What are mutual funds?
Before going to types of mutual funds let’s understand what are mutual funds. Mutual funds are organisations that create a pool of money that is collected from investors and are invested by professionals in different asset classes like security, stock, bonds, etc.
These professional investors take the decision where to invest the money to produce a capital gain or income. They then distribute the money back to their original investors after keeping a small share for themselves. This small share is known as the expense ratio, and it generally ranges from 0.5% to 2%.
Types of mutual funds
Now let us see the different types of mutual funds available and the differences between them. There are many different types of mutual funds, but mainly they are of 4 types:
Let’s have a look at each of them in detail.
1. Equity Funds or Growth Funds
Equity mutual funds are those funds that are invested in stocks, and that is why they are also known as stock funds. As the money is invested in the stock market, so they are highly volatile and yields a high return. Equity funds are preferred by investors who are not much experienced or have a small capital to invest yet want a higher return.
As these are high risk and high return funds, more investors invest in equity funds. According to the Investment Company Institute (ICI), approximately 55 per cent of the mutual funds in the market are equity mutual funds.
Equity funds can be further sub-divided into 3 main categories depending on the goal of the funds.
Size of Company
Depending upon the market capitalization, the equity fund can be divided into three parts:
- Large Cap Funds: Companies whose evaluation is equal to or more than $10 billion.
- Mid Cap Funds: Companies whose net worth ranges between $2 billion to $10 billion.
- Small Cap Funds: Companies that are worth $300 million to $2 billion.
International and Global Funds
Depending upon companies location, the equity funds can be divided into international and global funds. It gives the investor the ability to target companies of different countries that are small, fast-growing and high returning.
- International Funds: Funds that are invested in companies that are located outside the home country.
- Global Funds: Funds that are invested in companies that are doing business anywhere around the world including your own country.
Industry or Sector Funds
Industry or sector funds is another type of equity fund. When the funds are invested in target-based industries or sectors, then it is known as industry or sector funds. A sector or industry consists of a group of companies that operate in the same line of business such as healthcare, aviation, oil and gas, real estate etc. For example, JPMorgan and Bank of America are part of the banking sector, Abraxas Petroleum and Adams Resources & Energy are part of the oil and gas sector.
If you are an investor you might have noticed that if a particular stock is doing good on a certain day, other stocks in the same sectors may also be doing well. It is because investors believe that if a certain sector is doing well, then all companies of the sector will tend to perform well in future.
Value funds are those funds where the money is invested in companies whose stocks are undervalued by the market. The value fund investors select the stock based on its fundamental characteristics associated with a stock’s intrinsic value. Value funds are used for long term investment where the money is allocated in stock to grow gradually over time. Therefore, value funds investing requires a lot of diligence and patience.
Key points of Equity Fund
- The funds are invested in stocks of companies.
- Higher risk and higher return.
- Requires long term investment.
- Returns depend on the stock market.
2. Bond Funds or Debt Funds
Bond funds are the second most popular fixed income mutual funds. A bond fund investment selects the assets that pay a fixed return. These funds are invested in government and corporate bonds and other debt bonds. Therefore, a bond fund is also referred to as a debt fund. As per the Investment Company Institute, 20 per cent of the mutual funds in the market are bond funds.
Bond funds are considered less risky and generate lower interest income as compared to equity funds. As the risk is minimal, it is best suited for investors that are near to retirement. The interest rate of a bond fund is more than the interest rate of money market investments and certificates of deposit. The risk is also higher than the two because there are many different types of bond funds and return depends on the types of bonds.
How do bond funds work
Let’s see an example to understand how do bond mutual funds work.
Suppose there is a company ABC that needs a loan of $1000, and you lend the company $1000. In return, the company issues a bond to certify the transaction. Thereby, the company ABC becomes the bond issuer. In this bond, the company mentions the principal amount, maturity of the bond and annual interest rate. By this example, the principal amount is $1000 and let’s say the maturity of the bond is 3 years and the interest rate is 7 per cent. Therefore, your income will be 7% of 1000 equals $70 per year. If you find it to be a good deal, you can become the bondholder by investing in the company.
The bond issuer promises to pay you $70 every year, and also return the principal amount ($1000) by the end of 3rd year. But there are some risks like, in case the bond issuer doesn’t have enough money to pay you. This risk is known as credit risk. Therefore, the risk depends on company to company.
Good and stable companies that have strong revenue, good cash flow and profit provide low-interest rates but tend to be less risky. These companies have high credit ratings. Whereas unstable companies with shaky financials give a higher interest rate but are riskier. The credit risk of these companies is higher.
Key points of Bond Fund
- It has lower risks and provides a lower return.
- Short and long term investing.
- Funds are invested in government bonds, corporate bonds and other debt bonds.
- It gives a fixed income return.
3. Balance Funds or Hybrid Funds
Hybrid funds are another type of mutual fund where the money is invested in different asset classes. It is basically a combination of equity and debt funds. Therefore, investors have the option to invest in the different asset classes. These funds provide cushioning to investors who want to take risks but still want to maintain a safety net.
