank account of the unit holder in a couple of business days.
Disclaimer: The content on this website is for educational purposes only and should not be considered investment advice. Always conduct your own research and consult a financial advisor before making investment decisions. Have a profitable day!