Chapter 7: Types of Mutual Funds
Mutual funds in India are proliferating, and there’s no doubt about that, as we discussed at the beginning of this guide. There are 44 AMCs registered in India as of 2023, a few more in the process of getting their mandatory licenses to operate in the industry, offering more than 2500+ schemes to an Indian investor.
These numbers are increasing daily, thanks to financial engineering done by the AMCs that allows them to launch newer ways to invest for all the mutual fund investors.
Naturally, when so many available schemes exist, how can one select a scheme best suited for investments?
Well, don’t worry we shall cover this in our guide, and as a step towards achieving this goal, we first need to understand what are the types of Mutual Funds that are available and also understand how each of the schemes is structurally designed to meet various investment objectives of an investor.
There are 4 ways we can determine the types of mutual funds available to investors in India.
- Types of Mutual Funds – Based on categorization by SEBI
- Types of Mutual Funds – Based on organization
- Types of Mutual Funds – Based on portfolio management style
- Types of Mutual Funds – Based on investment objective
Let’s understand each type of categorization step-by-step.
Based on Categorisation by SEBI
Mutual fund AMCs use financial engineering to design and launch various new products or mutual fund schemes for investors. The problem is not with innovation; innovation has been the catalyst for growth in any field, hasn’t it?
The problem is that these newly designed schemes were being packaged/ bundled with various combinations of asset classes with fancy names, catching the attention of the investors through various marketing gimmicks. Almost every AMC in the last decade has lured investors to invest in hybrid schemes. Still, little or no attention was given to investor education on the risks associated with investing in such schemes.
Now, as these hybrid schemes have a combination of various asset classes, these schemes are difficult to understand and have increased risk, which most retail investors cannot gauge while subscribing to these funds.
So therefore, with an ultimate goal of making investments more accessible and with an objective that these schemes should be easily understood just by looking at the naming conventions that the scheme is being marketed with, SEBI came up with guidelines on categorization and Rationalization of schemes in October 2017.
Based on the SEBI guidelines on the Categorization and Rationalization of schemes, mutual fund schemes are classified as –
Equity Schemes – investing in stocks.
Debt Schemes – investing in fixed market instruments such as government or corporate bonds.
Hybrid Schemes – investing in a combination of asset classes (mix of equity & debt or a combination within the equity schemes)
Other Specific Schemes – such as Index Funds & ETFs and Fund of Funds
Solution-oriented Schemes – for retirement, etc.
Each of the above has subcategories in which SEBI clearly states the asset allocation and conditions (explained in the table below).
Debt Schemes
All open-ended schemes are allocated to equity markets.
Debt Schemes
All open-ended funds having exposure in fixed instrument markets.
Hybrid Schemes
Solution-Oriented Schemes
The names of each category suggest the investment objectives. The table also suggests allocating the money that will be deployed into which asset class or combination of asset classes, thus providing complete transparency to the investors.
SEBI has done a fantastic job of Rationalising the Naming Conventions of all the schemes. There is indeed better clarity in understanding a mutual fund scheme just by reading its name, which is now self-explanatory after the implementation of the guidelines.
Some of the initiatives taken by SEBI to rationalize some of the categories.
The equity schemes category is further bifurcated into large, mid, and small cap categories. SEBI has also mandated threshold limits on the allocation of funds on a percentage basis within the schemes. This was a step towards standardizing all schemes based on categorization across all AMCs launching the same or similar schemes.
Further, to protect investors’ interests, SEBI has also ordered some scheme naming conventions, especially debt schemes, to be changed based on the risk level of the underlying portfolio. For example, the erstwhile ‘Credit Opportunity Fund’ is now called ‘Credit Risk Fund.’
Also, all ELSS funds must incorporate “ELSS and TAX SAVER“ to ensure consistency and easy identification for investors.
Some other changes such as balanced / hybrid funds are further categorized into
- Conservative Hybrid Funds
- Balanced Hybrid Funds
- Aggressive Hybrid Funds.
These initiatives have brought about a complete shift in the mutual fund industry, and such steps have made a great deal of transparency possible.