Investors can be conservative to moderate and aggressive depending upon their risk-taking capacity. Therefore, a hybrid fund is divided into three parts depending upon the investors capacity to take risks.
- Balance Funds: It is a type of hybrid fund where the money is invested in a combination of equity and debt funds. The investment proportion comprises nearly 40% to 60% equity funds and 60% to 40% debt funds. The risk is moderate.
- Conservative Hybrid Funds: In a conservative hybrid fund, the funds are invested 10% to 25% in stock funds and the rest 75% to 90% in debt funds. As the majority of assets are invested in debt funds, these are much safer funds.
- Aggressive Hybrid Fund: It is a type of hybrid fund where 60% to 80% of the funds are allocated in stock funds and the remaining 20% to 40% in debt funds. As the majority of the money is invested in stock funds, the risk is comparatively higher.
Key points of hybrid fund
- In a hybrid fund, the money is invested in equity and debt funds, as per the risk investor can bear.
- Moderate risk and moderate return.
- Short and long term investment.
4. Money Market Funds
Money market funds are fixed income short term debt funds that are invested in highly liquid instruments maturing in less than 12 months. These instruments comprise cash and cash equivalent instruments like Treasury bills, certificates of deposit and commercial papers.
- Treasury bills are issued by the government against loans for a specific period of time. These are very safe to invest in but gives a lower return compared to corporate bonds.
- The certificates of deposit is a type of term deposit offered by banks where customers can keep their money untouched for a fixed period of time. The interest rate is higher than the fixed deposits.
- Commercial papers are promissory notes offered by companies to generate short term loans. The commercial papers of high-rated companies are generally safe and offer higher interest rates.
Money market funds are considered to be one of the safest and low returning funds. Therefore, you don’t have to worry about losing your money. As per the Investment Company Institute, about 15% of mutual funds in the market are money market funds.
Key points of Money Market Fund
- Funds are invested in Treasury bills, commercial papers, certificates of deposite.
- Low risk and low return.
- Short term investment.
How to invest in mutual funds
To start investing in mutual funds, you need to open an account on one of the trading platforms. Register on any of the platforms and complete your KYC. You will require photo identity proofs, passport size photo, PAN card and a cancelled cheque.
Groww is an online platform that allows investors to invest in mutual funds, stocks, initial public offerings, digital gold, and exchange-traded funds. It was started by four former Flipkart employees in 2016 primarily as a mutual fund investment platform. The company is headquartered in Bangalore, Karnataka and has raised over $1 billion by May 2021.
Upstox is an online trading platform launched by RKSV that allows online trading in Equity, Commodity and Currency Derivatives trading services at BSE, NSE and MCX. It was launched to make online trading easier and cheaper. Upstox allows trading through the website and mobile app that offers trading, analysis, charting and many other rich trading features.
Benefits of mutual funds
Mutual funds allow the investors to invest in the short term as well as long term. Also, it gives the investor the ability to manage the risk. Let’s see some of the benefits of mutual funds.
1. Professional Management
When you invest in mutual funds your funds are invested by professional investors, also known as fund managers. These professional investors invest your funds in different stocks, bonds and other debt funds as per the current market situation. You will get the best returns without much hassle.
Investing in mutual funds allow you to withdraw your money anytime. Most mutual funds do not have any lock-in period that means you can redeem your funds anytime you need money. But there is a small exit load that you must consider if you withdraw your money within seven days.
Mutual funds give you the freedom to select the risk appetite and time frame for investment. That is why it is preferred by most investors, as investors get to choose from high-risk high reward to low-risk low reward. Therefore, it has something for every type of investor.
4. Low Cost
Mutual funds are one of the most cost-effective investment avenues. Fund managers charge a small fee ranging from 0.5% to 1.5% of the invested value. But this is a very small amount compared to the returns and liquidity they offer.
5. Good Return
Equity funds have given better returns in the long term than any other investments.
6. Safety and Transparency
As per the government guidelines, all mutual funds products must have colour codes. This helps the investor to understand the level of risk on the product.
Blue indicates low risk
Yellow is for medium risk
Brown indicates high risk
Also, you can verify the credentials of your fund manager, his qualifications, experience, asset under management (AUM) and details of the asset house where your funds are invested.
It allows you to diversify your portfolio by investing in different asset classes. When the money is invested in different asset classes the risk is minimised as all the asset classes rarely decline together.
Mutual funds are not traded in the open market. Investors can trade mutual funds through an authorized broker or directly with the fund.
There are various apps such as Groww and Upstox that allows you to invest in mutual funds.
You can invest in mutual funds through a broker, a brokerage, an advisor or directly through the mutual fund.
Mutual fund orders remain open until the market closes at 4 p.m. Eastern Time and are executed from 5:00 p.m. to 6:30 p.m.