Direct & Indirect Taxes, Tax Ready Reckoner, Tax Management, Tax Act. & Rules, Tax Planning & Tax Savings.

Direct & Indirect Taxes, Tax Ready Reckoner, Tax Management, Tax Act. & Rules, Tax Planning & Tax Savings.

Types of Mutual Fund Schemes – [Asset Class]

Types of Mutual Fund Schemes – [Asset Class]
[Types of Mutual Fund Schemes – [Asset Class]

Table of Contents

1.   Equity Mutual Fund Scheme [Securities]

Equity schemes invest primarily in equity shares of companies. Depending on the scheme objective, investments could be in:

Growth stocks   :               where earnings growth is expected to be attractive,

Momentum stocks:         that go up or down in line with the market and set the tone of the market,

Contrarian stocks             :               where investment is made contrary to the general tone of the market,

Value stocks       :               where the fund manager is of the view that current valuations in the market do not fully capture the intrinsic value of the company, or

Income stocks   :               that earn high returns through dividends.

In order to standardise categories and characteristics of each scheme category SEBI has mandated the following classification of Open-End Equity Schemes:

(1)   Multi-Cap Fund

An equity scheme investing across large cap, mid cap, small cap stocks. Minimum investment in equity and equity related instruments must be at least 65% of total assets.

Unlike large or mid cap funds, they can decide how money gets allocated between big, mid-sized, and small companies. This flexibility also allows them to make changes in the portfolio as market conditions change.

When you invest in a large, small, or mid-cap fund, the fund managers are restricted by the portfolio definition. This means that a fund manager of a large-cap fund cannot invest in shares of a small-cap company even if the opportunity is lucrative. Hence, a multi-cap fund is considered to be a better option for wealth creation as the fund managers of these funds can leverage investment opportunities across the spectrum of the market. Also, every investor can find a multi-cap scheme in sync with his financial needs.

Types of Multi-Cap Fund

While there are no specific names for them, multi-cap funds can be broadly classified into the following types:

  • Multi Cap Funds with a focus on large-cap stocks– These schemes primarily focus on investing in the large-cap segment and then explore opportunities in the mid/small-cap sectors.
  • Multi Cap Funds with a focus on small/mid-cap stocks– These schemes aggressively look for investment opportunities in the small/mid-cap segments and look at large-cap stocks only to protect any downside.
  • No specific focus on market capitalization – These schemes look for investment opportunities across market capitalizations with a clear focus on finding stocks that can outperform.

When to Invest in Multi-Cap Equity Fund?

Before we talk about the types of investors who can benefit from investing in multi-cap funds, here is a quick look at the comparative performance of different types of equity funds. The table below is a benchmark comparison of Equity schemes versus the S&P BSE Sensex Index:

Types of Equity Funds Returns
1 year 3 year 5 year 7 year
Large Cap Funds 28.87% 7.84% 11.85% 8.30%
Multi Cap Funds 28.87% 7.84% 11.85% 8.30%
Small and Mid Cap Funds 47.16% 20.33% 20.00% 13.52%

As you can see above, Multi Cap Funds have performed similar to Large Cap Funds in the last 7 years. However, Small Cap Funds and Mid Cap Funds offer better returns than Large and Multi-Cap schemes.

If your investment objective is wealth creation over the long-term and you have a moderate risk tolerance, then you might want to consider investing in Multi-Cap Mutual Funds. These schemes offer a diversified approach to investing in the equity markets and endeavor to make the best of every investment opportunity.

(2)   Large Cap Fund

An equity scheme predominantly investing in large cap stocks. Minimum investment in equity and equity related instruments of large cap companies must be 80% of total assets.

Large Cap Mutual Funds are equity funds that invest a bigger proportion of their total assets in companies with a large market capitalization. These companies are highly reputed and have an excellent track record of generating wealth for their investors over a long period. Large Cap Funds are hence known to generate regular dividends and steady compounding of wealth. Also, these schemes carry a lower risk as compared to the small-cap or mid-cap schemes and are known to generate steadier returns. They are a good option for investors with a relatively lower risk appetite and a long-term investment horizon. According to SEBI, large-cap companies fall in the top 100 of the list of companies according to market capitalization. Hence, investing in these companies is considered to be less risky and steady.

When to Invest in Large Cap Fund

By now you know that large-cap funds invest in big organizations. These schemes try to offer regular dividends and capital appreciation in the long-term. If you are a risk-averse investor but want to benefit from equity investments, then large-cap mutual funds are the best option available to you. Since these schemes invest in financially strong large-cap companies, they can withstand a slowdown in the markets. However, the returns are lower compared to mid-cap or small-cap funds.

In the long-term (around five to seven years), large-cap funds tend to offer good capital appreciation.

Risk and Return of Large Cap Funds

All equity mutual funds are affected by market conditions. When the benchmark of the scheme fluctuates, the Net Asset Value (NAV) moves up or down too. However, unlike small-cap and mid-cap schemes, the NAV of a large-cap fund does not fluctuate a lot. Hence, investing in large-cap schemes offers stability to your investment portfolio. Having said this, the returns from these schemes is usually lower than the mid-cap or small-cap funds. Remember, you should invest in large-cap funds if you desire stable returns at a lower risk exposure.

List of Large Cap Funds

Fund Name 1 Year 3 Year AUM ( In Crore)
Canara Robeco Bluechip Equity Fund 47.38% 19.1% ₹3691.25
Axis Bluechip Fund 46.35% 17.86% ₹29160.60
IDBI India Top 100 Equity Fund 51.82% 16.76% ₹486.26
BNP Paribas Large Cap Fund 42.73% 16.71% ₹1128.86
Kotak Bluechip Fund 49.7% 16.38% ₹2945.01

(3)   Large & Mid Cap Fund

An equity scheme investing in both large cap and mid cap stocks. Minimum investment in equity and equity related instruments of large cap companies must be 35% of total assets; minimum investment in equity and equity related instruments of mid cap stocks upto 35% of total assets.

