What are mutual funds?:

A Mutual Fund (MF) is formed when capital collected by various investors is invested in purchasing company shares, stocks, or bonds. Shared by thousands of investors, mutual funds investments are collectively managed by a professional fund manager to earn the highest possible returns. This is how mutual funds work, not only in India but, anywhere in the world.

Types of mutual funds

Mutual funds are broadly classified into three categories based on their investment traits and risks involved. Understand all mutual fund types and analyse them to check if your requirements would be served by investing in a particular type of mutual fund. Following are the types of mutual funds:

Equity Funds
Debt Funds
Balanced or Hybrid fund

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Equity Funds

Equity funds primarily invest in shares of different companies. Your equity funds investment would make a profit when the share prices surge, while they suffer a loss when the share prices fall. Investing in equity funds is apt for those who stay invested for an extended period and is comfortable with moderate to high risk.

1. What is an Equity Fund?

Equity funds aim to generate high returns by investing in the shares of companies of different market capitalization. They produce higher returns than debt funds and fixed deposits. The performance of the company decides the investors’ returns.

2. How do Equity Funds work?

An equity fund invests at least 60% of its assets in equity shares of companies in varying proportions. This should be in line with the investment mandate. It might be a purely large-cap, mid-cap, or small-cap fund or a mixture of market capitalisation. Moreover, the investing style may be value-oriented or growth-oriented. After allocating a significant portion of equity shares, the remaining amount will go into debt and money market instruments. This is to take care of sudden redemption requests as well as bring down the risk level to some extent. The fund manager makes buying or selling decisions to take advantage of the changing market movements and reap maximum returns.

3. Who should Invest in Equity Funds?

Your decision to invest in equity funds must align to your risk tolerance, investment horizon, and goals. Generally, if you have a long-term goal (say, five years or more), it is better to go for equity funds. It will also give the fund ample time to ride out the market fluctuations.

a. For budding investors

If you are a budding investor who wants to have exposure to the stock market, then large-cap equity funds may be the right choice. These funds invest in equity shares of the top 100 companies in the stock market. The well-established companies have historically delivered stable returns over the long-term.

b. For market savvy investors

In case you are well-versed with the market pulse but want to take calculated risks, you may think of investing in diversified equity funds. These invest in shares of companies across market capitalisation. These give an optimum combination of high return and lesser risk as compared to equity funds that only invest in small-cap/mid-caps.

4. Features of Equity Funds

a. 80C tax exemption ELSS is the only tax-saving investment under Section 80C of the Income Tax Act that gives you equity exposure (other than NPS). With its shortest lock-in period of three years and high return potential, ELSS has a good track record . You can invest in small but regular instalments or a lump sum as per your affordability.

b. Cost of investment

The frequent buying and selling of equity shares often impact the expense ratio of equity funds. Currently, SEBI has fixed the upper limit of expense ratio at 2.5% for equity funds and is planning to reduce it further. A lower expense ratio, of course, translates into higher returns for investors.

c. Holding period

When you redeem units of equity funds, you make capital gains. The capital gains are taxable in the hands of investors. The rate of taxation depends on how long you stay invested in equity funds, and this period is called the holding period.

d. Cost-efficiency & diversification

By investing in equity funds you can get exposure to a number of stocks by investing a nominal amount. For instance, if you have Rs 2,000 to invest, then you will be able to buy one stock of a large-cap company or one stock of 2-3 mid-cap companies. However, your portfolio will face concentration risk. But with the same amount, you can get exposure to a lot many stocks when you invest in equity funds. This allows you to diversify and benefit meaningfully.

5. Types of Equity Funds

You can categorise equity funds based on their investment mandate and the kind of stocks and sectors they invest in.

a. Based on Sector and Themes

Equity funds that focus their investments on a particular sector or theme fall under this category. Sector funds invest in a specific industry such as FMCG or Pharma or, Technology. Thematic funds follow one specific subject such as emerging consumer companies or international stocks. Since sector funds and thematic funds focus on a particular sector or theme, they tend to be riskier. This is because of their performance face sectoral as well as market risks. However, industry and thematic funds can be diversified in terms of market capitalisation.

b. Based on Market Capitalisation

Large-cap equity funds: Typically, large-cap companies are well-established, making them large-cap funds stable and reliable investments. Mid-cap equity funds: They invest in medium-sized companies. Mid-and-small-cap funds: There are even funds that invest in both mid-cap as well as small-cap funds. Small-cap funds: Since smaller companies are prone to volatility, small-cap funds deliver fluctuating returns. Multi-cap funds: Equity funds that invest across market capitalisation, which is in large-cap, mid-cap, and small-cap stocks, are called multi-cap funds.

