Types of Mutual Funds

In this post we will discuss various types of mutual fund schemes available in market. You may like to check my previous post on mutual funds basics before digging deeper into this. If you’ve already checked that out, let’s get started!

Broadly mutual funds invest in equity, debt or a mix of both. Funds can be open ended or close ended and the underlying portfolio depends on the investment objective of scheme. Each scheme is offered by AMCs in direct and regular variants.

Types of Mutual Funds based on Asset Allocation

1. Equity Funds

These funds invest in a pool of stocks. These are categorized as high-risk products and are suitable for long term growth and capital appreciation. Equity schemes can be further classified in below types –

Market Capitalization based Funds

These funds invest based on the market capitalization of stocks. For example, large cap funds invest in top companies with highest market capitalization, similarly mid cap and small cap funds invest in stocks based on their respective market cap. Multi cap funds are a mix of all kinds of stocks and provide an even more diversified portfolio.

Sector Specific Funds

These funds invest in stocks of a specific sector. For example, a banking sector fund will only invest in stocks of banks, an automobile sector fund will only invest in stocks of automobile companies and so on.

Tax Saver / ELSS Funds

ELSS stands for Equity Linked Savings Scheme. These schemes have a lock in period of 3 years and investments made under these schemes are tax free under u/s 80C, Income Tax Act.

Index Funds

Index funds are passively managed funds, i.e. they track a particular index and returns are in line with the respective index. The portfolio of index funds contains same stocks as present in the index and your investment is not dependent on fund manager. For example, if you invest in a NIFTY index fund, it will have all stocks present in NIFTY and in same ratio. Your profit or loss will be in proportion to how NIFTY is performing.

2. Debt Funds

These funds invest money in fixed income or debt instruments like government or corporate bonds, debentures etc. They are low risk compared to equity funds and their return potential is also low. These schemes are suitable for short to medium term investments with an objective of achieving steady income.

3. Liquid Funds

These funds invest in very short term debt instruments like commercial paper, call money, government securities, treasury bill etc. which have maturity period of 91 days or less. Liquid funds target to generate reasonable returns for investors over a short period of time. These funds can be a low risk alternative of savings account.

4. Hybrid Funds

These funds divide their investments in both equity and debt instruments. The fund managers keep balancing the allocation based on market situations. These funds are suitable for generating moderate returns with medium risk.

5. Gilt Funds

These funds only invest in government securities and are suitable for risk averse investors. However, these funds are subject to high interest rate risks.

Direct vs Regular Plans

All mutual fund schemes explained above come in two variants, direct plans & regular plans. Direct plans were introduced by SEBI in 2013 as a low-cost alternative of regular plans. So, what does it all mean for a regular investor like you and me? To understand that, we first need to understand TER / expense ratio.

What is TER / Total Expense Ratio?

Expense ratio is the price you pay to mutual fund company or AMC for managing your money. AMCs use this money to pay their fund managers and employees, meet administrative and technology expenses. If you invest Rs.10,000 in a scheme whose expense ratio is 2%, then you would be paying Rs. 200 to AMC for managing your money.

Expense ratio has a direct impact on your returns. If you are investing in a scheme with expense ratio of 2% and the fund manager manages to generate an overall return of 12%, then your actual return is 10%.

Direct plan

A direct plan is what you buy directly from mutual fund company or AMC, there is no third party involved here. The only cost you pay in form of expense ratio is the marginal operating cost of AMC and fund manager. Simply put, the expense ratio is lower.

Regular Plan

A Regular plan is what you buy from a third party which may be a financial advisor, agent or commission based online platform. In regular plans, the AMC has to pay an additional commission to the third party involved. This additional cost is passed on the investor in form of a high expense ratio. This means that expense ratio will consist the marginal cost of AMC and fund manager as well as the commission that AMC pays to third party.

Differences

You may notice that each scheme is offered in above two variants, direct & regular. There is no difference in underlying portfolio of scheme for both the variants. Only difference is that expense ratio is higher for regular plans. Direct plans expense ratios usually lie in a range of 0.5% to 1.5%, while regular plans usually have expense rations ranging from 1.5% to 2.75%. Roughly, regular plan will be 1% expensive than the direct counterpart. This 1% can have a huge impact on your returns in long run.

Below is an example of rough difference of 0.80% in expense ratio of regular and direct plans of a same scheme, images taken from value research.

TER – Regular Plan

TER – Direct Plan

Which plan is better – direct or regular?

Now question is, which one to choose? If you believe in DIY, then start doing your own research, get educated and invest in direct plans. If you don’t understand anything about mutual fund investing, connect with a financial advisor and get started with regular plans for now. Meanwhile, slowly build your fundamentals and keep learning to ultimately switch to direct plans.

How to buy direct plans?

You can buy direct plans of any AMC from either CAMS or KARVY. To know the process of getting registered with one of this, please check out mutual funds basics.

I hope this post was useful and you now know about different types of mutual funds. I’ll be coming up with next post soon where we will talk about different key terms used across mutual funds and how they impact your investment decisions.

Your feedback, comments and questions are most welcome!