Types of Funds
This section introduces some funds to the reader. The risk aspects underlying these funds and their suitability for different kinds of investors are discussed in later Chapters.
1. Open-Ended Funds, Close-Ended Funds and Interval Funds
Open-ended funds are open for investors to enter or exit at any time, even after the NFO.
When existing investors acquire additional units or new investors acquire units from the open-ended scheme, it is called a sale transaction. It happens at a sale price, which is equal to the NAV.
When investors choose to return any of their units to the scheme and get back their equivalent value, it is called a re-purchase transaction. This happens at a re-purchase price that is linked to the NAV.
Although some unit-holders may exit from the scheme, wholly or partly, the scheme continues operations with the remaining investors. The scheme does not have any kind of time frame in which it is to be closed. The on-going entry and exit of investors implies that the unit capital in an open-ended fund would keep changing on a regular basis.
Close-ended funds have a fixed maturity. Investors can buy units of a close-ended scheme, from the fund, only during its NFO. The fund makes arrangements for the units to be traded, post-NFO in a stock exchange. This is done through a listing of the scheme in a stock exchange. Such listing is compulsory for close-ended schemes. Therefore, after the NFO, investors who want to buy Units will have to find a seller for those units in the stock exchange. Similarly, investors who want to sell Units will have to find a buyer for those units in the stock exchange. Since post-NFO, sale and purchase of units happen to or from counter-party in the stock exchange – and not to or from the scheme – the unit capital of the scheme remains stable or fixed.
Since the post-NFO sale and purchase transactions happen on the stock exchange between two different investors, and that the fund is not involved in the transaction, the transaction price is likely to be different from the NAV. Depending on the demand-supply situation for the units of the scheme on the stock exchange, the transaction price could be higher or lower than the prevailing NAV.
Interval funds combine features of both open-ended and close-ended schemes. They are largely close-ended, but become open-ended at pre-specified intervals. For instance, an interval scheme might become open-ended between January 1 to 15, and July 1 to 15, each year. The benefit for investors is that, unlike in a purely close-ended scheme, they are not completely dependent on the stock exchange to be able to buy or sell units of the interval fund. However, between these intervals, the Units have to be compulsorily listed on stock exchanges to allow investors an exit route.
The periods when an interval scheme becomes open-ended, are called ‘transaction periods’; the period between the close of a transaction period, and the opening of the next transaction period is called ‘interval period’. Minimum duration of transaction period is 2 days, and minimum duration of interval period is 15 days. No redemption/repurchase of units is allowed except during the specified transaction period (during which both subscription and redemption may be made to and from the scheme).
2 Actively Managed Funds and Passive Funds
Actively managed funds are funds where the fund manager has the flexibility to choose the investment portfolio, within the broad parameters of the investment objective of the scheme. Since this increases the role of the fund manager, the expenses for running the fund turn out to be higher. Investors expect actively managed funds to perform better than the market.
Passive funds invest on the basis of a specified index, whose performance it seeks to track. Thus, a passive fund tracking the BSE Sensex would buy only the shares that are part of the composition of the BSE Sensex. The proportion of each share in the scheme’s portfolio would also be the same as the weightage assigned to the share in the computation of the BSE Sensex. Thus, the performance of these funds tends to mirror the concerned index. They are not designed to perform better than the market. Such schemes are also called index schemes. Since the portfolio is determined by the index itself, the fund manager has no role in deciding on investments. Therefore, these schemes have low running costs.
3 Debt, Equity and Hybrid Funds
A scheme might have an investment objective to invest largely in equity shares and equity-related investments like convertible debentures. The investment objective of such funds is to seek capital appreciation through investment in this growth asset. Such schemes are called equity schemes.
Schemes with an investment objective that limits them to investments in debt securities like Treasury Bills, Government Securities, Bonds and Debentures are called debt funds.
4 Types of Debt Funds
Gilt funds invest in only treasury bills and government securities, which do not have a credit risk (i.e. the risk that the issuer of the security defaults).
