Mutual Funds 1O1- Types (Part II)

In this article, we will take forward the conversation we started in “Mutual Funds 1O1- Types (Part I)”. If you haven’t given the previous article a read at- ,I would recommend doing that for better understanding.

Now, that we are all caught up let’s start from where we left:

3. Debt Funds Debt funds aim to provide safety and regular income to investors through investing in the fixed income instruments like Government bonds, corporate debentures etc. The periodic interest received on these bonds is used to provide regular income to unit holders in the form of dividend. These funds are considered less risky in comparison to equity funds. However the NAV of these funds is influenced by the market interest rate movements. If the interest rates in the market moves up, NAV of these funds declines and vice-versa. If an investor plans to exit at the maturity of the scheme then he is not affected by such movements. There are several types of debt funds like: 

3.1 Diversified Debt Funds: Diversified debt funds invest the corpus of the scheme in the debt securities of various sectors and in the government as well as corporate debt instruments. Because of inherent safety of debt and added diversification, these schemes are considered to offer moderate to low risk and return to its investors. 

3.2 High Yield Debt Funds: High yield debt funds are the mutual fund schemes which invest in the below investment grade bonds with a rating of BB or lower than that. Because these bonds are quite risky therefore in order to attract the investors they offer high yield. Thus in spite of debt investments these schemes offer high risk-high return to its investors. The NAV of these schemes is quite volatile and the scheme’s portfolio has high default risk and in turn high return. 

3.3 Fixed Maturity Plan (FMP): FMPs are Close ended schemes, issued by Mutual funds, and mature at fixed maturity date. It could be 15 days, 30, 90, 141, 180 or even 365 days. Some even have a three or five-year time frame. At the end of this period, the scheme matures, just like a fixed deposit. FMPs invest in fixed income instruments, like bonds, government securities, money market instruments (very short-term fixed return investments) etc. The objectives of FMPs are to generate steady returns over a fixed maturity period and protect the investors against market fluctuations. FMPs are typically passively managed fixed income schemes with the fund manager locking in to investments with maturities corresponding with the maturity of the plan. 

3.4 Floating Rate Debt Funds: These funds invest in floating rate debt securities. Example: rate of 10 year G-Sec +1%. Their NAV fluctuates less than debt funds investing in fixed rate instruments because their coupon rate moves in line with the market interest rate. 

3.5 Gilt Funds: Gilt funds as the name implies are the schemes which invest in the safest debt instruments. These schemes invest in the long term government bonds which do not have any risk of default. However these long-term bond prices are affected by the general interest rate movements and follow an inverse relationship. Thus NAV of the gilt fund goes down when interest rates in the market go up and vice-versa. A short term investor has to be careful about these movements 

3.6 Money Market or Liquid Fund: Money market mutual funds are often used by short term retail investors or corporates to park their short-term surplus funds. These funds offer the highest safety of principal and liquidity of funds to its investors. These funds invest the investor’s money in safe and liquid debt instruments like certificate of deposits, commercial papers, call and notice money market etc. These instruments are quite safe and have negligible default risk. At the same time they have very short maturities and therefore are not much influenced by interest rate movement because in such a short span of time there is very low probability of adverse interest rate movements. Thus money market mutual funds are considered as least risky among all the mutual funds 

4. Hybrid Funds: Hybrid funds are the funds which allocate the funds in the equity as well as debt securities. There are various types of such funds like: 

4.1 Balanced Fund: Balance funds also known as hybrid funds aim to provide the investor the capital appreciation of equity as well as regular income and safety of debt investment. They invest the pool of funds received from the investors under the scheme in the judicious mix of equity and debt instruments. The perfectly balanced fund will invest 50% of corpus in debt and 50% in equity. An equity oriented balanced fund will invest more than 65% of corpus in equity while a debt oriented balanced fund will allocate less than 65% of its corpus in equity. Thus they offer moderate risk and return to investors. 

4.2 Monthly Income Plan (MIP): The investment objective of the Monthly Income Plan is to distribute dividends among its unit holders, every month. It therefore invests largely in debt securities (75 to 80% of their corpus) so that periodic interest received from such debt investments can be used to declare regular dividends. However, a small percentage is invested in equity instruments to improve the scheme’s yield. 

4.3 Capital Protection Funds: Capital protection fund is a fund whereby the AMC (asset management company) safeguards the capital invested, irrespective of the fund’s performance. These schemes ensure the capital protection for the investors by investing in the government securities with no risk of default. A calculated portion of corpus is invested in fixed income instruments to ensure the capital protection and balance in equity for some capital appreciation in the portfolio. This calculated portion is decided by applying the time value of money concepts to the returns received in the fixed income instruments. For example, Let us assume in a capital guaranteed scheme, a person invests Rs.10000 and the scheme is a close ended scheme for 3 years. After 3 years, he has to be given back at least Rs.10000.Fund will invest Rs.7938 in Debt fund generating a return of 8% which will provide Rs.10000 after 3 years. Rs.2062 will be invested in the derivative market and will generate returns or at the most it may remain Rs.2062. If it remains Rs.2062, the investor will get back Rs.10000+2062= Rs.12062 a return of 6.45%. 

5. Fund of Funds: A mutual fund which invests the pool of funds collected from the investors under the schemes, in the other mutual fund schemes is called Fund of Funds. Just as a mutual fund invests the funds in different securities like equity, debt etc., a fund of funds holds units of many different mutual fund schemes and cash/ Money market securities / Short term deposits. A fund of funds permits investors to achieve the appropriate diversification and suitable asset allocation with investments in various fund categories that are all packaged in the form of one fund. However, if the fund of funds carries an operating expense, investors are essentially paying double for an expense that is already included in the expense figures of the underlying funds. 

While the liquid funds are perceived as least risky and therefore offering lowest returns, the sector funds give highest returns though at the cost of huge risk. Other schemes have varying risk-return profiles which may be categorized as high, moderate & low risk-return combinations etc. as shown in the figure.