The ratio in which the investment is diversified, between large and mid cap companies, might differ from fund to funds. Due to their exposure in both large and midcap funds, these funds are positioned on a higher risk return trade-off plane compared to a pure large cap fund.

(4)   Mid Cap Fund

An equity scheme predominantly investing in mid cap stocks. Minimum investment in equity and equity related instruments of mid cap companies must be 65% of total assets.

Mid Cap Funds invest in equity and equity-related instruments of mid-cap companies. According to the Securities and Exchange Board of India (SEBI), mid-cap companies are those which are ranked between 101 and 250 in the list of companies according to market capitalization.

Since mid-cap companies fall between the small-cap and large-cap companies, they offer certain advantages and disadvantages to both of them. Mid-cap funds usually offer better returns than large-cap funds but are more volatile than them.

Mid Cap mutual funds are subject to dividend distribution tax and capital gains tax.

Invest in Mid Cap Equity Funds

Mid Cap Mutual Funds carry a higher risk than Large Cap Funds. Hence, you must opt for these schemes if you have a higher risk tolerance. Also, you need an investment horizon of around 8-10 years. Remember, the mid-cap segment holds a lot of opportunities for investment and wealth creation. Hence, it is important to choose a scheme that focuses a lot on researching the market and finding good investment opportunities.

(5)   Small Cap Fund

An equity scheme predominantly investing in small cap stocks. Minimum investment in equity and equity related instruments of small cap companies must be 80% of total assets.

Small-Cap Funds invest a major portion of their investible corpus into equity or equity-related instruments of small-cap companies. According to the Securities and Exchange Board of India (SEBI), small-cap schemes need to invest at least 80% of their total assets in small-cap companies. Also, SEBI defines small-cap companies as those which are ranked below the 250th rank in terms of market capitalization. In monetary terms, these are companies with a market capitalization of less than Rs. 500 crores.

It is important to note that small-cap funds carry a high level of risk. Even the slightest volatility in the market can have a huge impact on the share prices of small-cap companies. However, these stocks also have a huge potential to offer amazing returns. Think about it – a small company has a lot of scope for growth and when it does grow, the share price would increase dramatically. However, many investors tend to turn towards small-cap schemes for short-term investment needs. This can be counterproductive as small companies need time to grow. Hence, it is usually recommended to opt for small-cap funds if you have a higher risk tolerance and a long investment horizon.

The returns on Small Cap Funds are subject to capital gains tax (for any capital gains made) and Dividend Distribution Tax or DDT (for any dividend received).

(6)   Dividend Yield Fund

An equity scheme predominantly investing in dividend yielding stocks, with minimum investment in equity of 70-80% of total assets.

Dividend Yield is the dividend paid per unit divided by the market price. Dividend Yield Mutual Funds are equity funds which invest in equity and equity-related instruments of companies which are known to declare high dividends. Further, a company can declare high dividends only if it makes good profits. Therefore, most of these stocks belong to profit-making companies with an excellent track record.

Typically, a dividend yield fund invests around 70-80% of its corpus in stocks that have a dividend yield higher than that of the market (or benchmark). Hence, it acts as a filter to help the fund manager in selecting stocks. Companies that pay good dividends usually have great cash flows and are more stable than most other stocks.

(7)   Value Fund

An equity scheme following a value investment strategy. Minimum investment in equity and equity related instruments must be 65% of total assets.

When an investor (or a fund manager) adopts a value investing strategy, he looks for stocks which are undervalued and trade for less than their respective intrinsic values. There are many companies in the market whose stock price is not the true indicator of their worth. They are intrinsically more valuable and have a lot of potentials to grow. The intrinsic value of a company is calculated by considering its financials, business model, competitive position, management team, etc. If the company’s market value is less than its intrinsic value, then it is considered to have ‘value’.

Therefore, a Value Fund is an equity fund which invests in stocks of companies having ‘value’.

Investors who have high exposure to growth stocks opt for value funds to ensure a stable return on investment in any market cycle.

(8)   Contra Fund

An equity scheme following contrarian investment strategy. Minimum investment in equity and equity related instruments must be 65% of total assets.

A Contra Mutual Fund invests against the existing market trends and purchases stocks which are not performing well currently. The fund manager takes a contrarian view of the stock when it is shunned by the investors and also when there is a superlative demand for the same. Both over-performance and under-performance lead to a distorted value of the asset which the fund manager tries to capitalize on.

The fund manager of a Contra Mutual Fund purchases stocks at a value lower than its expected value in the long-term. There can be times when certain sectors witness a slump due to the prevalent market conditions. A contra fund invests in stocks of companies from these sectors and holds on to them till the demand increases. It is important to note here that these funds tend to perform better over the long-term and are not ideal for short-term investments.

You should consider investing in a Contra Mutual Fund if you have a reasonable risk tolerance, an investment horizon of 5+ years, and tons of patience.

(9)   Focused Fund

An equity scheme investing in a maximum of 30 stocks; the focus, viz. multi cap, large cap, mid cap, small cap needs to be stated with a minimum investment in equity and equity related instruments of 65% of total assets.

Focused funds are a category of mutual fund investment that comprises a smaller variety in stocks. With this investment scheme, the funds are concentrated on limited variation from only a few sectors, instead of a diverse mixture of different equity positions.

These funds mostly hold their positions in roughly 20-30 companies or less, while other funds hold positions in over 100 companies.