This is one way of understanding the types of mutual funds available in the mutual fund industry. SEBI’s guidelines have structured the mutual fund industry at large and are an attempt to regulate AMCs for the benefit of investors.
But as a layman retail investor, the above categorisation is just information and it may need some deeper understanding of financial markets to understand these schemes.
Based on Organization
As we learned, many schemes are available, but not all are structured similarly. Some schemes are available for purchase or sale at any point on a perpetual basis at the convenience of the investors. Then, some schemes are launched for a specific period (with a fixed maturity period) to which investors can subscribe.
There are 3 types of structures that the schemes are designed for.
Open-Ended Funds
This allows the investor to invest in the mutual fund scheme anytime after the launch of its NFO. Investors are also allowed to purchase any additional units if they wish to buy them after the launch, and they can also redeem fully or partly from the scheme as and when they wish to.
The unit capital, meaning the funds in the mutual fund scheme, will fluctuate as some investors invest or redeem the scheme, but the fund continues to operate with the existing investors who own the units issued by the AMC.
Most mutual fund schemes issued these days are open-ended since they provide greater liquidity and comfort to investors.
Close-ended Funds
These are schemes issued by the AMC for a particular period (having a fixed maturity). After the maturity period, the units are canceled, and the money is returned to the investors (including any gains or deducting losses, if any).
Investors cannot transact with the fund once the NFO is closed. However, after the NFO is closed, the fund issuing close-ended funds must list them on a stock exchange to provide some liquidity to its investors.
Those who wish to redeem the funds can go to the exchange and see if there are any buyers for the same scheme. If there are, they can give their units to the counterparty buyer.
Interval Funds
These are funds that combine open-ended and closed-ended funds. Interval funds are largely open-ended, meaning they are open for investors to buy or redeem for a specific time interval, such as a few days in a month, and then they are closed for transactions.
The period when interval funds become open-ended is called the transaction period, and when the funds are closed for transactions, that period is termed the Interval Period.
Unlike closed-ended funds, interval funds provide better liquidity since investors need not depend on an exchange to look for potential buyers or sellers for entry or exit opportunities.
Based on the investment objectives
Mutual funds can also be classified based on the investment objective that an investor ought to seek.
There are three main objectives that an investor seeks while investing in mutual funds are:
- Growth – to compound their savings for long-term wealth creation.
- Income – to get regular income from their capital/savings.
- Liquidity – to park any excess funds for the short term.
Mutual funds help investors cater to all the above objectives that an investor is looking for, and there are various mutual fund schemes explicitly designed to achieve these individual goals. Indeed mutual funds offer a customized solution to fulfil every objective of an investor.
To seek the above-mentioned objectives, an investor can choose from the following categories of funds-
Growth Funds
These are funds that have higher exposure to equity markets since the objective of the fund is to create wealth in the long term. As we know, the power of compounding works wonders in the long term in the equity markets. Investors seeking wealth creation should consider investing in funds that have higher growth potential in the long term. ( you can refer to the equity schemes mentioned in the previous chapter for reference)
Income Funds
Income funds help an investor earn a regular, fixed income for the medium to long term. Investors seeking this objective should invest in medium—to short-term debt funds that have exposure to fixed money market instruments such as bonds, Gsecs, etc. A risk-averse investor can choose to deploy capital into Income funds, wherein a fixed return is generated on the invested amount, thereby creating a regular income for the investor.
Liquidity Funds
Liquidity funds are funds that have exposure to ultra-short-term money market instruments and are used by investors to park their surplus money or keep their emergency funds invested. A risk-averse investor who needs to park his/her money for a very short-term goal that they wish to fulfil or create an emergency fund value and keep it invested just to assure some liquidity can use liquid funds.
So you see the universe of mutual funds is vast, and the mutual fund houses cater to all the needs of an average retail investor so that every Investor can certainly plan the finances better.
Mutual funds do provide a great deal of flexibility to retail investors. They can use a combination of the above funds and create their own financial plan based on their risk profile.
In the next chapter, we will learn to evaluate how to a mutual fund.