What are mutual funds?
Mutual funds issue shares to each investor, which stands for the proportionate ownership in the fund’s portfolio-so the profit and loss are shared by the investor according to their investment.
Through a mutual fund, an individual investor has access to professionally managed diversified portfolios so that risk is spread across multiple securities.
Types of Mutual Funds Based on Asset Class
Mutual funds grouped by asset class focus on specific financial assets, each with distinct growth and income characteristics.
1. Equity Funds (Stock Funds)
These funds invest primarily in equities or stocks. Categories include large, mid-cap, and small-cap funds based on company size, value, growth, or blend funds based on strategy.Â
Value funds focus on undervalued stocks, whereas growth funds target companies with strong earnings.Â
Large-Cap Funds investments in large companies having stable earnings.Â
They are relatively less volatile than other equity funds and are safer as compared to equity within the equity segment.
Mid-Cap and Small-Cap Funds: Emphasis on smaller, growth companies.Â
Where there is a lot of risk involved but can provide much higher potential return, if you are willing to take greater volatility.
2. Debt Funds (Bond Funds):
They invest in fixed income from government and corporate bonds. Bonds usually bring stability of return but are risky to the investor due to interest-rate risk.Â
They are more secure than equity funds and more appealing to the investor who is looking for better-acquired returns with lesser risks.Â
Government Bond Funds investment in bonds issued by the government, which are the safest investment since they have the full backing of the government.Â
Corporate Bond Funds invest in bonds issued by companies. The returns are much higher than for government bonds but also higher in risk.
3. Money Market Funds (Short-Term Securities)
These are investments in low-risk short-term debt papers like Treasury bills, commercial paper, and certificates of deposit.Â
The money is not generally very significant in return but is used for either liquidity or emergency funds.Â
They are for those investors who are likely to take less risk but quick access to cash.
4. Hybrid Funds (Balanced Funds)
Investment in a balanced portfolio of stocks, bonds, and other forms of securities reduce the risk involved with investment.Â
Allocations into the portfolio could be done depending upon market conditions or requirements of investing.Â
They offer a combination of equities and bonds and thus provide growth and income in a single portfolio.Â
These are intended to achieve the risk and return balance-a more stable fund than just equity alone.Â
The ratio of the stock to the bond is such that both growth and stability in these funds is kept so that both the dimensions are balanced.Â
Aggressive Hybrid Funds are those which could have a more significant allocation towards equities with a view to growth opportunities with a moderate level of risk.
Types of Mutual Funds Based on Investment Goals
These funds meet specific financial goals that are unique goals and preferences of investors.
1. Growth Funds
Invest in high-growth stocks that offer capital appreciation. Growth funds suit long-term investors who prefer high growth rather than current income and who have the potential to bear the fluctuations in the market.
2. Income Funds
These funds mainly provide the investor with regular income as they are invested in bonds and high-quality debt.Â
These are good for investors who are looking for a steady income after retirement without much risk of the invested sum.
3. Liquid Funds:
It is an instrument of short-term debt with the aim to preserve liquidity and capital. These funds provide instant liquidity in case of an emergency and are involved with almost nil risk. They are considered apt for emergencies or short-term investments.
4. Tax-Saving Funds (ELSS-Equity-Linked Savings Schemes)
These equities funds are tax saving under Section 80C of Income Tax Act.Â
They have a lock-in period of three years and are best suited for those who are looking for capital appreciation along with income-tax saving.
5.Aggressive Growth Funds:
These investments are best suited to those who are looking for capital appreciation with a high risk appetite and long-term investment horizon.
6. Capital Protection Funds:
These funds are to protect principal investment with small returns.Â
Investors invest part of their asset base in low-risk debt instruments.Â
They are best suited for those clients are willing to take minimal risk on their capital
7. Fixed Maturity Funds (FMF):
The FMFs invest in securities whose maturity date is the same as that of the fund.Â
Such funds ensure that returns are predictable and the interest rate risk is minimized. They offer stability for a given period to those investors.
8. Pension Funds:
Pension funds primarily serve the purpose of saving for retirement, working in the long term through the correct balance of equity and debt investments.Â
It is highly for investors who wish to look forward to having a safe financial future after retirement.
Types of Mutual Funds Based on Structure
The structure of a mutual fund determines the trading flexibility, entry, and exit points of that fund.
1.Open-Ended Funds
Open-ended funds offer investors an opportunity to buy and sell units that are highly liquid at any given time.Â
They are used for the long-term because an investor is always free to enter or leave at their will.
2.Closed-Ended Funds
These funds have a limited number of units issued and have a predetermined maturity date. One can buy units during the new fund offering period and are freely traded on the stock exchanges.Â
This type of fund is ideal for investors who want to make disciplined investments for a long-term investment.
3.Interval Funds
Interval funds derive their characteristics from both open- and closed-ended funds.Â
In this type of fund, unit holders can exercise the right to redeem units only at certain intervals.Â
Thus, one finds a balance between their liquidity and the need for long-term investment.
