Types of Mutual Funds
Getting
a handle on what's under the hood helps you become a better investor
and put together a more successful portfolio. To do this one must know
the different types of funds that cater to investor needs, whatever the
age, financial position, risk tolerance and return expectations. The
mutual fund schemes can be classified according to both their
investment objective (like income, growth, tax saving) as well as the
number of units (if these are unlimited then the fund is an open-ended
one while if there are limited units then the fund is close-ended).
This
section provides descriptions of the characteristics -- such as
investment objective and potential for volatility of your investment --
of various categories of funds. These descriptions are organized by the
type of securities purchased by each fund: equities, fixed-income,
money market instruments, or some combination of these.
Open-ended schemes
Open-ended
schemes do not have a fixed maturity period. Investors can buy or sell
units at NAV-related prices from and to the mutual fund on any business
day. These schemes have unlimited capitalization, open-ended schemes do
not have a fixed maturity, there is no cap on the amount you can buy
from the fund and the unit capital can keep growing. These funds are
not generally listed on any exchange.
Open-ended
schemes are preferred for their liquidity. Such funds can issue and
redeem units any time during the life of a scheme. Hence, unit capital
of open-ended funds can fluctuate on a daily basis. The advantages of
open-ended funds over close-ended are as follows:
Any
time exit option, The issuing company directly takes the responsibility
of providing an entry and an exit. This provides ready liquidity to the
investors and avoids reliance on transfer deeds, signature
verifications and bad deliveries. Any time entry option, An open-ended
fund allows one to enter the fund at any time and even to invest at
regular intervals.
Close ended schemes
Close-ended
schemes have fixed maturity periods. Investors can buy into these funds
during the period when these funds are open in the initial issue. After
that such schemes can not issue new units except in case of bonus or
rights issue. However, after the initial issue, you can buy or sell
units of the scheme on the stock exchanges where they are listed. The
market price of the units could vary from the NAV of the scheme due to
demand and supply factors, investors' expectations and other market
factors
Classification according to investment objectives
Mutual
funds can be further classified based on their specific investment
objective such as growth of capital, safety of principal, current
income or tax-exempt income.
In general mutual funds fall into three general categories:
1] Equity Funds are those that invest in shares or equity of companies.
2] Fixed-Income Funds invest in government or corporate securities that offer fixed rates of return are
3] While funds that invest in a combination of both stocks and bonds are called Balanced Funds.
Growth Funds
Growth
funds primarily look for growth of capital with secondary emphasis on
dividend. Such funds invest in shares with a potential for growth and
capital appreciation. They invest in well-established companies where
the company itself and the industry in which it operates are thought to
have good long-term growth potential, and hence growth funds provide
low current income. Growth funds generally incur higher risks than
income funds in an effort to secure more pronounced growth.
Some
growth funds concentrate on one or more industry sectors and also
invest in a broad range of industries. Growth funds are suitable for
investors who can afford to assume the risk of potential loss in value
of their investment in the hope of achieving substantial and rapid
gains. They are not suitable for investors who must conserve their
principal or who must maximize current income.
Growth and Income Funds
Growth
and income funds seek long-term growth of capital as well as current
income. The investment strategies used to reach these goals vary among
funds. Some invest in a dual portfolio consisting of growth stocks and
income stocks, or a combination of growth stocks, stocks paying high
dividends, preferred stocks, convertible securities or fixed-income
securities such as corporate bonds and money market instruments. Others
may invest in growth stocks and earn current income by selling covered
call options on their portfolio stocks.
Growth
and income funds have low to moderate stability of principal and
moderate potential for current income and growth. They are suitable for
investors who can assume some risk to achieve growth of capital but who
also want to maintain a moderate level of current income.
Fixed-Income Funds
Fixed
income funds primarily look to provide current income consistent with
the preservation of capital. These funds invest in corporate bonds or
government-backed mortgage securities that have a fixed rate of return.
Within the fixed-income category, funds vary greatly in their stability
of principal and in their dividend yields. High-yield funds, which seek
to maximize yield by investing in lower-rated bonds of longer
maturities, entail less stability of principal than fixed-income funds
that invest in higher-rated but lower-yielding securities.
Some
fixed-income funds seek to minimize risk by investing exclusively in
securities whose timely payment of interest and principal is backed by
the full faith and credit of the Indian Government. Fixed-income funds
are suitable for investors who want to maximize current income and who
can assume a degree of capital risk in order to do so.
Balanced
The
Balanced fund aims to provide both growth and income. These funds
invest in both shares and fixed income securities in the proportion
indicated in their offer documents. Ideal for investors who are looking
for a combination of income and moderate growth.
Money Market Funds/Liquid Funds
For
the cautious investor, these funds provide a very high stability of
principal while seeking a moderate to high current income. They invest
in highly liquid, virtually risk-free, short-term debt securities of
agencies of the Indian Government, banks and corporations and Treasury
Bills. Because of their short-term investments, money market mutual
funds are able to keep a virtually constant unit price; only the yield
fluctuates.
