Typical mutual fund investors invest in a few types of mutual funds that are broadly well understood, advertised, and accepted. And, that is good thing. Investors should invest only those instruments that they understand in terms of their risk profile, asset mix, and suitability for their time-frame. Mostly, these funds fall into one of these following categories:
Diversified Equity mutual funds: These are the bread and butter of the retail mutual fund industry. These funds invest in stocks across the equity market according to their mandate. They are further classified into large-cap funds, small and mid cap funds, micro cap funds depending on the market capitalization they invest in. They could also be classified as active or passive funds (such as index funds) depending on how they are managed. Broadly diversified funds created as tax saving vehicles also fall in this category. Funds such as HDFC Top 200, Franklin India Bluechip, DSP Blackrock Top 100, ICICI Prudential Dynamic, Reliance Regular savings equity fund fall under this category.
Sectoral equity mutual funds: These are narrowly diversified equity funds that focus on specific sectors – infrastructure, pharmaceutical, FMCG, Power etc. Funds such as ICICI Prudential Infrastructure, Reliance Banking Retail, Franklin Pharma fund fall in this category.
Hybrid funds: These funds invest in a mix of debt and equity markets (also include Gold in some cases). They could be debt-oriented funds – also called monthly income plans - that invest predominantly in debt instruments and about 15-20% in the equity market. Or they could be equity-oriented hybrid funds – sometimes called balanced funds – that invest predominantly (at least 65%) in the equity market. Popular funds in this category are HDFC Prudence, Reliance MIP, DSP Blackrock Balanced and others.
Income funds: These are pure debt funds that invest in medium to long term debt instruments and provide returns along the lines of corporate fixed deposits with better tax treatment. Funds such as Canara Robeco Income, DWS Dynamic Bond fund belong to this category.
Short-term debt funds and liquid funds: These funds invest in short-term (six months to a year) debt instruments or even shorter-term money market instruments. In the case of liquid funds, returns are usually on par with savings account returns, and in the case of short-term funds, in par with bank FD returns. Funds such as Templeton India Short term fund, UTI Short term Income fund and Quantum liquid fund fall into this category.
Fixed maturity plans (FMPs): These are closed-ended funds that offer FD like returns for specific tenure. These funds are popular when the prevailing interest rates are on the higher side causing investors to lock-in the rate in instruments that also offer better tax treatment for the returns they would get.
These six categories of mutual funds are the ones that are most popular with regular, retail investors. One could even say that they are as popular in the same order that they are listed above – the diversified equity funds are most popular, while not many have heard of FMPs.
However, beyond these six categories of funds lies another world of mutual funds that offer a wider variety of investment options to investors. They deserve to be recognized and understood if only because it would provide people with options that they might not be aware exist for them. However, they should be approached with caution and only be chosen if it fits an investor’s asset allocation plan, risk profile, and investment timeline.
Into the wild…
Asset allocation funds: These are hybrid funds too – in the sense that they invest in both the stock market as well as bond market. However, as opposed to debt-oriented hybrid or equity-oriented hybrids, these funds do not have a specific rigid limitation or bound as to how much they should invest in stocks or bonds at any time. They can invest 100% in equity at one time, and a few months later, be 100% in debt. Usually, the basis for their asset allocation pattern is made public in the offer document. Such a broad mandate gives these funds the flexibility to react to any market condition.
An example is one of the earliest such asset allocation funds - Franklin Templeton Dynamic PE Ratio Fund of Funds. This is a fund of funds -which means it invests in other mutual funds. In this case, they invest in exactly two funds – the Franklin India Bluechip fund (equity) and Templeton India Income fund (debt). The ratio of investments between these two funds depends on whether the market is over valued or not – based on the Price to Earnings ratio of NSE Nifty index. The fund could be invested 0:100 or 100:0 or 50:50 or any other ratio between these two funds.
Another example of an asset allocation fund is the UTI Variable Investment fund. Investors can consider such funds when they want to give their fund managers full flexibility in determining the asset mix in their investment.
International funds: As the name suggests, these fund invest in equity markets outside India. They could be themed geographically – such as funds that invest in China, or they could be themed sectorally – such as funds that invest in gold mining companies or agricultural commodities, or they could not be themed at all – broadly diversified to invest in any stock anywhere in the world.
Some of these funds are so-called “feeder” funds – the fund here operates only to collect the money and send it abroad to a real fund that does the management of the portfolio. For example, Deutsche mutual fund’s DWS Global Thematic Offshore fund is a feeder fund to DWS Invest Global Thematic fund that is managed from Europe.
There are some fund houses that specialize in offering international funds – apart from Deutsche, Mirae Asset is known for its China themed funds such as the China Advantage fund. In the commodity side, DWS offers an agri-themed global fund called DWS Global Agribusiness Offshore fund that could be well suited for investors who want exposure to stocks that would take advantage of global food inflation. Also, there are mining funds such as DSP Blackrock World Gold fund and AIG World Gold fund that provide a second-level exposure to the gold price increase. In the purely diversified category, Principal offers the Principal Global opportunities fund.
One important thing that investors need to be aware of is that the traditional rules of investing sometimes do not apply to these funds. For example, since the units of these funds need to be bought or sold overseas, redemption of units would take longer – sometimes up to seven working days. Also, in some cases, holidays abroad would impact investors’ perception of which day’s NAV would apply. Some mining funds are, for example, sensitive to Canadian holiday calendars.