See also  Types of Mutual Fund Schemes – by Position Philosophy

These funds are also known as “best idea funds” owing to their mandate of choosing a limited number of companies for purchasing stocks. The principal aim of these funds is to deliver maximum returns by investing in high performing assets.

Focused equity fund investments are usually for veteran investors and individuals with a high-risk appetite. Since these funds are considered to be more volatile, it is best for investors looking for safe investment options to refrain from investing in it.

Additionally, since these funds only invest in several carefully selected securities, they are much more effective in bringing high returns to investors.

(10) Sectoral / Thematic Fund

An equity scheme investing in a sector or a theme, with a minimum investment in equity and equity related instruments of the specified sector / theme of 80% of total assets.

Sector Mutual Funds are equity schemes that invest in a specific sector of the economy. These sectors can be utilities, energy, infrastructure, etc. Sector Funds also sometimes referred to as sectoral funds can invest in stocks of companies with varying market capitalizations and security classes. These funds allow people to invest in the best-performing stocks in the specified sector.

Broadly speaking, sector funds can be classified into the following types:

  • Real Estate Funds– which allow investors with a small investible corpus to participate in the real estate market.
  • Utility Funds– which invest in well-performing companies from the utility sector and are usually focused towards offering steady dividends.
  • Natural Resources Funds – which are focused on investing in companies from the oil and natural gas, energy, forestry, and timber-related industries.
  • Technology Funds – which allow investors to gain exposure to the technology sector.
  • Financial Funds – which invest primarily in companies from the financial industry like banking, insurance, accounting firms, etc.
  • Communications Funds –which focus on investing in the telecommunications sector and often include internet-related companies too.
  • Healthcare Funds –which cover companies and for-profit medical institutions like pharmaceutical companies, path lab chains, etc.
  • Precious Metals Funds –which offer the investors exposure to various precious metals like gold, platinum, silver, copper, and palladium.

(11) ELSS (Equity linked Saving Scheme) Fund

An equity linked saving scheme with a statutory lock in of 3 years and tax benefit. A minimum investment in equity and equity related instruments of 80% of total assets.

ELSS funds are equity funds that invest a major portion of their corpus into equity or equity-related instruments. ELSS funds are also called tax saving schemes since they offer tax exemption of up to Rs. 150,000 from your annual taxable income under Section 80C of the Income Tax Act.

Further, the income that you earn under this scheme at the end of the three-year tenure will be considered as Long Term Capital Gain (LTCG) and will be taxed at 10% (if the income is above Rs. 1 lakh).

SEBI has categorised the investment universe of listed companies as follows, to ensure uniformity in the industry:

Large Cap            :               The top 100 listed companies in terms of full market capitalization.

Mid Cap               :               Companies ranked from 101 to 250 in terms of full market capitalization.

Small Cap            :               Listed companies ranked 251 onwards in terms of full market capitalization.

The capitalisation is to be computed as the average across all the stock exchanges where the company is listed. AMFI is responsible to put together the list and upload it on their website every six months. The list, based on data as at the end of June and December each year, is to be uploaded within 5 calendar days from the end of each six-month period.

Some important features of ELSS funds are as follows:

  • A minimum of 80% of the total investible corpus is invested in equity and equity-related instruments
  • The fund invests in equity in a diversified manner – across different market capitalizations, themes, and sectors.
  • There is no maximum tenure of investment. However, there is a lock-in period of three years.
  • Tax exemption on the invested amount under Section 80C of the Income Tax Act.
  • Income is treated as LTCG and taxed according to the prevalent tax rules.

2.   Debt Mutual Fund Schemes

Debt schemes, as the name suggests, invest only in debt securities.

(A)   Types of Risk

Their risk, is primarily driven by the following:

(i)      Credit Risk:

Companies with sound financials are unlikely to default on the debt securities they issue. So, schemes that invest only in debt securities of such companies are subject to a lower credit risk, as compared to schemes that invest in debt securities issued by companies whose financials are weak. Since the government of the country is least likely to default, securities issued by the government (Gilt Securities) are considered to be lowest in credit risk. Lower the credit risk of a debt security, higher would be its credit rating.

(ii)    Interest Risk / Price Risk:

Market value of debt securities change value in the market in synch with changes in overall yields in the debt market. Debt securities that are due for maturity very soon (say, a day) fluctuate in value a lot lesser than those that will mature a long time into the future (say, 10 years). Macaulay duration is the weighted average time in which a debt instrument will be repaid. Low Macaulay duration indicates that the debt security or debt scheme portfolio is expected to be less volatile as compared to an alternative that has high Macaulay duration.

(B)   Types of Open-end Debt Mutual Fund Scheme:

SEBI has adopted the following classification for Open-End Debt Schemes:

(i)      Overnight Fund

Debt scheme that invests in overnight securities having maturity of 1 day.

The Overnight Fund is described by the Securities and Exchange Board of India (SEBI) as an open-ended debt Mutual Funds schemes that park money into overnight securities. In other words, it is a liquid form of a particular debt fund.

Investors who wish to put their money in such schemes put forward a purchase and redemption request for their choice of overnight funds during the trading hours.

At the beginning of each business day, the Asset Under Management (AUM) is in cash amount. The bonds are purchased overnight, and they mature by the following business day. Fund managers tend to take the cash amount to buy more of such bonds overnight, and the cycle continues.

Like debt funds, an overnight fund is subject to taxation. If an investment is held for more than 3 years, it will be subjected to the long-term capital gains tax with indexation. If an investor decides to sell off their funds before three years; they must pay a tax that matches their tax slab.

(ii)    Liquid Fund

Debt scheme that invests in debt and money market securities with maturity of upto 91 days only.