Diversified debt funds on the other hand, invest in a mix of government and non-government debt securities such as corporate bonds, debentures and commercial paper. These schemes are also known as Income Funds.
Junk bond schemes or high yield bond schemes invest in companies that are of poor credit quality. Such schemes operate on the premise that the attractive returns offered by the investee companies makes up for the losses arising out of a few companies defaulting.
Fixed maturity plans are a kind of debt fund where the investment portfolio is closely aligned to the maturity of the scheme. AMCs tend to structure the scheme around pre-identified investments. Further, being close-ended schemes, they do not accept moneys post-NFO. Thanks to these characteristics, the fund manager has little ongoing role in deciding on the investment options.
As will be seen in Chapter8, such a portfolio construction gives more clarity to investors on the likely returns if they stay invested in the scheme until its maturity (though there can be no guarantee or assurance of such returns). This helps them compare the returns with alternative investments like bank deposits.
Floating rate funds invest largely in floating rate debt securities i.e. debt securities where the interest rate payable by the issuer changes in line with the market. For example, a debt security where interest payable is described as‘5-year Government Security yield plus 1%’, will pay interest rate of 7%, when the 5-year Government Security yield is 6%; if 5-year Government Security yield goes down to 3%, then only 4% interest will be payable on that debt security. The NAVs of such schemes fluctuate lesser than other debt funds that invest more in debt securities offering a fixed rate of interest.
Liquid schemes or money market schemes are a variant of debt schemes that invest only in short term debt securities. They can invest in debt securities of upto 91 days maturity. However, securities in the portfolio having maturity more than 60-days need to be valued at market prices [“marked to market” (MTM)]. Since MTM contributes to volatility of NAV, fund managers of liquid schemes prefer to keep most of their portfolio in debt securities of less than 60-day maturity. As will be seen later in this Work Book, this helps in positioning liquid schemes as the lowest in price risk among all kinds of mutual fund schemes. Therefore, these schemes are ideal for investors seeking high liquidity with safety of capital.
5 Types of Equity Funds
Diversified equity fund is a category of funds that invest in a diverse mix of securities that cut across sectors.
Sector funds however invest in only a specific sector. For example, a banking sector fund will invest in only shares of banking companies. Gold sector fund will invest in only shares of gold-related companies.
Thematic funds invest in line with an investment theme. For example, an infrastructure thematic fund might invest in shares of companies that are into infrastructure construction, infrastructure toll-collection, cement, steel, telecom, power etc. The investment is thus more broad-based than a sector fund; but narrower than a diversified equity fund.
Equity Linked Savings Schemes (ELSS), as seen earlier, offer tax benefits to investors. However, the investment is subject to lock-in for a period of 3 years.
Rajiv Gandhi Equity Savings Schemes (RGESS) too, as seen earlier, offer tax benefits to first-time investors. Investments are subject to a fixed lock-in period of 1 year, and flexible lock-in period of 2 years.
Equity Income / Dividend Yield Schemes invest in securities whose shares fluctuate less, and the dividend represents a larger proportion of the returns on those shares. The NAV of such equity schemes are expected to fluctuate lesser than other categories of equity schemes.
Arbitrage Funds take opposite positions in different markets / securities, such that the risk is neutralized, but a return is earned. For instance, by buying a share in BSE, and simultaneously selling the same share in the NSE at a higher price. Most arbitrage funds take contrary positions between the equity market and the futures and options market. (‘Futures’ and ‘Options’ are commonly referred to as derivatives. These are designed to help investors to take positions or protect their risk in some other security, such as an equity share. They are traded in exchanges like the NSE and the BSE. Chapter10 provides an example of futures contract that is linked to gold).
Although these schemes invest in equity markets, the expected returns are in line with liquid funds.