C. Based on Investment Style

All the funds discussed above follow active investing style, wherein the fund manager decides the portfolio composition. However, there are funds whose portfolio composition imitate a specific index. Equity funds that follow a particular index are called index funds. These are passively-managed funds that invest in the same companies, in the equal proportions, making up the index the fund follows. Example, a Sensex index fund will have investments in all 30 Sensex companies in the same proportion in which the companies form part of the index. Index funds are low-cost funds as they don’t require the active management of a fund manager.

6. Performance of Equity Funds in India

Amongst all other categories of mutual funds, equity funds generally deliver the highest returns. On an average, equity funds have generated before-tax returns in the range of 10% to 12%. These returns may fluctuate as per market movements and overall economic conditions. To earn returns in line with your expectations, you need to choose your equity funds carefully. For that, you have to strictly follow the stock markets and possess knowledge of the quantitative and qualitative factors. ClearTax assists by handpicking the top-performing investment portfolios for you, which suits your financial goals.

7. Benefits of Investing in Equity Funds

The benefits of investing in mutual funds are many:

a. Expert money management
b. Low Cost
c. Convenience
d. Diversification
e. Systematic investments
f. Flexibility
g. Liquidity

The primary benefit of investing in equity funds is that you don’t need to worry about choosing stocks and sectors to invest in. Successful equity investing requires a lot of research and knowledge. You need to dig deep into the financials of a company before you invest in it. You also need to have an understanding of how a particular sector is expected to perform in the future. Of course, all of this requires a lot of time and effort, which most common investors don’t have. Hence, the solution is to leave the stock-picking to an expert fund manager by investing in an equity fund.

8. Taxation of Equity Funds

Capital gains earned on the holding period of up to one year are called short-term capital gains (STCG) and are taxed at the rate of 15%. Conversely, capital gains made on holding more than one year are called long-term capital gains (LTCG). Owing to the changes in Union Budget 2018-19, LTCG over Rs 1 lakh will be taxed at the rate of 10%, without the benefit of indexation.

9. SIP or lumpsum- which is better?

a. Lump-sum
If you can afford to invest a lump sum in one go per annum, this method too can work overtime. However, not everyone finds it feasible to arrange for a large sum and hence, opts for SIPs instead.

b. Systematic Investment Plan (SIP)
A SIP is usually a monthly investment that happens automatically on a pre-decided date. You give a mandate to the fund company to deduct the investment from your bank account. SIPs give you the benefit of rupee cost averaging. This means that when the markets are high, you will be allotted fewer units. And when the markets are low, you will get more units for the same amount. This way, you invest at different levels of the market. SIPs also inculcate financial discipline and make mutual funds affordable for all.

Debt Funds

1. What is a Debt Fund?

a debt instrument is similar to giving a loan to the issuing entity. A debt fund invests in fixed-interest generating securities like corporate bonds, government securities, treasury bills, commercial paper and other money market instruments. The fundamental reason for investing in debt funds is to earn interest income and capital appreciation. The issuer pre-decides the interest rate you will receive as well as the maturity period. Hence, they are also known as ‘fixed-income’ securities.

2. How do Debt Funds work?

Debt funds invest in different securities, based on their credit ratings. A security’s credit rating signifies whether the issuer will default in disbursing the returns they promised. The fund manager of a debt fund ensures that he invests in high credit quality instruments. A higher credit rating means that the entity is more likely to pay interest on the debt security regularly as well as pay back the principal amount upon maturity.

Debt funds which invest in higher-rated securities are less volatile when compared to that of low-rated securities. Additionally, maturity also depends on the investment strategy of the fund manager and the overall interest rate regime in the economy. A falling interest rate regime encourages the manager to invest in long-term securities. Conversely, a rising interest rate regime encourages him to invest in short-term securities.

