A mutual fund is nothing but a financial product that invests in bonds or stocks or both. The pool of money for investments is accumulated by the investors and is managed by portfolio managers. Owning units of a Mutual fund is like owning a small slice of your favorite stock like Alphabet (Google) or Facebook. Investors get mutual fund units in the proportion of their investments.
Types of Mutual Funds
There are primarily two types of Mutual Funds – Active Funds and Passive Funds. Let us discuss the most popular mutual fund types within these two classifications. Various types of MF’s are available to cater the need of investors with different financial goals and age groups. They have different investment objectives and risk profiles.
#1 – Active vs. Passive Funds
The first classification of types of mutual funds is done on the basis of whether the fund is active or passive. Both the investment approaches differ in how manager wants to invest money and generate returns for account holders. Active funds seek to outperform a specific benchmark it has set for itself such as S&P 500 or BSE Sensex. To achieve this, active funds buy and sell stocks and manager pay attention to factors like economy, political situations, and other trends. He also does research around stock specific factors like ratio analysis, earnings growth, cash flow available to shareholders and future financial projections etc.
Passive funds on the other hand try to mimic the holdings of a particular index to create similar returns. Manager buys index stocks and applies same weighting. The objective here is not to beat the index but to remain closer to it. Since index funds require less research and other operational activities, the cost of buying it is less than an active fund.
In last five years, passive funds saw lot of inflows and their assets under management increased many folds on account of lower fees and better performance than active funds.
#2 – Equity Fund
Equity Funds is a type of mutual fund Invests in common stocks of companies listed on stock market. The primary investment objective of this class of funds is long-term capital growth. Equities are high risk, high reward asset class. They can be best suited to people with high risk taking ability and looking for higher returns.
There are multiple types of equity funds being offered
- Sector funds– Most risky of the lot, these funds invest in a particular sector in the economy e.g. IT sector fund will invest in technology companies only.
- Region or Country funds– Manager invests money in a particular region such as Asia, Latin America or Europe or in a specific country like the United Stated, India or China. This is slightly lower risk fund than sector fund.
- Large, Mid & Small Cap funds– Investment objective is to invest in particular market capitalisation companies such as large cap funds will invest in blue chip big stocks only, while small cap fund will invest in stocks with say less than $1 billion market cap. The riskiness decreases with increase in market cap.
- Diversified Funds– Less risky, as investment spread across sectors, regions, countries and market caps. Manager of this fund requires more skills and knowledge than any other above mentioned types. So selecting a right fund could be challenging. I will try to explain it to readers in “how to choose a Mutual fund” section.
#3 – Fixed Income Funds (FI)
This type of mutual fund is bond or debt fund that are less risky option of investing than in equity fund. The primary objective is to provide steady cash flow to investors. Investment happens in government and corporate debt securities.
source: T. Rowe
These are more suitable for people with risk aversion or reaching their retirement age etc.
- High Yield funds– Carries the highest risk of FI funds due to their investment in junk bonds. Junk bonds are lowest-rated bonds (BB or below) by credit rating agencies such as S&P or Moody’s. Provides attractive returns than most other fund types in this group.
- Corporate Bond funds– Companies borrow money at a fixed interest/coupon rate. Mutual fund manager invests in these securities and receives steady cash payments.
- Government Bond Funds or Gilts– Lower risk fund in this group. Invests in government securities like treasury bonds, notes or gilts etc.
- Money Market Fund- Lowest risk funds that invest mostly in treasury bills. Return will be less than other types of FI funds but the risk of losing the money is also negligible.
#4 – Balanced Funds
These type of mutual funds are known as hybrid funds. The portfolio holds both equity and debt securities. The primary objective is to gain a capital appreciation and generate income for investors. A typical balanced fund invests a 60% in equity and a 40% in fixed income.
#5 – Alternative Funds
These types of mutual funds are a non-conventional investment vehicle, unlike stocks and bonds. High net worth and institutional investors are predominantly using this MF type. Due to its complex nature, individual investors are not advised to sign-up for these funds. Alternative Investments funds invest in real estate, commodities, derivative and futures contracts, and also in hedge funds.
This is a guide to Top 5 types of Mutual Funds – Active Passive Mutual Funds, Index Funds, Balanced Funds, Fixed Income Funds, Alternate Funds, Equity Funds. You may also learn more about Mutual Funds from the articles below –