If you scroll through any mutual fund website, and you will find a lot of data about how a particular fund or scheme of the AMC has outperformed the market. There could be an analysis of how the particular fund has beaten the market index. There could also be a comparison between a particular fund and the other funds in the category to highlight the superiority of a particular fund. There could be an elegant table or chart which outlines how that particular fund could have created wealth for an investor over a period of time. As a smart investor, it is your job to conduct 6 basic tests before deciding on buying a mutual fund.
- 1. Liquid Funds – Shortest end of the maturity
- 2. Short term funds – Slightly longer on the maturity scale
- 3. Arbitrage Funds – Called equity funds but behave like debt funds
- 4. Bond Funds – Invest in private sector bonds and gilts
- 5. Gilt Funds – Focus on G-Secs
- 6. Fixed Maturity Plans (FMPs)
- 7. Floating Rate Funds
- 8. Monthly Income Plans (MIPs)
1. Liquid Funds – Shortest end of the maturity
This is essentially a liquid cash management product. Corporates and HNIs use this method to park their funds which need to be withdrawn at short notice. Since these liquid funds do not attract entry and exit load, they permit easy entry and exit for short term investors. The maximum maturity that these liquid funds will invest is normally 91 days. They typically invest in the call money market and in 91 day Treasury bills. They are the lowest risk and are not very susceptible to changes in the market interest rates.
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2. Short term funds – Slightly longer on the maturity scale
These short term funds are slightly longer in the maturity bracket compared to pure liquid funds. They typically invest in debt securities having a maturity up to 3-4 years. The short term funds are meant for investors who want to park their funds for a maximum period of 2 years. Of course, their risk is higher than liquid funds, but due to their short tenure of bonds, they are less susceptible to interest rate risk.
3. Arbitrage Funds – Called equity funds but behave like debt funds
Arbitrage funds actually mirror a debt product by being long on equities and creating a short position in futures. This way they create a mirror of a 1 month debt product that can be rolled over infinitely. These funds are classified as equity funds and hence they are tax efficient from an investor’s perspective. But these funds are not always attractive. It largely depends on the equity-futures spread in the market. If the spread compresses, then most investors lose interest in these arbitrage funds.
4. Bond Funds – Invest in private sector bonds and gilts
Bond funds are long term debt funds which invest in debt instruments that have longer maturities. These funds typically invest in private debt, quasi institutional debt, and state government debt and in gilts. These funds are susceptible to interest rate risk. Therefore it makes sense to invest in these products when you have the view that interest rates are going to fall. Otherwise it may result in capital losses. One needs to remember that Bond funds have an element of default risk too as private sector bonds are also included in their portfolio. We saw this risk manifest itself recently in the JP Morgan Mutual Fund’s holdings in the bonds of Amtek Auto
5. Gilt Funds – Focus on G-Secs
Gilt funds are almost similar to bond funds. The only difference is that they do not invest in private bonds but only in government debt. They are also funds that invest in long tenure bonds. While these gilt funds carry a high level of interest rate risk, they are not exposed to default risk, since there is no risk of default in the case of government securities. These are the most popular among corporate and institutional investors.
6. Fixed Maturity Plans (FMPs)
These are almost akin to closed-ended funds. Here the fund has a specific maturity and can be redeemed only at that particular maturity. Hence investors need to understand that the asset liability mismatch does not happen to them. For example, if you have a liability maturing in 2 years, there is no point in creating a 3-year FMP. Of course, these FMPs are listed on stock exchanges but then there is an additional cost that it involves.
Recommended Read: Benefits of Investing in Mutual Funds over Direct Equities
7. Floating Rate Funds
These are funds where the interest yield is reset at regular intervals. This makes sense in a rising interest scenario, where investors can get the benefit of higher yield and they do not suffer capital loss as in case of bond funds and gilt funds. This is a good product to manage interest rate risk in a rising interest environment.
8. Monthly Income Plans (MIPs)
These are debt funds that also have an exposure to equity in small measure to provide that additional return kicker. These MIPs have a monthly payout and hence operate as a kind of a systematic withdrawal plan for investors. It needs to be remembered that these are not assured return schemes and they will vary based on the performance of the MIP.
As an investor it is necessary for you to understand the nuances of the various categories of fixed income funds so that you can pigeonhole your choice of fund to your exact requirement and your view on interest rates.