Therefore,
they are an attractive alternative to bank accounts. With yields that
are generally competitive with - and usually higher than -- yields on
bank savings account, they offer several advantages. Money can be
withdrawn any time without penalty. Although not insured, money market
funds invest only in highly liquid, short-term, top-rated money market
instruments. Money market funds are suitable for investors who want
high stability of principal and current income with immediate liquidity.
Specialty/Sector Funds
These
funds invest in securities of a specific industry or sector of the
economy such as health care, technology, leisure, utilities or precious
metals. The funds enable investors to diversify holdings among many
companies within an industry, a more conservative approach than
investing directly in one particular company.
Sector
funds offer the opportunity for sharp capital gains in cases where the
fund's industry is "in favor" but also entail the risk of capital
losses when the industry is out of favor. While sector funds restrict
holdings to a particular industry, other specialty funds such as index
funds give investors a broadly diversified portfolio and attempt to
mirror the performance of various market averages.
Index
funds generally buy shares in all the companies composing the BSE
Sensex or NSE Nifty or other broad stock market indices. They are not
suitable for investors who must conserve their principal or maximize
current income.
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Risk vs Reward
Having
understood the basics of mutual funds the next step is to build a
successful investment portfolio. Before you can begin to build a
portfolio, one should understand some other elements of mutual fund
investing and how they can affect the potential value of your
investments over the years. The first thing that has to be kept in mind
is that when you invest in mutual funds, there is no guarantee that you
will end up with more money when you withdraw your investment than what
you started out with. That is the potential of loss is always there.
The loss of value in your investment is what is considered risk in
investing.
Even
so, the opportunity for investment growth that is possible through
investments in mutual funds far exceeds that concern for most
investors. Here's why.
At the cornerstone of investing is the
basic principal that the greater the risk you take, the greater the
potential reward. Or stated in another way, you get what you pay for
and you get paid a higher return only when you're willing to accept
more volatility.
Risk
then, refers to the volatility -- the up and down activity in the
markets and individual issues that occurs constantly over time. This
volatility can be caused by a number of factors -- interest rate
changes, inflation or general economic conditions. It is this
variability, uncertainty and potential for loss, that causes investors
to worry. We all fear the possibility that a stock we invest in will
fall substantially. But it is this very volatility that is the exact
reason that you can expect to earn a higher long-term return from these
investments than from a savings account.
Different types of
mutual funds have different levels of volatility or potential price
change, and those with the greater chance of losing value are also the
funds that can produce the greater returns for you over time. So risk
has two sides: it causes the value of your investments to fluctuate,
but it is precisely the reason you can expect to earn higher returns.
You
might find it helpful to remember that all financial investments will
fluctuate. There are very few perfectly safe havens and those simply
don't pay enough to beat inflation over the long run.
Types of risks
All
investments involve some form of risk. Consider these common types of
risk and evaluate them against potential rewards when you select an
investment.
Market Risk
At
times the prices or yields of all the securities in a particular market
rise or fall due to broad outside influences. When this happens, the
stock prices of both an outstanding, highly profitable company and a
fledgling corporation may be affected. This change in price is due to
"market risk". Also known as systematic risk.
Inflation Risk
Sometimes
referred to as "loss of purchasing power." Whenever inflation rises
forward faster than the earnings on your investment, you run the risk
that you'll actually be able to buy less, not more. Inflation risk also
occurs when prices rise faster than your returns.
Credit Risk
In
short, how stable is the company or entity to which you lend your money
when you invest? How certain are you that it will be able to pay the
interest you are promised, or repay your principal when the investment
matures?
Interest Rate Risk
Changing
interest rates affect both equities and bonds in many ways. Investors
are reminded that "predicting" which way rates will go is rarely
successful. A diversified portfolio can help in offseting these
changes.
Exchange risk
A
number of companies generate revenues in foreign currencies and may
have investments or expenses also denominated in foreign currencies.
Changes in exchange rates may, therefore, have a positive or negative
impact on companies which in turn would have an effect on the
investment of the fund.
Investment Risks
The
sectoral fund schemes, investments will be predominantly in equities of
select companies in the particular sectors. Accordingly, the NAV of the
schemes are linked to the equity performance of such companies and may
be more volatile than a more diversified portfolio of equities.
Changes in the Government Policy
Changes
in Government policy especially in regard to the tax benefits may
impact the business prospects of the companies leading to an impact on
the investments made by the fund
Effect of loss of key professionals and inability to adapt business to the rapid technological change.
An
industries' key asset is often the personnel who run the business i.e.
intellectual properties of the key employees of the respective
companies. Given the ever-changing complexion of few industries and the
high obsolescence levels, availability of qualified, trained and
motivated personnel is very critical for the success of industries in
few sectors. It is, therefore, necessary to attract key personnel and
also to retain them to meet the changing environment and challenges the
sector offers. Failure or inability to attract/retain such qualified
key personnel may impact the prospects of the companies in the
particular sector in which the fund invests.