3. Who should invest in Debt Funds?

Debt funds try to optimize returns by diversifying across different types of securities. This allows debt funds to earn decent returns. However, there is no guarantee of returns. Debt fund returns often fall in a predictable range. This makes them safer avenues for conservative investors. They are also suitable for people with both short-term and medium-term investment horizons. Short-term ranges from 3 months to 1 year, while medium-term ranges from 3 years to 5 years.

a. Short-term debt funds
For a short-term investor, debt funds like liquid funds may be an ideal investment, compared to keeping your money in a saving bank account. Liquid funds offer higher returns in the range of 7%-9% along with similar kind of liquidity for meeting emergency requirements.

b. Medium-term debt funds
For a medium-term investor, debt funds like dynamic bond funds can be ideal for riding the interest rate volatility. When compared to 5-year bank FDs, debt bond funds offer higher returns. If you are looking to earn a regular income from your investments, then the Monthly Income Plans may be a good option.

4. Types of Debt Funds

As mentioned above, there are many types of debt mutual funds, suiting diverse investors. The primary differentiating factor between debt funds is the maturity period of the instruments they invest in. Here are the different types of debt funds:

a. Dynamic Bond Funds
As the name suggests, these are ‘dynamic’ funds. Meaning, the fund manager keeps changing portfolio composition according to fluctuating interest rate regime. Dynamic bond funds have a different average maturity period as these funds take interest rate calls and invest in instruments of longer as well as shorter maturities.

b. Income Funds
Income Funds take a call on the interest rates and invest predominantly in debt securities with extended maturities. This makes them more stable than dynamic bond funds. The average maturity of income funds is around 5-6 years.

c. Short-Term and Ultra Short-Term Debt Funds
These are debt funds that invest in instruments with shorter maturities, ranging from 1 to 3 years. Short-term funds are ideal for conservative investors as these funds are not affected by interest rate movements.

d. Liquid Funds
Liquid funds invest in debt instruments with a maturity of not more than 91 days. This makes them almost risk-free. Rarely have liquid funds seen negative returns. These funds are better alternatives to savings bank accounts as they provide similar liquidity with higher returns. Many mutual fund companies offer instant redemption on liquid fund investments through unique debt cards.

e. Gilt Funds
Gilt Funds invest in only government securities – high-rated securities with very low credit risk. Since the government seldom defaults on the loan it takes in the form of debt instruments; gilt funds are an ideal choice for risk-averse fixed-income investors.

f. Credit Opportunities Funds
These are relatively newer debt funds. Unlike other debt funds, credit opportunities funds do not invest according to the maturities of debt instruments. These funds try to earn higher returns by taking a call on credit risks or by holding lower-rated bonds that come with higher interest rates. Credit opportunities funds are relatively riskier debt funds.

g. Fixed Maturity Plans
Fixed maturity plans (FMP) are closed-ended debt funds. These funds also invest in fixed income securities like corporate bonds and government securities. All FMPs have a fixed horizon for which your money will be locked-in. This horizon can be in months or years. However, you can invest only during the initial offer period. It is like a fixed deposit that can deliver superior, tax-efficient returns but does not guarantee high returns.

5. Things to consider as an investor

a. Risk
Debt funds suffer from credit risk and interest rate risk, which makes them riskier than bank FDs. In credit risk, the fund manager may invest in low-credit rated securities which have a higher probability of default. In interest rate risk, the bond prices may fall due to an increase in the interest rates.

b. Return
Even though debt funds are fixed-income havens, they don’t offer guaranteed returns. The Net Asset Value (NAV) of a debt fund tends to fall with a rise in the overall interest rates in the economy. Hence, they are suitable for a falling interest rate regime.

c. Cost
Debt fund managers charge a fee to manage your money called an expense ratio. Until now, SEBI had mandated the upper limit of expense ratio to be no more than 2.25% of the overall assets. Considering the lower returns generated by debt fund as compared to equity funds, a long-term holding period would help in recovering the money lost through expense ratio.

d. Investment Horizon
If you have a short-term investment horizon of 3 months to 1 year, you may go for liquid funds. Conversely, ideal tenures for short-term bond funds can be 2 to 3 years. In case of an intermediate horizon of 3 to 5 years, dynamic bond funds would be appropriate. Basically, the longer the horizon, the better the returns.

e. Financial Goals
You can use debt funds as an alternative source of income to supplement your income from salary. Additionally, budding investors can invest some portion in debt funds for liquidity. Retirees may invest the bulk of retirement benefits in a debt fund to receive a pension.

f. Tax on Gains
Capital gains from debt funds are taxable. The rate of taxation is based on the holding period, i.e., how long you stay invested in a debt fund. A capital gain made during a period of fewer than 3 years is known as a Short-term Capital Gain (STCG). A capital gain made over a period of 3 years or more is known as Long-term Capital Gains (LTCG). Investors can add STCG from debt funds to his/her income. Here, the tax is as per the income slab. A fixed 20% tax after indexation applies for STCG from debt funds.