Fund of Funds: These are mutual funds that invest in other mutual funds. Why would such funds exist, what would be the reason for creating them? There are three possible reasons:
One, they could be asset allocation funds that could invest in debt and equity in dynamic proportions. Instead of manage both the ratio and the underlying investments, it would be better for the fund to manage only the debt:equity ratio and leave the management of debt and equity to other fund managers. This can be achieved if the fund invests in other funds. Example of such a fund is, as mentioned earlier, the Franklin Templeton Dynamic PE ratio fund of funds.
Second, they could be providing a single-point solution for portfolio management. Every investor wants to invest in more than one mutual fund to achieve broad market diversification and to choose best of breed funds across fund houses. So, why not have a fund of fund that does this for the investor, and manages the distribution across the various schemes? For an investor, this fund of fund would practically work like an advisory solution for their portfolio. Quantum mutual fund’s Equity Fund of Fund is one such fund.
Third, there are situations where a mutual fund is a more convenient vehicle for investing in an underlying asset than directly in the asset itself. For example, investing in an exchange-traded fund requires a demat/brokerage account that is not required for investing in a mutual fund. So, a fund of fund that invests in an ETF provides the convenience of investing in the same ETF without demat account to the investors. Recent Gold offerings such as Reliance Gold savings fund belong to this category.
Investors need to be aware of increased expenses when choosing to invest in Fund of funds. The top-level fund charges additional fund management fees of up to 0.75% on top of the fees of the underlying funds. However, some fund of funds such as the Reliance Gold savings fund provide a cap for the total combined expenses.
Arbitrage funds: Regular equity funds invest in stocks traded in the exchange. However stock exchange has two separate markets – the cash market and the derivatives market. Cash market refers to the traditional stock market (used by regular equity funds). Derivatives market deal in futures and options, which are instruments that trade based on prices of some underlying stocks. Occasionally the prices between a stock and its underlying derivative product diverge and this presents an investment opportunity called arbitrage opportunity.
Arbitrage funds look for such opportunities and invest in both the stock and its derivative instrument to take advantage of such differentials. They try to “generate income by investing predominantly in arbitrage opportunities between cash and derivative market and arbitrage opportunities within the derivative segment”. When opportunities are not available they deploy excess cash in debt and money market instruments.
Although the strategy sounds very exotic, in reality, such funds offer a return at a lesser risk than a pure equity fund. Having said that, the returns are also proportional to the availability of such arbitrage opportunities in a regular manner in the market. These funds tend to perform better than equity funds in down market as well, while providing the same long-term tax benefit as an equity fund.
There are several arbitrage funds available in the Indian mutual fund market – HDFC Arbitrage retail fund, Kotak Equity Arbitrage fund, and SBI Arbitrage opportunities funds are some examples in this category.
Esoteric debt funds: The fund categories listed above are either equity funds or hybrid funds. There are some esoteric funds in the pure debt fund category as well. Some of these are:
Gilt funds: Generally, debt mutual funds invest in a variety of instruments such as bank deposits, corporate deposits, money market instruments etc. However, Gilt funds invest predominantly in government issued securities including treasury bills. Since the government backs these instruments, the credit risk of these funds is low, but they are subject to interest rate risks. In a rising interest rate scenario, the prices of gilt securities fall causing a fall in the NAV of the scheme. Examples of such schemes are Birla Sunlife Gilt Long term, HDFC Gilt Long term, and ICICI Prudential Gilt Investment funds.
Interval funds: In India, mutual funds are categorized as open-ended schemes or closed-ended schemes. With an open-ended scheme, investors can enter and exit the scheme at any time. With a closed-ended scheme, investors can enter during the NFO period and exit upon the end of the tenure of the fund.
Interval funds are a hybrid between these two models. While they can be invested in during the NFO time, there are specified pre-determined time slots during which redemptions/re-investments can be made from/into the fund. Example funds in this category are HDFC Quarterly Interval Plan and Birla Sunlife’s Income quarterly series funds.
Floating rate funds: Typically debt funds invest in deposit instruments that have a fixed interest rate or coupon rate. They invest in a diverse set of such fixed rate instruments of different tenures and manage a portfolio of these assets. However, a floating rate fund invests in instruments whose rates are not fixed. They move with the prevailing interest rates – up or down. Theoretically, such funds provide an attractive opportunity to investors because the yield on their investments will move with the interest rates and thus provide a cushion from the interest rate risk. However, in reality, there is a paucity of such floating rate debt instruments to invest in the Indian debt market. Due to this, floating rate funds end up simulating a varying rate by “laddering” their investments across timelines, and this affects the returns of the funds.
The world of mutual funds in India is wide and varied. And, the variety of mutual funds available in the market is only going to grow. In developed markets such as United States, there are even more types of mutual funds available such as funds that only short stocks in the market (betting on stocks that will go down), funds that invest using algorithmic trading, funds that focus only on futures and options, funds that are into currency trading and much, much more. Investors in India can look forward to the advent of such funds in India in due course of time. The key is to ensure that investing is done with a full awareness of what the fund is investing in and whether or not such a fund fits into a portfolio.
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