A Liquid Mutual Fund is a debt fund which invests in fixed-income instruments like commercial paper, government securities, treasury bills, etc. with a maturity of up to 91 days. The net asset value or NAV of a liquid fund is calculated for 365 days. Further, investors can get their withdrawals processed within 24 hours. These funds carry the lowest interest-rate risk in the debt funds category.

The core objective of a liquid fund is providing capital protection and liquidity to the investors. Therefore, the fund manager selects high-quality debt securities and invests according to the scheme’s mandate. Liquid funds are known to offer better returns than a regular savings account.

If you have a good amount of cash which is not invested anywhere and are looking for a short-duration investment option with lower risks, then liquid funds are ideal for you. Your money can earn better returns than merely lying in a savings account along with the same liquidity.

Since the underlying assets of a liquid fund have a maturity of up to 91 days, they do not experience a lot of volatility. Hence, the NAV of the fund remains almost steady. This makes liquid funds low-risk investments.

(iii)   Ultra-Short-Term Fund

Debt scheme that maintains the Macaulay duration of its portfolio between 3 months and 6 months.

Ultra Short Term Mutual Funds invest in debt securities and money market instruments so that the Macaulay Duration of the fund’s portfolio is between 3-6 months. Hence, conservative investors with a 3-6 month investment horizon find these funds ideal. These funds are best suited for investors who want to meet certain financial goals in 6 months. The average returns of these funds range between 7 and 9%.

The fund manager of an Ultra Short Mutual Fund selects money market instruments and debt securities according to the investment objective of the fund ensuring that the Macaulay duration is between 3 and 6 months.

Since the Macaulay duration of the portfolio of an Ultra Short Fund is between 3 and 6 months, it is best suited to investors with an investment horizon of around six months and a lower risk preference. Further, these funds tend to offer better returns than keeping your funds in a savings account for a similar tenure.

An Ultra Short Term Fund is a debt fund and carries the three risks that all debt funds carry: (i) Credit Risk, (ii) Interest Rate Risk ; (iii) Liquidity Risk.

(iv)   Low Duration Fund

Debt scheme that maintains the Macaulay duration of its portfolio between 6 months and 12 months.

Low Duration Funds invest in money market instruments and debt securities so that the Macaulay Duration of the fund is between six and twelve months. These funds are ideally suited to low-risk investors with a one-year investment horizon. Low Duration Funds have a higher maturity than liquid funds and overnight funds but lower maturity than short, medium and long duration funds. These funds allow investors to park their money for 6-12 months and earn returns better than a regular savings account. The average returns of these funds range between 6.5 and 8.5%.

The fund manager of a low duration fund selects debt securities and money market instruments according to the investment objective of the fund ensuring that the Macaulay duration is between 6 and 12 months.

Therefore, investors having an investment horizon of 6-12 months and lower risk tolerance can benefit from investing in low duration funds. These funds are also a good option for investing the idle funds lying in the savings account and earning better returns.

(v)     Money Market Fund

Debt scheme that invests in instruments that will mature within 12 months.

Money Market Funds are short-term debt funds. They invest in various money market instruments and endeavor to offer good returns over a period of up to one year while maintaining high levels of liquidity. The average maturity of a Money Market Fund is one year.

Money Market is an exchange where the trade of cash and cash-equivalent instruments takes place. The instruments that are traded in the money markets have maturities which can vary from overnight to one year. Here are some key money market instruments in India: (i) Treasury Bills or T-Bills; (ii) Certificate of Deposit or CD

Since these schemes invest in money market instruments, they are ideal for investors with lower risk tolerance and an investment horizon of up to one year. Typically, investors with idle cash lying in their savings account can earn better returns by investing in these funds.

(vi)   Low Duration Fund

Debt scheme that maintains the Macaulay duration of its portfolio between 6-12 months.

Low Duration Funds invest in money market instruments and debt securities so that the Macaulay Duration of the fund is between six and twelve months. These funds are ideally suited to low-risk investors with a one-year investment horizon. Low Duration Funds have a higher maturity than liquid funds and overnight funds but lower maturity than short, medium and long duration funds. These funds allow investors to park their money for 6-12 months and earn returns better than a regular savings account. The average returns of these funds range between 6.5 and 8.5%.

The fund manager of a low duration fund selects debt securities and money market instruments according to the investment objective of the fund ensuring that the Macaulay duration is between 6 and 12 months.

A low duration fund focuses on investing in debt securities and money market instruments with a Macaulay duration of 6-12 months. Therefore, investors having an investment horizon of 6-12 months and lower risk tolerance can benefit from investing in low duration funds. These funds are also a good option for investing the idle funds lying in the savings account and earning better returns.

(vii)  Medium Duration Fund

Debt scheme that maintains the Macaulay duration of its portfolio between 3 years and 4 years.

Medium Duration Funds invest in debt securities and money market instruments so that the Macaulay Duration of the fund’s portfolio is between three and four years. Hence, these funds are recommended to conservative investors with a four-year investment horizon. Medium Duration Funds have a higher maturity than overnight funds, liquid funds, ultra-short duration funds, low duration funds, money market funds, and short duration funds but lower maturity than medium to long duration funds and long duration funds. These funds are best suited for investors who want to meet certain financial goals in 3 years and are a good alternative to bank deposits. The average returns of these funds range between 7 and 9%.

The fund manager of a medium duration fund selects money market instruments and debt securities according to the investment objective of the fund ensuring that the Macaulay duration is between 3 and 4 years.

Since the Macaulay duration of the portfolio of a medium duration fund is between 3 and 4 years, it is best suited to investors with an investment horizon of little over three years and a lower risk preference. Further, these funds tend to offer better returns than a fixed deposit for a similar tenure.