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Choosing a fund
Mutual
fund is the best investment tool for the retail investor as it offers
the twin benefits of good returns and safety as compared with other
avenues such as bank deposits or stock investing. Having looked at the
various types of mutual funds, one has to now go about selecting a fund
suiting your requirements. Choose the wrong fund and you would have
been better off keeping money in a bank fixed deposit.Keep in mind the
points listed below and you could at least marginalise your investment
risk.
Past performance
While
past performance is not an indicator of the future it does throw some
light on the investment philosophies of the fund, how it has performed
in the past and the kind of returns it is offering to the investor over
a period of time. Also check out the two-year and one-year returns for
consistency. How did these funds perform in the bull and bear markets
of the immediate past? Tracking the performance in the bear market is
particularly important because the true test of a portfolio is often
revealed in how little it falls in a bad market.
Know your fund manager
The
success of a fund to a great extent depends on the fund manager. The
same fund managers manage most successful funds. Ask before investing,
has the fund manager or strategy changed recently? For instance, the
portfolio manager who generated the fund's successful performance may
no longer be managing the fund.
Does it suit your risk profile?
Certain
sector-specific schemes come with a high-risk high-return tag. Such
plans are suspect to crashes in case the industry loses the marketmen's
fancy. If the investor is totally risk averse he can opt for pure debt
schemes with little or no risk. Most prefer the balanced schemes which
invest in the equity and debt markets. Growth and pure equity plans
give greater returns than pure debt plans but their risk is higher.
Read the prospectus
The
prospectus says a lot about the fund. A reading of the fund's
prospectus is a must to learn about its investment strategy and the
risk that it will expose you to. Funds with higher rates of return may
take risks that are beyond your comfort level and are inconsistent with
your financial goals. But remember that all funds carry some level of
risk. Just because a fund invests in government or corporate bonds does
not mean it does not have significant risk. Thinking about your
long-term investment strategies and tolerance for risk can help you
decide what type of fund is best suited for you.
How will the fund affect the diversification of your portfolio?
When
choosing a mutual fund, you should consider how your interest in that
fund affects the overall diversification of your investment portfolio.
Maintaining a diversified and balanced portfolio is key to maintaining
an acceptable level of risk.
What it costs you?
A
fund with high costs must perform better than a low-cost fund to
generate the same returns for you. Even small differences in fees can
translate into large differences in returns over time.
Finally,
don't pick a fund simply because it has shown a spurt in value in the
current rally. Ferret out information of a fund for atleast three
years. The one thing to remember while investing in equity funds is
that it makes no sense to get in and out of a fund with each turn of
the market. Like stocks, the right equity mutual fund will pay off big
-- if you have the patience. Similarly, it makes little sense to hold
on to a fund that lags behind the total market year after year.
Tax aspects of Mutual Funds
Tax Implications of Dividend Income
Equity Schemes
Equity Schemes are schemes, which have less than 50 per cent investments in Equity shares of domestic companies.
As
far as Equity Schemes are concerned no Distribution Tax is payable on
dividend. In the hands of the investors, dividend is tax-free.
Other Schemes
For
schemes other than equity, in the hands of the investors, dividend is
tax-free. However, Distribution Tax on dividend @ 12.81 per cent to be
paid by Mutual Funds.
Tax Implications of Capital Gains
The
difference between the sale consideration (selling price) and the cost
of acquisition (purchase price) of the asset is called capital gain. If
the investor sells his units and earns capital gains he is liable to
pay capital gains tax.
Capital gains are of two types: Short Term and Long Term Capital Gains.
Short Term Capital Gains
The
holding period of the Mutual Fund units is less than or equal to 12
months from the date of allotment of units then short term capital
gains is applicable.
On Short Term capital gains no Indexation benefit is applicable.
Tax and TDS Rate (excluding surcharge)
Resident Indians and Domestic Companies
The Gain will be added to the total income of the Investor and taxed at the marginal rate of tax. No TDS.
NRIs: 30 per cent TDS from the gain.
Long Term Capital Gains
The holding period of Mutual Fund units is more than 12 months from the date of allotment of units.
On Long Term capital gains Indexation benefit is applicable.
Tax and TDS Rate (excluding surcharge)
Resident Indians and Domestic Companies
The Gain will be taxed
A) at 20 per cent with indexation benefit or
B) B) at 10 per cent without indexation benefit, whichever is lower. No TDS.
NRIs: 20 per cent TDS from the Gain
Surcharge
Resident Indians : If the Gain exceeds Rs 8.5 lakhs, surcharge is payable by investors @ 10 per cent.
Domestic Companies: Payable by the investor @ 2.5 per cent.
NRIs: If the Gain from the Fund exceeds Rs 8.5 lakhs, surcharge is deducted at source @ 2.5 per cent.
Indexation
Indexation
means that the purchase price is marked up by an inflation index
resulting in lower capital gains and hence lower tax.
Inflation index for the year of transfer
Inflation index = ----------------------------------------------------
Inflation
index for the year of acquisition
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