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Mutual Funds

A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund's assets and attempt to produce capital gains or income for the fund's investors. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus.


Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds, and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund. Mutual funds invest in a vast number of securities, and performance is usually tracked as the change in the total market cap of the fund—derived by the aggregating performance of the underlying investments.

KEY TAKEAWAYS
A mutual fund is a type of investment vehicle consisting of a portfolio of stocks, bonds, or other securities. 
Mutual funds give small or individual investors access to diversified, professionally managed portfolios at a low price.
Mutual funds are divided into several kinds of categories, representing the kinds of securities they invest in, their investment objectives, and the type of returns they seek.
Mutual funds charge annual fees (called expense ratios) and, in some cases, commissions, which can affect their overall returns.
The overwhelming majority of money in employer-sponsored retirement plans goes into mutual funds.

Mutual funds pool money from the investing public and use that money to buy other securities, usually stocks and bonds. The value of the mutual fund company depends on the performance of the securities it decides to buy. So, when you buy a unit or share of a mutual fund, you are buying the performance of its portfolio or, more precisely, a part of the portfolio's value. Investing in a share of a mutual fund is different from investing in shares of stock. Unlike stock, mutual fund shares do not give its holders any voting rights. A share of a mutual fund represents investments in many different stocks (or other securities) instead of just one holding.

Investors typically earn a return from a mutual fund in three ways:

Income is earned from dividends on stocks and interest on bonds held in the fund's portfolio. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution. Funds often give investors a choice either to receive a check for distributions or to reinvest the earnings and get more shares.
If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution.
If fund holdings increase in price but are not sold by the fund manager, the fund's shares increase in price. You can then sell your mutual fund shares for a profit in the market.
If a mutual fund is construed as a virtual company, its CEO is the fund manager, sometimes called its investment adviser. The fund manager is hired by a board of directors and is legally obligated to work in the best interest of mutual fund shareholders. Most fund managers are also owners of the fund. There are very few other employees in a mutual fund company. The investment adviser or fund manager may employ some analysts to help pick investments or perform market research. A fund accountant is kept on staff to calculate the fund's NAV, the daily value of the portfolio that determines if share prices go up or down. Mutual funds need to have a compliance officer or two, and probably an attorney, to keep up with government regulations. 
 

MUTUAL FUND SCHEME CLASSIFICATION

Mutual funds come in many varieties, designed to meet different investor goals. Mutual funds can be broadly classified based on –

  1. Organisation Structure – Open ended, Close ended, Interval
  2. Management of Portfolio – Actively or Passively
  3. Investment Objective – Growth, Income, Liquidity
  4. Underlying Portfolio – Equity, Debt, Hybrid, Money market instruments, Multi Asset
  5. Thematic / solution oriented – Tax saving, Retirement benefit, Child welfare, Arbitrage
  6. Exchange Traded Funds
  7. Overseas funds
  8. Fund of fund

SCHEME CLASSIFICATION BY ORGANIZATION STRUCTURE

• Open-ended schemes are perpetual, and open for subscription and repurchase on a continuous basis on all business days at the current NAV.

• Close-ended schemes have a fixed maturity date. The units are issued at the time of the initial offer and redeemed only on maturity. The units of close-ended schemes are mandatorily listed to provide exit route before maturity and can be sold/traded on the stock exchanges.

• Interval schemes allow purchase and redemption during specified transaction periods (intervals). The transaction period has to be for a minimum of 2 days and there should be at least a 15-day gap between two transaction periods. The units of interval schemes are also mandatorily listed on the stock exchanges.

 

SCHEME CLASSIFICATION BY PORTFOLIO MANAGEMENT

Active Funds

In an Active Fund, the Fund Manager is ‘Active’ in deciding whether to Buy, Hold, or Sell the underlying securities and in stock selection. Active funds adopt different strategies and styles to create and manage the portfolio.

  • The investment strategy and style are described upfront in the Scheme Information document (offer document)
  • Active funds expect to generate better returns (alpha) than the benchmark index.
  • The risk and return in the fund will depend upon the strategy adopted.
  • Active funds implement strategies to ‘select’ the stocks for the portfolio.

Passive Funds

Passive Funds hold a portfolio that replicates a stated Index or Benchmark e.g. –

  • Index Funds
  • Exchange Traded Funds (ETFs)

In a Passive Fund, the fund manager has a passive role, as the stock selection / Buy, Hold, Sell decision is driven by the Benchmark Index and the fund manager / dealer merely needs to replicate the same with minimal tracking error.

ACTIVE V/S PASSIVE FUNDS

Active Fund –

  • Rely on professional fund managers who manage investments.
  • Aim to outperform Benchmark Index
  • Suited for investors who wish to take advantage of fund managers' alpha generation potential.

Passive Funds –

  • Investment holdings mirror and closely track a benchmark index, e.g., Index Funds or Exchange Traded Funds (ETFs)
  • Suited for investors who want to allocate exactly as per market index.
  • Lower Expense ratio hence lower costs to investors and better liquidity

CLASSIFICATION BY INVESTMENT OBJECTIVES

Mutual funds offer products that cater to the different investment objectives of the investors such as –

  1. Capital Appreciation (Growth)
  2. Capital Preservation
  3. Regular Income
  4. Liquidity
  5. Tax-Saving

Mutual funds also offer investment plans, such as Growth and Dividend options, to help tailor the investment to the investors’ needs.

GROWTH FUNDS

  • Growth Funds are schemes that are designed to provide capital appreciation.
  • Primarily invest in growth oriented assets, such as equity
  • Investment in growth-oriented funds require a medium to long-term investment horizon.
  • Historically, Equity as an asset class has outperformed most other kind of investments held over the long term. However, returns from Growth funds tend to be volatile over the short-term since the prices of the underlying equity shares may change.
  • Hence investors must be able to take volatility in the returns in the short-term.

INCOME FUNDS

  • The objective of Income Funds is to provide regular and steady income to investors.
  • Income funds invest in fixed income securities such as Corporate Bonds, Debentures and Government securities.
  • The fund’s return is from the interest income earned on these investments as well as capital gains from any change in the value of the securities.
  • The fund will distribute the income provided the portfolio generates the required returns. There is no guarantee of income.
  • The returns will depend upon the tenor and credit quality of the securities held.

LIQUID / OVERNIGHT /MONEY MARKET MUTUAL FUNDS

  • Liquid Schemes, Overnight Funds and Money market mutual fund are investment options for investors seeking liquidity and principal protection, with commensurate returns.
    – The funds invest in money market instruments* with maturities not exceeding 91 days.
    – The return from the funds will depend upon the short-term interest rate prevalent in the market.
  • These are ideal for investors who wish to park their surplus funds for short periods.
    – Investors who use these funds for longer holding periods may be sacrificing better returns possible from products suitable for a longer holding period.

    * Money Market Instruments includes commercial papers, commercial bills, treasury bills, Government securities having an unexpired maturity up to one year, call or notice money, certificate of deposit, usance bills, and any other like instruments as specified by the Reserve Bank of India from time to time.

CLASSIFICATION BY INVESTMENT PORTFOLIO

  • Mutual fund products can be classified based on their underlying portfolio composition
    – The first level of categorization will be on the basis of the asset class the fund invests in, such as equity / debt / money market instruments or gold.
    – The second level of categorization is on the basis of strategies and styles used to create the portfolio, such as, Income fund, Dynamic Bond Fund, Infrastructure fund, Large-cap/Mid-cap/Small-cap Equity fund, Value fund, etc.
    – The portfolio composition flows out of the investment objectives of the scheme.