(viii) Medium To Long Duration Fund

Debt scheme that maintains the Macaulay duration of its portfolio between 4 years and 7 years.

Medium to long duration funds as the name suggests, invest in debt securities with an average maturity period of 4 to 7 years. The fund seeks to generate a higher return as compared to medium and low duration funds.

You may find medium to long duration funds to be volatile during periods of fluctuating interest rates. Medium to long duration funds could offer a higher return in a falling interest rate scenario.

See also  Offer Document of Mutual Fund

It helps you earn return through a combination of interest-earnings and capital gains.
The return from medium to long duration funds may be higher as compared to bank fixed deposits over a similar tenure. It offers a tax-efficient income if you fall in the higher income tax brackets. You may consider investing in medium to long duration funds if you want a higher return in a falling interest rate scenario.

(ix)    Long Duration Fund

Debt scheme that maintains the Macaulay duration of its portfolio greater than 7 years.

Long duration funds are open-ended mutual funds that invest predominantly in government and corporate bonds with a longer residual maturity period. It generates returns from both interest income and capital appreciation from the securities in the portfolio. However, these funds are riskier as compared to most debt funds. The fund manager of a long duration fund selects bonds with a Macaulay duration of more than seven years. It could offer a higher return as compared to medium duration funds in a falling interest rate scenario.

You may consider investing in long duration funds if you are willing to bear short-term volatility and stay invested for the long-run. It could offer a higher return as compared to most debt funds as it invests in bonds of a longer duration. You could invest in long duration funds if you are willing to bear the risk of fluctuating interest rates for a higher return. It generates a higher return when interest rates are expected to fall. Long duration funds are taxed in a similar manner to debt funds.

(x)     Dynamic Bond Fund

Debt scheme that invests across duration, depending on the call it takes on future direction of yields in the debt market.

Dynamic Mutual Funds have a ‘dynamic’ maturity as well as composition. These funds have an investment objective of delivering optimum returns in falling as well as rising market cycles. The fund manager of a dynamic debt fund manages the portfolio dynamically with respect to the changes in the interest rates.

Dynamic Mutual Funds are a good option for investors who want to generate returns from their bond investments regardless of the interest rates.

(xi)    Corporate Bond Fund

Debt scheme that invests in excess of 80% of its assets in the highest rated debt securities.

A corporate bond fund is essentially a mutual fund which invests more than 80% of their total financial resources in corporate bonds. Business organisations sell these to fund their short expenses, such as working capital needs, advertising, insurance premium payments, etc.

Corporate bond funds are increasingly becoming a popular debt instrument for businesses to raise required finances as associated costs are lower as compared to bank loans.

There are broadly two types of corporate bond a mutual fund invests in –

  1. Top-rated companies which have incredibly high CRISIL credit ratings. These are generally top public sector companies and Navratnas.
  2. Companies having a slightly lower credit rating of AA-

Corporate bond mutual funds have lower risk sensitivity as it is a debt instrument ensuring capital protection. It is ideal for risk-averse people looking for high returns on their investments. The time period of the top corporate bond funds generally ranges between 1 and 4 years, preserving liquidity of the investor. Corporate bonds offer higher interest rates because they carry higher credit risk.

(xii)  Credit Risk Fund

Debt scheme that invests in excess of 65% of its assets in debt securities that are below the highest in credit rating.

Credit Risk Mutual Funds are debt funds which invest in low-credit quality debt securities. These funds have higher risks since they invest in low-quality instruments because Securities with a low credit rating tend to offer higher interest rates. Usually, instruments with a credit rating below AA are considered to carry a higher credit risk. The fund managers of Credit Risk Funds also choose securities which might get a boost in rating (as per their analysis). This can have a positive impact on the NAV of the fund.

Credit Risk Funds invest in debt securities and money market instruments which have a low credit rating since such instruments tend to offer higher interest rates. Also, when the rating of a security is upgraded, the fund benefits. Usually, credit risk funds tend to offer 2-3% higher returns than risk-free debt investments.

You must consider investing in these funds if you have a medium-to-high risk tolerance and want to invest in debt funds. They are tax-efficient for investors in the highest tax slab since Long Term Capital Gains (LTCG) are taxed at 20% while their tax slab rates are 30%.

(xiii) Banking & PSU Fund

Debt scheme that invests at least 80% of its assets in debt securities of banks, public sector undertakings (PSU), and public financial institutions.

A banking and PSU debt fund is one of the most popular types of mutual funds, as it has nominal risk associated with the total investment. Fund managers mainly target the Maharatna and Navratna companies to build the portfolio, as they have a history of yielding substantial gains.

The characteristics of a banking and PSU fund can be described as follows –

I.  Debt instruments such as debentures, bonds, certificates of deposit, etc. comprise 80% of the corpus.

II.  Companies issuing banking and PSU funds have a minimum AAA- credit rating from the best agencies.

The benefits of investing in a PSU and banking debt fund can be listed as –

I.   Low risks as the portfolio managers primarily procure debt securities for respective mutual funds.

II.  Have relatively high credit ratings as determined by the top rating agencies.

III.  PSU Banking sectors are backed by the Government of India, and hence, the investment enjoys superlative security.

Individuals realising capital gains upon resale of NAV units of banking and PSU funds after three years are taxed as LTCG (long term capital gains). After adjustment for indexation, and LTCG tax rate at 20% is imposed on total profits realised.

(xiv) Gilt Fund

Debt scheme that invests at least 80% of its assets in government securities across maturities. Apart from being the most liquid securities in the debt market, government securities are eligible for liquidity support.

