Based on the underlying assets they invest in, mutual funds can be classified into various types. Primarily these are
- Equity Fund
- Debt Fund
- Balanced Mutual Funds
- Equity Linked Saving Scheme
- Index Funds
- Exchange Traded Funds
- Hedge Funds
An equity fund invest predominantly in shares. The investment in shares in case of an equity mutual fund doesn;t go below 65% of the portfolio. The remaining can be ( need not be ) of debt and cash. The returns of Equity Mutual Funds correspond to the market return. Usually these funds carry moderate to high risk. Thus the returns are highest in these funds, along with the highest risk also.
Equity Funds can generate capital gains. However, long term capital gains ( that is capital gains generated after staying invested for more than one year) are tax free. Short term capital gains are counted towards taxable income.
Debt Funds can be considered as a replacement for Fixed Deposits ( even though higher risk than FD’s). These funds mainly invest in bonds and corporate debentures. A debt mutual fund will have atleast 65% of its Assets under management in debt securities. These debt securities are government bonds, company bons, corporate debentures and bank deposits.
We saw that in equity funds the long term capital gains don’t apply after one year of staying invested. In the case of debt funds it is three years. The taxation rate is 10% without indexation and 20% with indexation. Short term tax gains are applicable post 3 years. The risk in debt funds are moderately low.
Balanced Mutual Fund
Balanced Funds are a midway between equity and debt funds. These aim at providing the best of both worlds to investors. These funds invest in stocks, bonds and cash instruments. Thus when the stock market is in an upswing it will not give returns on par with equity funds but better than debt funds and vice versa.
Many equity houses maintain a major chunk of their funds based in equity so that their subscribers can enjoy tax benefits from the capital gains. When these funds maintain more than 65% of their portfolio in shares, it is technically considered an equity fund and hence capital gains tax won’t be applicable on them post one year of holding.
Equity Linked Savings Scheme
Equity Linked Savings Scheme has dual objectives: to give returns commensurate to market and to also allow for saving tax unde 80 C. ELSS locks in your money for three years and for these three years you can’t redeem your money. ELSS is the tax saving scheme with the lowest lock in period in India.
These funds invest primarily in shares and have all the benefits/risks of an Equity Fund associated with them.
Index Funds are passive funds. The funds that we discussed above are actively managed, which means that the fund manager actively decides how to invest the fund corpus and what portfolio to maintain. In the case of index fund, it simply copies a particular index on which it is based. For example an index fund that tracks the sensex, will keep the shares that make the SENSEX and buy them in the same weightage as that of the SENSEX. An index fund, which copies the sensex will also consist 30 shares like sensex and keep the similar weight-age of each share.
Warren Buffet calls the index funds as the best investment option for an investor who is not aware of the intricacies of the market too much. Even though an index fund copies a given index, it can’t exactly replicate the performance of an index. This is because there is a slight delay involved in copying the index. This delay is called a tracking error.
Index Funds, being passively managed have lesser expense ratios as compared to actively managed funds.
Exchange Traded Fund
Exchange Traded funds are index funds itself. However, unlike index funds, these funds are traded in the stock exchange very much like shares. Therefore the price of an exchange Traded Fund keeps fluctuating in the market. These mutual funds can be bought from the market from a stock broker.
Hedge Funds are mutual funds that are not regulated heavily. The government has decided that only High net worth individuals can put their money together in hedge funds. The minimum investment is one crore.
The strategy of hedge funds are very aggressive and they invest all across the globe. They trade in commodities other than gold ( other mutual funds can invest only in gold as a commodity). The fund manager is given a portion of the profit and does not charge an expense ratio. The strategies of these funds are also different and a close coordination between the fund manager and the investor is needed to understand for how long the money needs to stay invested for the fund manager’s strategy