6 Gold Funds
These funds invest in gold and gold-related securities. They can be structured in either of the following formats:
Gold Exchange Traded Fund, which is like an index fund that invests in gold, gold-related securities or gold deposit schemes of banks. The structure of exchange traded funds is discussed later in this chapter. The NAV of such funds moves in line with gold prices in the market.
Gold Sector Fund i.e. the fund will invest in shares of companies engaged in gold mining and processing. Though gold prices influence these shares, the prices of these shares are more closely linked to the profitability and gold reserves of the companies. Therefore, NAV of these funds do not closely mirror gold prices.
(Gold Sector Fund is like any equity sector fund, which was discussed under ‘Types of Equity Funds’. It is discussed here to highlight the difference from a Gold ETF. It is important to understand that unlike Gold sector fund, Gold ETF does not invest in equity shares of companies involved in Gold related businesses including gold mining.)
7 Types of Hybrid Funds
Monthly Income Plan seeks to declare a dividend every month. It therefore invests largely in debt securities. However, a small percentage is invested in equity shares to improve the scheme’s yield.
As will be discussed in Unit8, the term ‘Monthly Income’ is a bit of a misnomer and investor needs to study the scheme properly, before presuming that an income will be received every month.
Another very popular category among the hybrid funds is the Balanced Fund category. These schemes were historically launched for the purpose of giving an investor exposure to both equity and debt simultaneously in one portfolio. The objective of these schemes was to provide growth and stability (or regular income), where equity had the potential to meet the former objective and debt the latter. The balanced funds can have fixed or flexible allocation between equity and debt. One can get the information about the allocation and investment style from the Scheme Information Document.
Capital Protected Schemes are close-ended schemes, which are structured to ensure that investors get their principal back, irrespective of what happens to the market. This is ideally done by investing in Zero Coupon Government Securities whose maturity is aligned to the scheme’s maturity. (Zero coupon securities are securities that do not pay a regular interest, but accumulate the interest, and pay it along with the principal when the security matures).
As detailed in the following example, the investment is structured, such that the principal amount invested in the zero-coupon security, together with the interest that accumulates during the period of the scheme would grow to the amount that the investor invested at the start.
Suppose an investor invested Rs 10,000 in a capital protected scheme of 5 years. If 5-year government securities yield 7% at that time, then an amount of Rs 7,129.86 invested in 5-year zero-coupon government securities would mature to Rs 10,000 in 5 years. Thus, by investing Rs 7,129.86 in the 5-year zero-coupon government security, the scheme ensures that it will have Rs 10,000 to repay to the investor in 5 years.
After investing in the government security, Rs 2,870.14 is left over (Rs 10,000 invested by the investor, less Rs 7129.86 invested in government securities). This amount is invested in riskier securities like equities. Even if the risky investment becomes completely worthless (a rare possibility), the investor is assured of getting back the principal invested, out of the maturity moneys received on the government security.
Some of these schemes are structured with a minor difference – the investment is made in good quality debt securities issued by companies, rather than Central Government Securities. Since any borrower other than the government can default, it would be appropriate to view these alternate structures as Capital Protection Oriented Schemes rather than Capital Protected Schemes.
It may be noted that capital protection can also be offered through a guarantee from a guarantor, who has the financial strength to offer the guarantee. Such schemes are however not prevalent in the market.
Some of these funds are also launched as Asset Allocation Funds. These schemes are not different from those under the Hybrid category. One should go through the Scheme Information Document to understand the unique characteristics of the individual scheme.
8 Real Estate Funds / Real Estate Investment Trusts.
They take exposure to real estate. Such funds make it possible for small investors to take exposure to real estate as an asset class. Although permitted by law, real estate mutual funds are yet to hit the market in India. SEBI has also announced the legislative framework for Real Estate Investment Trusts, which are aimed at high net worth investors.
9 Commodity Funds
Commodities, as an asset class, include:
food crops like wheat and gram
spices like pepper and turmeric
fibres like cotton
industrial metals like copper and aluminium
energy products like oil and natural gas
precious metals (bullion) like gold and silver
The investment objective of commodity funds would specify which of these commodities it proposes to invest in.