Gilt Funds are debt funds which only invest in bonds and fixed interest-bearing securities issued by the state and central governments. These investments are made in instruments having varying maturities. Since the money is invested with the government, these funds are said to carry minimal risk.

For most conservative investors, Gilt funds are a perfect combination of reasonable returns and minimal risks. However, it is important to note that Gilt Funds are affected by the changes in interest rates.

Unlike bond funds which may invest in corporate bonds, Gilt Funds solely invest in g-secs or government securities. This makes Gilt Mutual Funds low-risk investments which offer reasonable returns along with capital preservation. Hence, they are a good investment option for people with lower risk tolerance and seeking investment opportunities in government securities.

Gilt Funds carry no credit risk as they are issued by the government who never defaults on its payments. However, these funds carry the risk of changing interest rates. If the interest rates rise sharply, the NAV of a Gilt Fund falls drastically.

(xv)  Gilt Fund With 10-Year Constant Duration

A gilt fund with 10-year constant duration entails a fixed maturity period of 10 years and is suitable for long term investment schemes for individuals having a lower aptitude for market risks.

A gilt fund is considered as one of the safest investment options in the market, as it is issued by the union government and the RBI. The corpus amount has negligible risk involved, as the government is liable to pay the money back to the investors. Nonetheless, returns generated on the same can fluctuate depending upon the pattern of interest rate fluctuations in the country.

A gilt fund with 10 year constant duration is subject to long term capital gains tax, as the maturity period is longer than three years.

(xvi) Floater Fund

Debt scheme that invests at least 65% of its assets in debt securities with floating rate of interest, i.e. interest rate that goes up or down in line with the interest rate or yield on some benchmark in the debt market. For example, the benchmark could be the State Bank of India 3-year fixed deposit rate.

The SEBI classification scheme is a good beginning to bring some order to Indian mutual fund offerings. It can be argued that too many categories have been created for debt schemes. Further, the logic for pegging the duration of the medium duration fund at 3 to 4 years is not clear. It could have been kept at 3 to 5 years, in synch with the 1 to 3 year duration for short-duration fund; consequently, the medium to long duration fund could have been at 5 to 7 years, thus ensuring a 2- year window across these three categories of debt schemes.

Conservative investors need to note that, by definition, gilt funds can now have upto 20% of non-gilt securities. Thus, gilt funds could have an element of credit risk.

Besides these schemes which are part of the SEBI classification scheme for open-end debt schemes, investors come across the following terms in the market.

(xvii) Income Schemes

These schemes invest in bond securities issued by the government or any other issuer. They have considerable flexibility in deciding on the maturity of their investment portfolio. Corporate Bond Fund and Credit Risk Fund are examples of income schemes.

(xviii) Junk Bond Schemes

Junk bond schemes invest in securities that are below investment grade. The hope is that attractive returns in such poor-quality investments would more than make up for the higher risk of losing the entire investment in some cases.

“High yield” bonds is a politically correct way of referring to junk bonds.

According to Benjamin Graham, “A junk bond could be appropriate if you are retired, are looking for extra monthly income to supplement your pension, and can tolerate temporary tumbles in value . . . A junk-bond fund, though, is only a minor option — not an obligation — for the intelligent investor.”

SEBI guidelines limit investment in unrated securities and securities that are below investment grade to 25 per cent of the net assets of any scheme. Therefore, currently it is not yet possible to have a full-fledged junk bond mutual fund scheme in India.

(xix)  Fixed Maturity Plan (FMP)

An investor in a debt security gets her expected yield if she holds a fixed coupon debt security until maturity, and the issuer honours its commitment. But if she sells her security earlier, then what she recovers would depend on the market situation at the time of sale. She could equally end up with a capital gain or a capital loss.

A FMP seeks to replicate a similar pay-off structure for the investor by investing exclusively in debt securities of the pre-specified maturity. Thus, if an investor is desirous of investing for four years, she can invest in a fund that will invest in debt securities of 4-year maturity.

FMPs are closed-end in nature. Therefore, as per SEBI Guidelines, these need to be listed in a stock exchange.

On maturity, the scheme would redeem the securities in its portfolio and pay the investor. The investor, however, can exit earlier by selling the units in a stock exchange. But what she would recover in an early exit would depend on the market situation at her time of exit.

Thus, an investor is reasonably certain of the return if she stays invested in the scheme for the period originally envisaged, and the companies where the FMP has invested fulfil their obligations. But she also has an earlier exit option.

Normally, an assured returns scheme can be offered only if there is a named guarantor who offers the guarantee. An FMP operates like an assured returns scheme through the back door since the investor is reasonably assured of the expected return (subject to credit risk and re-investment risk) if she holds the units for the originally envisaged period — but there is no named guarantor for the return. It must be noted that the trade practice of informally mentioning an “indicative return” for such schemes is illegal.

Another benefit of FMP is its tax efficiency. The income accrued in the scheme would not bear a tax on year to year basis. Therefore, annual interest earned by the scheme would be re-invested on “gross basis”. If the same income were to be received directly by the investor, it would be subject to tax each year, thus reducing the amount available for re-investment.

When a series of FMPs are issued for different maturities, they are called “Serial Funds”. These funds can choose to invest exclusively in government securities, in which case they become “Serial Gilts”. Alternatively, they can invest in non-government securities, in which case they become “Serial Income Schemes.

” The suffix “Gilt” to any of the above categories means that the portfolio will not take much exposure to non-Government securities.

3.   Hybrid Mutual Fund Schemes

Hybrid schemes invest in a mix of equity and debt. The debt investments ensure a basic interest income, which the fund manager hopes to top up with capital gains on the equity portfolio. However, losses can eat into the basic interest income and capital.

