MITALI DHOKE MAR 29, 2023 / READING TIME: APPROX. 5 MINS
A wise investor will build a diversified portfolio with different types of mutual fund schemes so that it mitigates the overall portfolio risks and maximises the return-generating potential of your portfolio.
4. Types of mutual funds based on portfolio management
When you invest in a fund, your money is spread across a wide range of underlying investments, which are overseen by a fund manager. The fund managers manage your mutual fund portfolios in two ways, either actively or passively.
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Active Mutual Funds
Actively Managed Mutual Funds are those wherein the fund manager's objective is to continuously keep looking for ways to generate better returns. Together with a team of analysts and researchers, the manager will 'actively' buy, hold and sell stocks to try to achieve this goal. An actively managed fund means a fund manager is more involved in decision-making and is more active in looking after which stocks and bonds go in and out of a mutual fund portfolio and when.
However, there's never any guarantee that even the most talented fund manager will pick investments that will outperform on a regular basis. All investments are subject to the whims of the market and sentiment, so they could rise or fall in value.
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Passive Mutual Funds
Passively Managed Mutual Funds are those wherein the fund manager does not actively manage the portfolio. Only when there is a change in the index composition there is a change in the portfolio. The primary goal of passive mutual funds is to generate returns that are consistent with the market; they do not need to outperform it; instead, they simply replicate the movement. Index Funds and Exchange Traded Funds are an example of passively managed mutual funds.
Since stock selection is not at the discretion of fund managers, the operating costs of these funds are lower, leading to lower expense ratios. As a result, investors benefit by keeping a sizeable portion of the fund's returns. However, keep in mind that as passive funds mirror the index, the returns could be lower or equal to those of the benchmark, making it unlikely that investors would aim to outperform the index. While actively managed funds have a chance to outperform index returns and generate 'alpha.'
5. Types of mutual funds based on speciality
These mutual funds invest in specific kinds of elements, and they could be equity or debt fund.
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Index Funds
Index Funds are passive investment tools that replicate an index's performance. These funds contain exactly the same number of shares of the selected index as does the replicated index.
Indices are used as a standard to evaluate how well the market has performed overall. Indices are also formed to monitor the performance of companies in a specific sector. Every index is formed of stock participants. The index's value and the stock market's stock prices are directly correlated. Investors choose to invest in index funds because they can get returns that are as high as the index. For instance, examples of index funds include schemes that track indices like SENSEX, NIFTY 50, NIFTY 100, NIFTY Midcap 150 etc. Although index funds cannot outdo the market (which is the reason why they are not popular in India), they play it safe by mimicking the index performance.
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Exchange Traded Funds (ETF)
Exchange Traded Funds are those funds that are traded in real time basis on the recognised stock exchange and invest in equities or gold as their underlying asset class. ETFs can be positioned to follow any style or theme, and can replicate an index or invest in a list of stocks from a certain sector or market caps.
For instance, a NIFTY 50 ETF, will mirror the performance and portfolio of the NIFTY 50 TRI Index in the same ratio. ETFs can also follow a commodity like gold, which tracks the price of physical gold, or an index that represents a particular industry like NIFTY Pharma. ETFs are index funds, and while the majority of them are passively managed, there are also some that are actively managed.
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Sectoral Funds
Sector Funds invest solely in one specific sector, theme-based mutual funds. It invests at least 80% of its corpus in businesses belonging to a particular sector of the economy, like - banking and financial services, IT, pharma, and so on. The returns from these funds are linked to the performance of the sector. For instance, a pharma fund will put 80% of its money into pharmaceutical firms like Sun Pharmaceutical, Cipla, Lupin, and others.
While sectoral funds that invest in successful businesses from a certain industry might provide investors with significant returns, there is also a negative side to this. These funds lack diversification, in contrast to diversified equities funds, which raises the risk of concentration. Investors are advised to keep track of the various sector-related trends.
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Fund of Funds
A mutual fund scheme called a Fund of Funds is created to invest in various mutual funds, allowing investors to diversify their holdings. The performance of the target fund is the only factor that influences the returns. Multi-manager funds is another name for these kinds of funds.
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Asset Allocation Funds
Asset Allocation Funds, commonly referred to as Balance Advantage Funds, are mutual funds that invest in a combination of debt and equity assets. These funds strive to give investors significant returns with low risk by constantly managing their allocation based on market conditions.
Do note that each fund house's asset allocation fund has a unique asset allocation technique that they use. Asset allocation funds can control the distribution of equity and debt based on a predetermined formula or fund managers' assumptions based on current market patterns. Each strategy has its pros and cons and is suited to different investment needs and risk profiles. Nonetheless, asset allocation funds can be the ideal option for investors looking for balanced exposure to various asset classes. It is similar to hybrid funds in some ways, but the fund manager must have exceptional skill in selecting the appropriate combination of asset classes.
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International Funds (Overseas)
Schemes that invest in businesses listed on foreign stock exchanges are known as international funds, foreign mutual funds, or overseas mutual funds. Investors can lower their investment risks associated with the domestic market by taking advantage of the geographic diversification offered by these funds. These types of investments allow investors to participate and benefit from the growth of international companies. But one needs to have a high-risk appetite and must be willing to stay invested for the long term.
International Mutual Funds can provide investors with good returns even when the Indian Stock Markets are unfavourable, which is why they are preferred by investors seeking global exposure. An investor can use a hybrid strategy (for example, invest 60% in domestic funds and the remaining 40% in overseas investments). There are various international fund of funds schemes that allow investors to passively invest in international securities, which is less risky as compared to direct investment in foreign stocks.
Thus, given the wide variety of mutual fund schemes available in India, choose the ones that best suit your investment preferences and risk tolerance. When selecting the best mutual fund scheme, consider alignment with your financial goals and the time horizon required to achieve them.
To learn about the various sub-categories under the above-mentioned types of mutual funds, let us switch to the next chapter…