As with gold, such funds can be structured as Commodity ETF or Commodity Sector Funds. In India, mutual fund schemes are not permitted to invest in commodities, other than Gold (which was discussed earlier). Therefore, the commodity funds in the market are in the nature of Commodity Sector Funds, i.e. funds that invest in shares of companies that are into commodities. Like Gold Sector Funds, Commodity Sector Funds too are a kind of equity fund.
10 International Funds
These are funds that invest outside the country. For instance, a mutual fund may offer a scheme to investors in India, with an investment objective to invest abroad.
One way for the fund to manage the investment is to hire the requisite people who will manage the fund. Since their salaries would add to the fixed costs of managing the fund, it can be justified only if a large corpus of funds is available for such investment.
An alternative route would be to tie up with a foreign fund (called the host fund). If an Indian mutual fund sees potential in China, it will tie up with a Chinese fund. In India, it will launch what is called a feeder fund. Investors in India will invest in the feeder fund. The moneys collected in the feeder fund would be invested in the Chinese host fund. Thus, when the Chinese market does well, the Chinese host fund would do well, and the feeder fund in India will follow suit.
Such feeder funds can be used for any kind of international investment, subject to the scheme objective. The investment could be specific to a country (like the China fund) or diversified across countries. A feeder fund can be aligned to any host fund with any investment objective in any part of the world, subject to legal restrictions of India and the other country.
In such schemes, the local investors invest in rupees for buying the Units. The rupees are converted into foreign currency for investing abroad. They need to be re-converted into rupees when the moneys are to be paid back to the local investors. Since the future foreign currency rates cannot be predicted today, there is an element of foreign currency risk.
11 Fund of Funds
The feeder fund was an example of a fund that invests in another fund. Similarly, funds can be structured to invest in various other funds, whether in India or abroad. Such funds are called fund of funds. These ‘fund of funds’ pre-specify the mutual funds whose schemes they will buy and / or the kind of schemes they will invest in. They are designed to help investors get over the trouble of choosing between multiple schemes and their variants in the market.
Thus, an investor invests in a fund of funds, which in turn will manage the investments in various schemes and options in the market.
12 Exchange Traded Funds
Exchange Traded funds (ETF) are open-ended funds, whose units are traded in a stock exchange.
A feature of open-ended funds, which allows investors to buy and sell units from the mutual fund, is made available only to very large investors in an ETF.
Other investors will have to buy and sell units of the ETF in the stock exchange. In order to facilitate such transactions in the stock market, the mutual fund appoints some intermediaries as market makers, whose job is to offer a price quote for buying and selling units at all times.
If more investors in the stock exchange want to buy units of the ETF, then their moneys would be due to the market maker. The market maker would use the moneys to buy a basket of securities that is in line with the investment objective of the scheme, and exchange the same for units of the scheme from the mutual fund. Thus, the market maker can offer the units to the investors.
If there is more selling interest in the stock exchange, then the market maker will end up with units, against which he needs to make payment to the investors. When these units are offered to the mutual fund for extinguishment, corresponding securities will be released from the investment portfolio of the scheme. Sale of the released securities will generate the liquidity to pay the unit-holders for the units sold by them.
The major advantage of the market makers is to provide liquidity in the units of the ETFs to the investors.
In a regular open-ended mutual fund, all the purchases of units by investors on a day happen at a single price. Similarly, all the sales of units by investors on a day happen at a single price. The securities market however keeps fluctuating during the day. A key benefit of an ETF is that investors can buy and sell their units in the stock exchange, at various prices during the day that closely track the market at that time. This transaction price may be close to the NAV, but not necessarily the same as NAV. Further, the unique structure of ETFs, make them more cost-effective than normal index funds, although the investor would bear a brokerage cost when he transacts with the market maker.