Types of Mutual Fund Based on Index, International, Retirement and More

In the previous chapters, we discussed various classifications of mutual funds based on equity, debt and hybrid nature. In this last chapter of mutual funds classification, we will learn about other types of mutual funds. Let’s start with the solution-oriented funds. As the name suggests, these funds help you invest to achieve a specific goal. These goals can be either retirement, children’s education, etc. 

Retirement Funds 

Financially secured retirement becomes a crucial goal of each and everyone’s life. You will stop working after a certain age, but the expenses will continue to rise with rising inflation levels. At that time, you will need a regular source of income to meet your day-to-day expenses and emergency needs. 

Retirement funds act as a viable solution to help achieve the goal of retirement planning. These funds are also referred to as pension funds. These funds help you to accumulate a corpus till you are working and then provide you with a steady income to the extent of the final portfolio value. As per SEBI’s mandate, these funds have a minimum lock-in of 5 years or till the retirement age is attained, whichever is earlier. 

Types of plans available under the retirement funds category include:

• Equity funds 
• Debt funds 
• Hybrid funds 

Depending on the risk tolerance levels, you can choose the category of retirement funds you find suitable. The above-mentioned funds and their suitability have already been discussed in the previous chapter. 

Children's fund

As the name suggests, these funds are investment options designed for parents or guardians to save and invest money to meet their children's financial goals, such as education, marriage, etc. Inflation will reduce the purchasing power of savings in the future. With the rising education fees and aspirations to send their child abroad, the need to grow savings to achieve such goals will also become equally important. Thus, a children's fund is a mutual fund with specific child-related goals and terms. 

Most of the children’s fund invests in a mix of equity and debt portfolios. Investors can also choose between higher debt and equity-based investments depending on their risk appetite and time horizon. However, please note that these children’s funds come with a lock-in period of 5 years or until the child reaches the age of majority, whichever is earlier. Therefore, it makes for a suitable long-term investment option for most parents. 

Multi-Asset Funds

The focus of the earlier chapter was to cover funds focusing on equity and debt asset classes. Even hybrid funds used a mix of only debt and equity in their portfolio. However, multi-asset funds are for you if you want another asset class to be part of your same mutual fund portfolio. A multi-asset fund is a type of mutual fund that aims to offer an investor exposure to many asset classes in a single fund. 

Multi-asset funds may invest in a mix of:

• Traditional equity
• Fixed-income strategies
• Index-tracking funds
• Financial derivatives
• And commodities like gold, silver, etc.

As per SEBI’s mandate, a multi-asset fund should invest in at least three asset classes with at least 10% allocation in each asset class. This diversity allows fund managers to potentially balance risk and reward and deliver steady, long-term returns for investors, particularly in volatile markets. Fund managers dynamically assess the market condition and allocate these funds to various asset classes. Therefore, if one asset class underperforms, the results can be balanced by the outperformance of another asset class, thus providing stability to the portfolio. 

Key benefits of multi-asset funds:

• These funds diversify investments across various asset classes, reducing portfolio volatility. This is helpful to investors, especially during a market downturn where one asset class might underperform while the other gains. 
• As these funds are professionally managed, the need for investors to actively manage and rebalance their portfolios is removed, therefore saving investors time and effort. 
• These funds are a one-stop solution for investors seeking a diversified and balanced portfolio. 

Arbitrage Funds

Before diving deep into this fund, it is very important to understand the meaning of arbitrage. 

Arbitrage refers to the simultaneous purchasing and selling of an asset to exploit and take advantage of the price differentials in the two markets where the same asset is traded and profit from it. The difference between the two exchanges, spot and derivatives market, etc. 

For example, if there is a more-than-expected price difference between a stock that is trading in the cash market and its futures market,  then an arbitrage fund will buy a stock in the cash market and simultaneously sell it in the futures market at a higher price, to earn returns from the difference in the price of the stock in the two markets. Please note that arbitrage funds will take an equal but opposite position in both markets, thereby locking in the price difference.

The positions are held until the expiry of the derivative contract, and both positions need to be exited at the same price to realise the price difference. The assumption is that the cash market price will converge with the futures market price at the end of the contract period, thereby delivering risk-free profit for the investor/trader. 

Price movements in either market do not affect the initial price differential, as the profit in one market is offset by the loss in the other. This entire process requires a lot of research and understanding of how the market functions, and not all investors have the required knowledge or the time to dedicate to research. This is where Arbitrage Mutual Funds come to the investor's rescue. 

Hence, Arbitrage funds are considered a good choice for investors who are cautious and want to benefit from the market's volatility without taking on too much risk.

Index Funds

All the funds discussed before involve the active participation of the fund managers in picking a particular security, making decisions about the portfolio constituents, rebalancing the portfolio, etc. This comes at a cost for the investors in terms of high management fees. 

However, what if an investor wishes to avoid the active involvement of fund managers in portfolio building and instead invest in a broad-based pre-defined market index like Nifty 50, Sensex, Nifty small cap, etc? In such a scenario, investors can invest in index funds that aim to create a portfolio that mirrors a market index. The securities that are part of the fund’s portfolio and their weights are the same as the index it aims to replicate.

