Mutual funds Demystified (Part 1): The Basics

Mutual fund is a fund or a common pool of money for a common purpose i.e. to invest in an asset class and to get the best return possible. The returns are generally based on the NAV (Net Asset Value) of the fund, which I will explain in a different blog entry soon. Mutual funds can be divided into the following types:

Based on the maturity of the fund: Here we have open ended and closed ended funds. Open-ended funds as the name itself suggest is a no lock in funds and can be invested and redeemed any time. Lock in funds on the other hand is locked in for a specific duration and can only be redeemed on the specified dates with or without load or on maturity example will be the fixed tenure funds issued by few fund houses fund houses.

Based on Charge/Load: There are two types of load, entry and exit. Entry is when we buy the funds, we have to pay some charge ideally it will be 2.5%. Exit load is when we come out or redeemed the funds. Ideally for exit load there are some conditions like redeem within six months with x% or later than that with y%. All these information will be available in the key information memorandum.

Based on the investment avenues/objectives: Investment avenues here mean the place where the money is invested by the fund. It’s based on the investment objectives. Avenues/Objectives can be the following
Liquid Fund : Liquid funds generally invests into safe papers like money market, certificate of deposits, treasury bills etc. The returns of these schemes generally fluctuate based on the interest rate.
Floating Rate Fund: Floating rate funds minimize the interest rate risk by investing in floating/fixed rate instruments. Fixed rate instruments include rated corporate paper. The advantage is protection of capital & market returns.
Gilt Fund: It is a liquid, which invests only into government securities. The interest rate risk applies here.
MIP: Also called monthly income plan, though nothing like a plan, which gives monthly returns. They have a mix of equity and debt/liquid plans in various ratios ideally it would be 30-20% equity and rest debt/liquid. Its ideal for risk averse people as the money is not totally invested into equity or into debt. Though personally I don’t like this fund because I believe in making a complete diversified portfolio including pure debt, equity, PMS, Stocks, real estate etc based on the risk profile, cash flow, goals and time horizon. My logic is to choose the best in each segment and not a mix.
Balanced Fund: Its something like an MIP. The difference is it tries to balance the portfolio of the fund by investing equally in equity and debt. This is ideal but practically it does not happen due to the tax rule, which states that any fund to get the benefit of diversified equity fund should have more than 65% invested in equity shares. The tax on diversified equity fund is less than debt funds. Shall be explaining in detail the tax structure on various asset classes later in my blog. So keep reading.
Equity Funds: Funds, which invests into equity stocks and shares of various companies. The details are Diversified Equity Fund: Funds, which invests more than 65% into equity. The tax structure is better than debt funds. It invests into companies in various industries so its diversified. The more diversified the better the equity fund. (Though not always. Shall explain why in my upcoming articles. Keep reading)

Caps Focussed Funds: These funds invest in some specific market capitalisation companies. Example are large cap funds investing into large cap companies or small cap investing tnto small companies. The highest market cap companies are called large cap. Though there is no rule which specifies a caps, but generally 5000cr capitalisation & above companies are called large cap, 1000 to 5000 cap are called mid cap and lesser than that are called small cap. The lover the cap the higher the risk in investment. There are also some funds which invests into all the caps like a diversified fund but has the flexibility to move between the caps to get the advantage of market movements. Example are Franklin Flexicap.

Specific Opportunity fund: These are funds which specifies some opportunities example are Fidelity India Special situations which has specified some special situations like mergers and acquitions, take over etc wherein their investment is only to those companies which might come into these situations on a later date and thereby profiting from it. there are also others like Dspml TIGER

Sector Funds: These are equity funds, which are invested, in some specified sectors like pharma, automobile, banks, IT etc. example are Diversified bank fund which only invests into banks or pharma funds which invests only into pharma companies. Personally I don’t like these as I feel one should be fully diversified.

Index funds: When the stock market fluctuations are high as we are observing recently the best place to invest is index fund. The funds try to imitate the market, say for ex if it’s a nifty linked index fund it will try to imitate the nifty. If nifty goes up by 5 % the fund to will go by 5% or vice versa.

ELSS: Equity linked Savings Scheme is a diversified equity fund mainly in the large cap arena. It gives tax benefit under sec 80 C though its locked in for three years. Shall be explaining in detail the tax structure on various asset classes later in my blog.

International fund: It invests totally outside our home country. Example Principle global opportunities fund. The problem is the tax rate. Shall explain later in upcoming article.

Global Funds: It invests outside as well as in our home country. The tax structure is better than international fund. Example Templeton India equity income fund.

Thats it for today. Watch out part two for more details. Have tried to keep the article short and simple. Hope it makes sense as before investing one should know where the money goes and what happens to it. Otherwise theres no difference between gambling and investing.
Keep reading & do comment…