Mutual Funds Basics

It is a professionally managed financial instrument that pools money from many investors to purchase securities such as stocks, bonds, money market instruments, etc. It offers more diversification and opportunity for investors to make smart investments without being actively engaged in the day to day investment activities.

Advantages of investing in mutual funds include:
  • Built-in diversification - Mutual Funds invest in a wide range of securities which helps offset the impact of poor performers, while taking advantage of the earning potential of the rest.
  • Professional Management - Mutual Funds are run by qualified and professional fund managers who actively track their funds and re-balance the portfolios from time to time as new information comes in.
  • Fulfils various investment objectives - Mutual funds can be used to meet various financial goals. For example:
    • ELSS funds for tax planning
    • Diversified equity funds for long term wealth creation
    • Debt mutual funds for stable returns and preservation of capital
  • Liquidity - For open-ended funds, you can redeem all or part of your investment any time you wish and receive the current value of the investments. However, it is important to watch out for lock-in period and exit load fees.
  • Regulations - All mutual funds are required to register with SEBI (Securities and Exchange Board of India). They are obliged to follow strict regulations designed to protect investors. All operations are also regularly monitored by SEBI.

Mutual funds can be classified as follows:

Mutual Funds

1. Equity Funds

An equity fund is a mutual fund that invests principally in stocks. In this way, the investor is able to buy a basket of stocks more easily than buying individual stocks and the investor also reaps the benefits of a diversified portfolio. Equity funds have historically provided the highest rate of return but are also more volatile as they are market dependent. Although, equity funds can generate outstanding returns in a short span of time as well, but investors should ideally have a long term time frame to counter volatility.

Equity funds can be further classified as:

 According to market capitalization

It is a measure by which we can classify a company’s size. It is the current market value of the company’s outstanding shares.

  • Large Cap Funds: When a larger proportion (>=80%) of the portfolio is invested in stocks of companies with large market capitalization.
  • Multi Cap Funds: Diversified mutual funds which invest in stocks across large,mid and small market capitalization.
  • Mid Cap Funds: When 65% or more of the portfolio is invested in stocks of mid and small size companies. They are usually more volatile than large cap funds.
  • Small Cap Funds: When 65% or more of the portfolio is invested in stocks of small size companies. Amongst all equity funds, they are the most volatile but have also provided the highest return over long holding periods.

 ELSS (Equity Linked Savings Scheme) Funds

ELSS funds, also known as tax saving mutual funds, are diversified equity funds with a lock in period of 3 years. They offer tax benefits u/s 80C up to Rs.1,50,000.

 Sector Funds

These funds invest predominantly (>=65%) in businesses that operate in a particular industry or sector of the economy. Since the overall market may alternate between favoring different sectors, these funds benefit investors with a deep understanding of a particular sector’s potential.
For example: Pharmaceuticals, FMCG, Banking, IT, etc.

 Equity FoF (Fund of Funds)

An Equity Fund of Funds is a mutual fund scheme that invests in various other equity funds rather than investing directly in stocks. It provides greater diversification than traditional Mutual Funds by spreading investors’ money across different investing styles.

 International Funds

These funds invest in stocks of companies located outside India. Schemes with a mandate to invest the majority of their assets in overseas markets/ global commodities will form a part of this category. Fund of funds dedicated to overseas markets will also form part of this category.

2. Hybrid Funds

A hybrid fund is a category of mutual fund that is characterized by a portfolio which is made up of a mix of stocks and bonds, which can vary over time. These funds usually provide more stable returns than equity funds but are more volatile than debt funds.

They can be further classified as:

 Equity oriented

Equity oriented funds allocate at least 65% of their portfolio into equity and the rest to debt. They are taxed just like equity mutual funds.

 Debt oriented

Debt oriented funds invest less than 65% of their portfolio into equity. They are taxed like debt mutual funds.


An arbitrage fund is a type of mutual fund that exploits the difference in the price of a stock between cash and derivatives markets or even different stock exchanges such as BSE and NSE. These funds are hybrid in nature as they have the provision of investing a sizeable portion of the portfolio in debt markets. However, as these funds invest predominantly in equities, their tax treatment is at par with equity funds.

 Hybrid FoF (Fund of Funds)

A Hybrid Fund of Funds is a mutual fund scheme that invests in other equity and debt funds rather than investing directly in stocks, bonds or money market instruments.

3. Debt Funds

Debt funds are mutual funds that invest in fixed income securities like bonds and treasury bills. These are suitable for investors whose main objective is preservation of capital with stable return.

They can be further classified as:

 Liquid Funds

These invest in very short term debt securities. Instruments in liquid funds have a maturity period of maximum 91 days. Investors who have short term surplus cash should consider these funds as they usually offer better returns than savings bank accounts.

 Ultra Short Term Funds

These funds invest in very short term debt securities and their average maturity is usually between 91 days to 1 year. They are preferred by investors who are willing to marginally increase their risk with an aim to earn commensurate returns. They usually generate returns a little higher than Liquid Funds.

 Short Term Funds

These funds invest in short term bonds or government securities whose average maturity is on an average between 1 to 3 years. As these funds have a higher maturity profile, they are more sensitive to changes in interest rates than Liquid and Ultra Short Term Funds.

 Medium Term Funds

These funds invest in medium term bonds or government securities with an average maturity of 3 to 7 years. These funds tend to work well when entry and exit are timed properly as they are sensitive to changes in interest rates.

 Long Term Funds

These funds invest in long term bonds or government securities with an average maturity greater than 7 years. They are highly vulnerable to the changes in interest rates and are suitable for investors who have a long term investment horizon and higher risk taking ability.

 Dynamic Bond Funds

They are invested in debt securities of different maturity profiles. These funds are actively managed and the portfolio varies dynamically according to the interest rate view of the fund managers.

 FTP or FMP (Fixed maturity plan) Funds

These are closed ended funds with a fixed maturity date which invest in debt & money market instruments maturing on or before the date of the maturity of the scheme. The returns of FMPs are usually stable and indicative, and they carry little or no interest rate risk. These can be purchased only during its New Fund Offer (NFO).
Due to the above risk and return characteristics, FTP / FMPs are quite similar to Fixed Deposits but with tenures of over three years, they enjoy significant tax advantages over FDs, especially for investors in the highest tax bracket.

 Debt FoF (Fund of Funds)

A Debt Fund of Funds is a mutual fund scheme that invests in various other debt funds rather than investing directly in bonds or other money market instruments.

4. ETFs (Exchange Traded Funds) and Gold

Exchange traded funds are essentially index funds that are listed and traded on exchanges. An ETF is a basket of stocks or any other asset class that reflects the composition of an index. Their primary objective is to track the index return as closely as possible and reflects passive fund management.

 Gold MFs

These are mutual funds which invest in various forms of gold. It can be in the form of Gold ETFs or stocks of gold mining companies.

 Gold ETFs

Gold ETFs are exchange traded funds where the underlying asset is gold. Therefore, value of gold ETF depends upon the price of gold.

 Equity ETFs

Equity ETFs are passive investment instruments that are based on equity market indices (like Nifty 50, Nifty 500, etc.) and invest in securities in same proportion as the underlying index. Because of its index mirroring property, their returns usually revolve around their benchmark indices.

 Debt ETFs

Debt ETFs are passive investment instruments that invest in various debt instruments like treasury bills, government securities, call money, etc.