As John Bogle, a legendary figure in the mutual fund industry, puts it: “The greatest benefit of a balanced investment programme is that it makes risk more palatable. An allocation to bonds moderates the short-term volatility of stocks, giving the risk averse long-term investor the courage and confidence to sustain a heavy allocation to equities. Choose a balance of stocks and bonds according to your unique circumstances — your investment objectives, your time horizon, your level of comfort with risk, and your financial resources”.

According to Hall, one of the common allocations used in these types of funds is known as the robot mix:

  • 55% in stock,
  • 35% in bonds, and
  • 10% in cash equivalents.

The golden balance is a 50:50 ratio between debt and equity. Balanced schemes of Indian mutual funds tend to have at least 65% equity exposure, keeping in mind existing tax laws, .

(A)   Types of Hybrid Mutual Fund Scheme

SEBI has proposed a classification system for hybrid schemes as follows:

See also  Mutual Fund Structure in India

(i)      Conservative Hybrid Fund

A scheme that invests 10% to 25% of its assets in equity, the balance being in debt.

Conservative Mutual Funds have a portfolio of debt and equity securities with a relatively lower risk. They primarily invest in debt securities (around 75-90%) with a small portion allocated to equity and equity-related instruments (around 10-25%). The small exposure to equity allows these schemes to earn better returns than pure debt schemes. Further, conservative funds usually invest in high-quality debt securities and large-cap stocks. These funds endeavor to offer regular income as well as capital appreciation while focusing on capital preservation. They have lower exposure to equities as compared to aggressive funds and have a clear focus of offering inflation-beating returns.

it is ideal for low-risk investors and people who are retired or nearing retirement. Since there is an exposure to high-quality stocks, low-risk investors get an opportunity to earn better returns as compared to investing in a pure debt fund. Further, these funds are also ideal for investors seeking regular returns as well as those with long-term financial goals with lower risk tolerance.

For taxation purposes, Conservative funds are treated similar to debt funds

(ii)    Balanced Hybrid Fund

A scheme that invests 40% to 60% of its assets in equity; the balance in debt.

These are financial instruments that invest in a mixture of both debt and equity segments in specific ratios. Also known as hybrid funds, these funds enable investors to diversify their mutual fund based portfolio. Since they maintain a balance between both debt and equity segments, they provide the best risk-reward balance and help to maximise the returns on investment.

Balanced mutual funds are mostly equity-oriented and take up about 40-60% of the fund’s portfolio. The biggest advantage of investing in these funds is that they ensure capital appreciation and provide a safety net against potential risks.

These funds are thus mostly oriented towards investors seeking a mixture of capital appreciation, income as well as low-risk investment options.

These funds are mostly meant for those who seek safety, income and medium capital appreciation from their investment. Those with low-risk appetite can invest in these hybrid funds to balance out the benefits and risks of the investment market.

(iii)   Aggressive Hybrid Fund

A scheme that invests 60% to 80% of its assets in equity, the balance in debt.

Aggressive Mutual Funds are hybrid funds which invest between 65 and 80% of their total assets in equity and equity-related instruments and the balance 20-35% in debt securities and money market instruments.

Most Aggressive Mutual Funds offer a much higher autonomy to the fund managers as compared to balanced funds. Therefore, Aggressive Funds can take advantage of arbitrage opportunities. Further, the fund manager can opt to follow the growth or value investing style while selecting stocks.

Aggressive funds endeavour to generate regular income along with long-term wealth generation by using a hybrid portfolio. In these funds, the fund manager primarily invests in equity and equity-related instruments while allocating a smaller portion to debt for stability. Therefore, investors with moderate risk tolerance and an investment horizon of at least 5 years can consider Aggressive Funds.

(iv)   Dynamic Asset Allocation Fund Or Balanced Advantage Fund

Dynamic asset allocation funds are a type of balanced funds or Hybrid Funds. Most of the funds in this category are invested and spread across various sectors including equity funds, real estate, stocks and bonds. Each of these funds are managed by a professional manager who takes care to ensure that the quality of investments is not lowered.

A scheme that manages its exposure to the asset classes dynamically. It has the mandate to vary its allocation between asset classes depending on its market view.

The balanced funding option is highly recommended for those who are looking for assured returns after the end of tenure. It is also a valuable asset to those who have limited funds to invest in multiple sectors. Above all, dynamic asset allocation Mutual Funds are preferred for their steady and recurring returns. It is perhaps the best and most suited investment vessel in an uncertain market.

(v)     Multi Asset Allocation Fund

A scheme that invests in at least three asset classes, e.g. equity, debt and gold with a minimum allocation of 10% to each asset class. Foreign securities are not treated as a separate asset class for this purpose.

As per the Brinson study, 93.4% of a fund’s average returns can be accredited to proper asset allocation. These schemes aim to offer a steady income and capital appreciation to the investors by allowing them to invest in a well-balanced portfolio of investments.

Through a multi-asset allocation fund, an investor gets to invest in equity and debt instruments, equity-oriented schemes, and gold and gold-oriented investment instruments. An investor can invest up to 80% of capital in either of the asset class. Mutual Funds units and stock lending up to 20% of assets can be a probable investment prospect for the said fund.

Generally, such funds can be further categorized as –

  1. Risk tolerance funds.
  2. Target-date funds.

The multi-asset allocation Mutual Funds are deemed suitable for investors who have a low-risk appetite but want to enjoy steady returns on their investments.

(vi)   Arbitrage Fund

Arbitrage Funds are equity-oriented hybrid funds which leverage arbitrage opportunities in the market. These can be a pricing mismatch between two exchanges, different pricing in the spot and futures market, etc. The fund manager of an arbitrage fund buys and sells the shares at the same time and earns the difference between the selling price and the buying price of the share.