6. How to invest in Debt Funds?

Investing in Debt Funds is made paperless and hassle-free at ClearTax. Using the following steps, you can start your investment journey:
at
Enter your details
Enter the investment details (investment amount and maturity period)
Complete your e-KYC in less than 5 minutes
Invest in a suitable plan from the hand-picked debt funds

7. Top 5 Debt Funds in India

There are various quantitative and qualitative parameters to determine the best debt funds as per your requirements. Additionally, it would be best if you keep your financial goals, risk appetite and investment horizon in mind. The following table represents the top 5 debt funds in India, based on the past 1 year returns. Investors may choose the funds with different investment horizon like 5 years or 10 years returns. You may include other criteria like financial ratios as well.

Hybrid Fund

1. What is a Hybrid Fund?

Hybrid funds invest in both debt instruments and equities to achieve maximum diversification and assured returns. A perfect blend! The choice of a hybrid fund depends on your risk preferences and investment objective.

2. How do Hybrid Funds work?

Hybrid funds aim to achieve wealth appreciation in the long-run and generate income in the short-run via a balanced portfolio. The fund manager allocates your money in varying proportions in equity and debt based on the investment objective of the fund. The fund manager may buy/sell securities to take advantage of market movements.

3. Who should invest in Hybrid Funds?

Hybrid funds are regarded as safer bets than pure equity funds. These provide higher returns than genuine debt funds and are a favourite among conservative investors. Budding investors who are eager to take exposure in equity markets can think of hybrid funds as the first step. As these are an ideal blend of equity and debt, the equity component helps to ride the equity wave.

At the same time, the debt component of the fund provides a cushion against extreme market turbulence. In that way, you receive stable returns instead of a total burnout that might be possible in case of pure equity funds. For the less conservative category of investors, the dynamic asset allocation feature of some hybrid funds becomes a great way to milk the maximum out of market fluctuations.

4. Types of Hybrid Funds

Hybrid funds can be further classified based on their asset allocation. Some types of hybrid funds have a higher equity allocation, while others allocate more to debt. Let’s have a look in detail.

a. Equity-oriented hybrid funds
When the fund manager invests 65% or more of the fund’s assets in equity and rest in debt and money market instruments, it’s called an equity-oriented fund. The equity component of the fund comprises of equity shares of companies across industries like FMCG, finance, healthcare, real estate, automobile, etc.

b. Debt-oriented balanced funds
The debt component of the fund constitutes the investment in fixed-income havens like government securities, debentures, bonds, treasury bills, etc. An asset allocation of 60% or more in debt and rest in equity is called a debt-oriented fund. For the sake of liquidity, some part of the fund would also be invested in cash and cash equivalents.

c. Balanced Funds
Balanced funds invest at least 65% of their portfolio in equity and equity-oriented instruments. This allows them to qualify as equity funds for taxation. It means that gains over and above Rs 1 lakh from balanced funds held for over one year are taxable at the rate of 10%.
The rest of the fund’s assets goes to debt securities and cash reserves. So, conservative investors can benefit from the return-earning capacity of equities without taking too many risks. The fixed income exposure to balanced funds helps in mitigating equity-related risks.

d. Monthly Income Plans
These are hybrid funds that invest predominantly in debt instruments. A monthly income plan (MIP) would generally have 15-20% exposure to equities. This would allow it to generate higher returns than regular debt funds. MIPs provide regular income to the investor in the form of dividends. An investor can choose the frequency of dividends, which can be monthly, quarterly, half-yearly, or annually. debt funds. MIPs provide regular income to the investor in the form of dividends. An investor can choose the frequency of dividends, which can be monthly, quarterly, half-yearly or annually.
MIPs also come with the growth option – they let the investments grow in the fund’s corpus. Hence, an MIP is not a small monthly income investment. Do not let the name mislead you. They are hybrid funds that invest mostly in debt and some amount of equities.

e. Arbitrage Funds
An arbitrage fund manager tries to maximise returns by buying the stock at a lower price in one market. He, then, sells it at a higher price in another market.
However, arbitrage opportunities are not always available quickly. In the absence of arbitrage opportunities, these funds might stick to debt instruments or cash. By design, arbitrage funds are relatively safer, like most debt funds. But its long-term capital gains are taxable like that of any equity fund.