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• If the fund sells securities that have increased in price, the fund has a capital gain. Most of the funds also pass on these gains to investors in a distribution.
• If fund holdings increase in price but are not sold by the fund manager, the fund’s shares increase in price. You can then sell your mutual fund shares for a profit.

Funds will also usually give you a choice either to receive a check for distributions or to reinvest the earnings and get more shares.

Advantages of Mutual Funds:

• Professional Management – The primary advantage of funds is the professional management of your money. Investor purchase funds because they do not have the time or the expertise to manage their own portfolios. A mutual fund is relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments.
• Diversification – By owning shares in a mutual fund instead of owning individual stocks or bonds, your risk is spread out. The idea behind diversification is to invest in a large number of assets so that a loss in any particular investment is minimized by gains in others. In other words, the more stocks and bonds you own, the less any one of them can hurt you. Large mutual funds typically own hundreds of different stocks in many different industries. It wouldn’t be possible for an investor to build this kind of portfolio with a small amount of money.
• Economies of Scale – Because a mutual fund buys and sells large amounts of securities at a time, its transaction costs are lower than what an individual would pay for securities transactions.
• Liquidity – Just like an individual stock, a mutual fund allows you to request that your units be converted into cash at any time.
• Simplicity – Buying a mutual fund is easy. Mutual fund companies own a line of schemes, and the minimum investment is small. Most companies also have automatic purchase plans whereby as little as Rs.500 can be invested on a monthly basis.

Mutual Funds: Different Types of Funds

No matter what type of investor you are, there is bound to be a mutual fund that fits your style. According to the last count there are more than 40 mutual funds companies in India selling more than 200 mutual fund schemes.

It’s important to understand that each mutual fund has different risks and rewards. In general, the higher the potential return, the higher the risk of loss. Although some funds are less risky than others, all mutual funds have some level of risk – it’s never possible to diversify away all risk. This is a fact for all investments.

Each fund has a predetermined investment objective that tailors the fund’s assets, regions of investments and investment strategies. At the fundamental level, there are three varieties of mutual funds:

• Equity funds (stocks)
• Fixed- income funds(bonds)
• Money market funds (T-bills, call money market)

All mutual funds are variations of these three asset classes. For example, while equity funds that invest in fast-growing companies are known as growth funds, equity funds that invest in companies of the same sector or region are known as speciality funds. Let’s go over the many different flavours of funds. We’ll start with the safest and then work through to the more risky.

Money Market Funds:

The money market fund consists of short-term debt instruments, mostly treasury bills. This is a safe place to park your money. You won’t get great returns, but you won’t have to worry about losing your principal. A typical return is twice the amount you would earn in the regular checking/savings account and a little less than the average certificate of deposit (CD).

Bond/Income Funds:

Income funds are named appropriately: their purpose is to give current income on a steady basis. When referring to mutual funds, the terms “fixed-income,” “bond,” and “income” are synonymous. These terms denote funds that invest primarily in government and corporate debt. While fund holdings may appreciate in value, the primary objective of these funds is to provide a steady cash flow to investors. As such, the audience for these funds consists of conservative investors and retirees.

Bond funds are likely to pay higher returns than certificates of deposits and money market investments, but bond funds aren’t without risk. Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest. For example, a fund specializing in high-yield junk bonds is much more risky than a fund that invests in government securities. Furthermore, nearly all bond funds are subject to interest rate risk, which means that if rates go up the value of the fund goes down.

Balanced Funds

The objective of these funds is to provide a balanced mixture of safety, income and capital appreciation. The strategy of balanced funds is to invest in a combination of fixed income and equities. A typical balanced fund might have a weighting of 60% equity and 40% fixed income. The weighting might also be restricted to a specified maximum or minimum for each asset class.

A similar type of fund is known as an asset allocation fund. Objectives are similar to those of a balanced fund, but these kinds of funds typically do not have to hold a specified percentage of any asset class. The portfolio manager is therefore given freedom to switch the ratio of asset classes as the economy moves through the business cycle.

Equity Funds

Funds that invest in stocks represent the largest category of mutual funds. Generally, the investment objective of this class of funds is long-term capital growth with some income. There are, however, many different types of equity funds because there are many different types of equities. A great way to understand the universe of equity funds is to use a style box, an example of which is below.

The idea is to classify funds based on both the size of the companies invested in and the investment style of the manager. The term value refers to a style of investing that looks for high quality companies that are out of favour with the market. These companies are characterized by low P/E andprice-to-book ratios and high dividend yields. The opposite of value is growth, which refers to companies that have had (and are expected to continue to have) strong growth in earnings, sales and cash flow. A compromise between value and growth is blend, which simply refers to companies that are neither value nor growth stocks and are classified as being somewhere in the middle.

For example, a mutual fund that invests in large-cap companies that are in strong financial shape but have recently seen their share prices fall would be placed in the upper left quadrant of the style box (large and value). The opposite of this would be a fund that invests in start-up technology companies with excellent growth prospects. Such a mutual fund would reside in the bottom right quadrant (small and growth).

Global/International Funds:

An international fund (or foreign fund) invests only outside your home country. Global funds invest anywhere around the world, including your home country.

It’s tough to classify these funds as either riskier or safer than domestic investments. They do tend to be more volatile and have unique country and/or political risks. But, on the flip side, they can, as part of a well-balanced portfolio, actually reduce risk by increasing diversification. Although the world’s economies are becoming more inter-related, it is likely that another economy somewhere is outperforming the economy of your home country.

Specialty Funds:

This classification of mutual funds is more of an all-encompassing category that consists of funds that have proved to be popular but don’t necessarily belong to the categories we’vedescribed so far. This type of mutual fund forgoes broad diversification to concentrate on a certain segment of the economy.

Sector funds are targeted at specific sectors of the economy such as financial, technology, health, etc. Sector funds are extremely volatile. There is a greater possibility of big gains, but you have to accept that your sector may tank.

Regional funds make it easier to focus on a specific area of the world. This may mean focusing on a region (say Latin America) or an individual country (for example, only Brazil). An advantage of these funds is that they make it easier to buy stock in foreign countries, which is otherwise difficult and expensive. Just like for sector funds, you have to accept the high risk of loss, which occurs if the region goes into a bad recession.

Socially-responsible funds (or ethical funds) invest only in companies that meet the criteria of certain guidelines or beliefs. Most socially responsible funds don”t invest in industries such as tobacco, alcoholic beverages, weapons or nuclear power. The idea is to get a competitive performance while still maintaining a healthy conscience.

Index Funds

The last but certainly not the least important are index funds. This type of mutual fund replicates the performance of a broad market index such as the NIFTY 50 or BSE Sensex. An investor in an index fund figures that most managers can”t beat the market. An index fund merely replicates the market return and benefits investors in the form of low fees.