Therefore, unlike other funds, an index fund manager does not rebalance the portfolio based on their view of the market or sector. Rebalancing is done only when the index tracks rebalances. In other words, Index funds are passively managed, and the fund manager makes only minor, periodic time-to-time adjustments to keep the fund in line with the benchmark index. 

Thus, the Index fund offers the same risk and returns as the index it tracks. Here, it becomes important for you to understand that while actively managed funds focus on outperforming their underlying benchmark, an index fund, being passively managed, simply tries to match the returns offered by the underlying index. Investors who prefer predictable returns and want to invest in the equity markets without taking many risks can choose index funds. Also, for actively managed funds, the management fees charged for index funds are also low. 

In the upcoming chapters, we will discuss active and passive management in more detail. 

Fund of Funds (FoF)

Until now, we have understood mutual funds used to invest in individual securities. But what if mutual funds are invested in the units of another mutual fund? Well, that’s precisely the concept behind a fund of funds. These funds invest in the units of other schemes, either of the same mutual fund or other mutual fund. The rationale behind selecting schemes for investment purposes will depend on the investment goal of the fund of funds. However, you must know that a FoF has two levels of expenses: 

• Scheme whose units the Fund of Funds invests in and 
• The expense of the Fund of Funds itself. 

However, regulations have set a cap on the total expenses that can be charged, including both levels:

• The total expense ratio in respect of FoF investing in liquid schemes, index funds & ETFs has been capped @ 1%
• The total expense ratio of FoF investing in equity-focused schemes has been capped @ 2.25%
• The total expense ratio of FoF investing in schemes other than those mentioned above has been capped at @2%

Fund of Funds can even invest in international funds, and therefore, Using this route, you can invest in domestic and international funds. Apart from international funds, it can invest in commodities funds, multi-manager funds, etc. This increases the diversification of the Fund of Funds portfolio. 

International Funds

All the funds we have discussed until now have focused on domestic securities, i.e., securities traded in domestic markets. However, you can pick international funds if you wish to invest in securities beyond your country. International funds allow investments in securities outside of India by holding in their portfolio securities in one or more of the following:

• Equities of companies listed abroad.
• Debt/loans of companies listed abroad.
• Exchange-Traded Funds [ETFs] of foreign countries.
• Passive index fund units in other countries.
• Actively managed mutual fund units in other countries.

International funds may also hold some of their portfolio in Indian equity or debt. To manage liquidity, these funds can hold some of their portfolios in money market instruments. 

You, as an investor, benefit from investing in an international fund by:

• Diversification, since global markets usually have a low correlation with domestic markets. Therefore, any domestic news might not impact international markets and vice versa. 
• Investment options that may not be available in your domestic country..
• Easy access to companies that are global leaders in their respective areas of operation.

However, there are risks associated with investing in such funds, such as: 

• International political events and macroeconomic factors less familiar to domestic investors can impact the international market and make it volatile. It becomes for you to interpret such events. 
• Adverse movements in foreign exchange rates may affect the returns of the fund on redemption.
• International countries may change their global investments and foreign funds flow policies. 
• For taxation purposes, these funds are considered non-equity-oriented mutual fund schemes.

We will learn more about the taxation of mutual funds in the upcoming chapter. 

Ethical Funds

There are other mutual fund categories that abide by socially responsible investing. These are referred to as Shariah Compliant Mutual Funds, which are a kind of socially responsible investing based on the principles of Shariah or Shariat law of the Muslim religion. Therefore, these mutual funds abide by the Shariah law which is considered a moral code of Islam.

Features Of Ethical Funds

These funds have certain restrictions on their investment style and need to invest within the boundaries of Islamic laws.

• Ethical funds tend to avoid high levels of risk. Therefore, companies with high debts and investments through derivatives instruments are avoided.
• Ethical funds also avoid investments in fixed-income instruments.
• However, please note that such funds are not restricted to Islam's followers. 

Restrictions As Per Shariah Law

Apart from the above-mentioned features, there are certain rules that are required to be followed by a mutual fund to be a Shariah-compliant fund.

• Total Debt to Asset Ratio

These funds avoid investments in companies with a total debt-to-assets ratio of one-fourth or higher. 

• Interest-Free Companies

Finding a company with 100% interest-free income is almost impossible. That is why such funds invest in companies whose interest income makes up to 3% of their total income.

• Restricted Business

Such funds are not allowed to invest in shares of a company involved in financial services like banks and insurance companies. These funds are also restricted to investing in companies that manufacture liquor, tobacco, and pork or are involved in gambling, pornography, nightclub activities, etc.

In 2010, The S&P was among the first to launch Shariah indices in India.  The two indices that were launched to be Shariah compliant for mutual funds were:

• S&P CNX Nifty Shariah
• S&P CNX 500 Shariah

Some ethical mutual funds that are available in India are:

• Taurus Ethical Fund
• Tata Ethical Fund

• Nippon India ETF Shariah BeEs (earlier Reliance ETF Shariah BeES)

This sums up our discussion on other classifications of mutual funds.