A scheme that seeks to earn risk-neutral income by taking opposite positions in different markets — e.g. buying a share in the cash market, and reversing the position, i.e. hedging the risk in the futures market]. Such schemes need to invest at least 65% of their assets in equity and equity related securities.

This is fundamentally different from any other form of investing where you purchase an asset and wait for it to grow in value before selling it. In an arbitrage fund, the fund manager invests in equities only when he finds a definite opportunity to earn returns. If there are no arbitrage opportunities available, then the fund invests in short-term money market instruments and debt securities.

Arbitrage funds are ideal for investors who want to invest in equity but don’t want to bear the risks. In a fluctuating market, many investors who are averse to risk can park their money in an arbitrage fund and earn good returns.

For taxation purposes, Arbitrage funds are treated similar to equity funds with the following tax rules:

(vii)  Equity Savings Fund

A scheme that invests in equity, debt and arbitrage. A minimum of 65% of total assets need to be equity, while debt needs to be at least 10% of the total assets. The scheme has to specify its minimum expected levels of hedged and unhedged position. Investors will also come across the following types of schemes which are in the nature of closed-end hybrid schemes.

The investment pattern followed by Equity Savings Fund is what sets it apart from other traditional investment schemes.

Since these funds invest in a mixture of various segments, they help to maximise returns on investments while maintaining a smart risk and reward balance. Thus, this savings scheme makes for a perfect option for conventional investors who still want to earn high returns from their investments. These are also the ideal option for individuals looking to gain capital to fulfil short term goal in the near future.

These funds are the perfect investment options for the individuals looking for equity exposure, but lacking the time frame for long term investment. These are low-risk funds but are designed to bear certain returns, unlike other equity assets. Additionally, few of these funds also look to provide investors with dividend incomes on a regular basis, even though they are not mandated to do so.

investors with a time frame of fewer than 24 months for their investments can meet their needs with this investment option.

(viii) Monthly Income Plan (MIP)

A MIP is a special case of hybrid fund that invests largely in debt. However, a small component of 15%-20% is invested in equity.

This is a good product for investors who are less oriented to taking investment risk, but would like some exposure to equity. The debt component in the portfolio ensures that the NAV of MIP does not fluctuate as widely as the equity market.

Investors should not get misled by the name. A “Monthly Income Plan” does not assure any monthly income. If the scheme does not earn a profit, then the scheme will not be able to distribute a dividend.

MIPs are taxed as debt schemes. So the favourable tax treatment that equity schemes enjoy is not available.

4.   Capital Protection Oriented Schemes

A capital protection oriented scheme is a kind of hybrid scheme, where a part of the initial issue proceeds is invested in gilts that would accumulate interest and mature to a value equivalent to the amount invested by the investor. Thus, the investors’ capital is protected. The remaining issue proceeds, namely the excess over what is required to be invested in gilts for capital protection, are invested in risky investments.

Suppose an investment in gilts for 5 years yields 7% return. In that case, a 5-year closed-end scheme that collects  100 from investors can invest as follows:

  • 30 in gilt of 5-year maturity,
  • Balance 70 in shares.

At the end of 5 years, the investment in gilt, including accumulated interest, would grow to  100 which would be adequate to cover the amount collected from investors. Thus, even if the investment in shares were completely wiped out, an extremely very remote possibility, the investor’s capital is still protected. The illustration assumes no costs are charged to the portfolio.

The above approach to capital protection is called Constant Proportion Portfolio Insurance (CPPI). An alternate is Option-based Portfolio Insurance (OBPI). Here, the capital protection is built through purchase of suitable derivative products. Derivatives are contracts whose value depends on some underlying, such as an equity index or a stock or interest rate.

Under SEBI regulations, capital protection oriented schemes can only be structured as closed-end schemes; re-purchase of units before maturity is not permitted.

Since capital protection depends on the portfolio, SEBI has provided that:

The proposed portfolio structure has to be rated by a SEBI-registered credit rating agency from the point of view of assessing the degree of certainty of achieving the objective of capital protection.

The debt component in the portfolio can be invested only in securities that have the highest investment grade rating.

Trustees would have to monitor the portfolio structure and report on it in their half-yearly trustees’ report.

5.   Real Estate Mutual Fund Schemes

In April 2008, SEBI announced guidelines for Real Estate Mutual Funds. These were aimed at wider retail participation.

In September 2014, SEBI announced a new set of regulations for Real Estate Investment Trusts (REIT). Under the regulations, the minimum amount for any investor in a REIT is  2 lakh.

Industry is yet to launch a Real Estate Mutual Fund scheme; REITs are yet to gain importance in India.

6.   Gold Mutual Funds Scheme

Industry offers Gold Funds in two formats:

Gold Exchange Traded Funds

An exhaustive discussion on Exchange Traded Funds (ETFs) is featured later in this Chapter. At this stage, it would suffice to note that Gold ETFs invest in physical gold or gold-related securities. Thus, investors earn returns that are linked to the performance of gold. Investors need to have a demat account in order to invest in any ETF.

Gold Savings Schemes

The structure of ETFs imposes two constraints on investors — firstly, every investors needs to have a demat account; secondly, investors cannot invest in a Gold ETF through SIP.

Gold Savings Schemes are an Indian innovation that addresses these constraints of Gold ETF. The Gold Savings Scheme is a fund that invests in Gold ETFs. It allows investors to invest through SIP and without the requirement of a demat account.

A limitation of gold savings schemes is that there is one more layer of cost, in addition to the costs built into the ETF transactions. This pulls down the returns for investors in Gold Savings Schemes, as compared to Gold ETF.

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