4) Index Funds
They purchase a specific index, such as the S&P 500. Fees and expenses are relatively low; hence, they are especially appealing to cost-sensitive investors.
Types of Mutual Funds Based on Risk
Mutual funds vary by degrees of risk in order to accommodate various risk tolerances of investors.
1. Very Low-Risk Funds
These are funds from money market funds and are placed mostly in low-risk securities.
These are ideal for conservative investors who are keen on capital preservation rather than growth.
2. Low-Risk Funds
Funds, such as government bond funds provide a steady income with slightly higher returns than very low-risk funds.Â
These funds are suited for investors who can bear less risk but would like to get more than the nominal returns.
3. Medium-Risk Funds:
Balanced funds that invest in equities and debt. The idea is to achieve moderate growth by controlled risks.Â
These are best suited for investors who desire investment with middle ground between pure growth and pure safety.
4. High-Risk Funds
High-risk funds include sector-specific equity funds, mainly used to achieve high capital appreciation with higher volatility.Â
These funds are for investors who are willing to take risk in the short run for high long-run gains.
Specialized Mutual Funds
There exist mutual funds based on certain unique investment opportunities through specific markets, strategies, or sectors.
1. Industry Funds:
Industry funds invest in a particular industry like that of technology or healthcare so that one can gain from the growth of the sector.
2. Index Funds:
Index funds copy the market index, like that of S&P 500. Funds are low-cost investments that provide an exposure to the general market or to its parts. They are mainly meant for passive investors.
3. Funds of Funds:
Invest in other mutual funds which give instant diversification in one single fund.Â
They are for the investors seeking broad exposure but have no desire to select individual funds.
4. Emerging Market Funds
Invest in the developing economy, which gives a chance with high growth potential and at the same time carries a higher risk.Â
They offer an opportunity to gain share from the growth of the emerging markets.Â
These investments are into foreign markets, thus widening the risk beyond the home country of the investor.Â
They have been made accessible as a way of reaching other countries’ economies and trends.
5. Global Funds
Investment in a combination of domestic and international assets. This gives investors an opportunity to invest across the globe.
6. Real Estate Funds
Exposure to real estate markets without actually owning any property. This is ideal for an investor seeking real estate diversification.
7. Commodities-Based Stock Funds
Investing in companies that operate on commodities such as oil, gold or agricultural products provides indirect commodity market exposure.
8. Market Neutral Funds
Such funds are targeted to reduce the market risks through the balancing of long and short positions, which makes it workable for steady returns among investors in any type of market.
9. Inverse/Leveraged Funds
These funds utilize either financial strategies to enhance their returns by leveraging the position with borrowed money or generate returns inverse to a specified index.Â
These funds are only for those investors who are willing to take high risk.Â
10. Asset Allocation Funds
Change the asset mix automatically through predefined strategies, maintaining some specific risk/return profile, which is appropriate for investors seeking hands-off diversification.
11. Gift Funds
Fund offerings designed specifically for charitable giving offer potential tax benefits and support to donor-specified causes.
12. Exchange-Traded Funds (ETFs)
Like stocks, ETFs trade on an exchange but bring mutual fund-like diversification.Â
ETFs just so happen to be the most popular investment that investor looks for, seeking liquidity, flexibility, and low-cost market exposure.
Advantages and disadvantages of Mutual Funds
Advantage:
Diversification: A mutual fund gives an investor exposure to different securities. The risk is thus diversified among various assets, industries, and regions.
Liquidity: One can easily buy and sell mutual funds, which provides the investor flexibility in accessing funds when needed.
Professional Management: Investors will be able to take advantage of expert management that monitors and adjusts the portfolios.
Diversification of Offerings: The diversification is achieved through different types of investment strategies, such as growth funds, value funds, and specific sector funds, etc.
Disadvantage:
Fees and Charges: Management charges trading costs reduces investors returns,Â
Cash Drag: Mutual funds keeping part of their assets in cash would drag returns down if market performance were good.
No FDIC Insurance: Mutual funds are not insured by the Federal Deposit Insurance Corporation (FDIC), and thus, it is possible that all the money invested may get lost.
Dilution: Successful investments may become very large, then it would be hard for managers to find a good investment and dilute returns.
Closing-of-Day Trading: For mutual funds, transactions are settled only at the end of a trading day, and thus, it does not provide flexibility as equities.
Conclusion
Mutual funds are useful as they diversify, provide professional management but come with the cost of being expensive, potentially dilutive, and also lack transparency on holdings.Â
Comparing mutual funds for an investor is extremely difficult due to lack of standardized metrics like P/E ratios or EPS, making investment decisions harder.Â
Despite these drawbacks, mutual funds are still very popular among retail investors, especially those who are looking for a more hands-off experience in investing and have access to wide-ranging assets and markets.Â
Proper research can go a long way in ensuring that their benefits are maximized. Mutual funds are convenient and diversified but have hidden costs and risks involved.