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Investors often ask for advice on the best mutual fund schemes, stocks, or real estate investments. However, these questions often focus on the investments themselves, neglecting the investor’s needs. Simon Sinek emphasizes that the discussion of investments should start with “why” – the purpose of investment.

Examples of financial goals include Shalini, an eight-year-old girl inspired by India’s space programs, Rabindra, a 45-year-old engineer working in a multinational firm, and Surinder Singh, who recently moved to a large city. These examples demonstrate the importance of understanding investors and their financial goals, saving or investing, different asset classes, investment risks, risk measures and management strategies, behavioral biases in investment decision making, risk profiling, understanding asset allocation, and do-it-yourself vs. taking professional help.

Goal setting is crucial when planning for investments, as all financial goals are about the need for money that cannot be fulfilled through the inflow at that time. While expenses may be high or low, income may be less than the amount required to fund the goal, which is why one needs to invest the money.

The first step in goal setting is to identify events in life that can be planned or unexpected. For example, the death of a family member, hospitalization, accident, theft, or fire can be funded through investments, but an emergency fund using savings and investment products can be created. Priorities must be assigned, such as retirement or children’s education, while a grand vacation may be a good-to-have goal.

Another important step is assigning a timeline and amount of funding required at the time of such events. For example, if someone is planning to buy a house, they need to decide the type of house and location, which will help arrive at the approximate cost and when they would like to buy it. Both the timeline and amount are critical for planning to achieve the goal.

Short term needs versus Long Term Goals

The chapter discusses the importance of planning for short-term needs versus long-term goals in life. It discusses examples such as Shalini’s higher education, Rabindra’s work, Surinder Singh’s house purchase, and Mrs. D’Souza’s retirement. Retirement goals can be broken into two parts: accumulating a sum for retirement and taking income out of the corpus thus accumulated.

The chapter also discusses the time management matrix, which classifies various tasks one undertakes during the day and over a period. Covey’s “urgent and important” matrix suggests that people often struggle with their finances due to not planning for important and not urgent events in life.

To achieve financial goals, it is essential to classify them in terms of timeline and importance in one’s life. The next step is to assign amounts to the financial goals, considering the cost of education and healthcare. Inflation adjustment for goal values is critical, as the cost of education has been increasing at a fast pace over the last few decades.

The pool approach is another approach to managing financial requirements, but it is important to know the horizon for investments. For example, in the case of Shalini’s higher education, if the inflation in college fees is expected to be 8% p.a., her parents need to provide for Rs. 1,07,94,625 in 10 years. However, there are too many assumptions involved, so it is crucial to start with some assumptions to plan properly.

Inflation has a long-term impact on long-term goals, and while immediate term and near-term goals may not have a big impact due to changes in price, it is essential to consider inflation in the cost of the goal. If inflation stays at the same level, monthly expenses would be roughly Rs. 53,725 after 10 years and Rs. 96,214 after 20 years.

In conclusion, planning for short-term needs and long-term goals requires careful planning and understanding of the horizon and inflation.

Saving and investments

Saving and investing are two distinct concepts that are often used interchangeably. Saving, originating from the root “safe,” emphasizes the safety of money, while investing aims to earn profits. Both involve a trade-off between risk and return. The dictionary definition of saving is “reduction in the amount of money used,” which refers to reducing consumption to save money for investment. Therefore, saving and investing are not separate but two steps in the same process. To invest money, one must first save, indicating that saving precedes investing.

Factors to evaluate investments

The three most important factors to evaluate investments are safety, liquidity, and returns. Other parameters include convenience, ticket size (the minimum investment required), taxability of earnings, and tax deduction. Safety involves understanding the degree of surety of income from an investment and the risks involved. Liquidity refers to how easily an investment can be liquidated and converted to cash. Returns are the primary purpose of investments, which can be in the form of regular income or capital appreciation. Exit charges or penalties can reduce returns, so they must be considered as a trade-off between liquidity and returns.

Convenience is another important factor to consider when evaluating investments. It is essential to consider the investor’s ability to conveniently check the value of the investment and receive the income. The minimum amount required for investment should also be considered. Some investments require large amounts, but it should not be the only factor.

Taxability of income is another important factor to consider. It is crucial to evaluate various other factors, not just taxation in isolation. For example, some products may offer lower tax on investment returns but low safety. Additionally, some products may offer low tax on investment returns only if the investor stays invested for a certain term or till the product’s maturity.

Lastly, tax deductions may be available for certain products, which can increase the return on investment. However, there may be a lock-in period for these deductions, requiring a balance between liquidity and tax deduction.

The discussion provides a framework for evaluating investment products, but it’s essential to consider the investor’s situation when evaluating options, as liquidity and tax deductions can be a trade-off.

Different Asset Classes

Asset classes are groups of investments that share similar characteristics. There are four broad asset classes: Real estate, Commodities, Equity, and Fixed income. Real estate is the most popular among all asset classes, but its popularity is not related to investment. It is often purchased for self-occupation, which should not be considered an investment. Real estate can be further classified into residential, land, and commercial real estate.

Traits of real estate include location, illiquidity, not being divisible, and the ability to invest in physical and financial forms. It can generate capital appreciation and current income in the form of rents. However, transaction costs, such as brokerage and registration fees, can reduce return on investment. Maintenance costs and taxes must also be considered before calculating return on investment.

Investments acquired or sold must be accounted for at the transaction price, excluding transaction costs such as brokerage, stamp charges, and any charge customarily included in the broker’s contract note.

Commodities

Commodities, such as agricultural commodities, petroleum products, and metals like gold and silver, are widely consumed by people. However, investing in these commodities is not feasible due to their perishability and storage difficulties. Commodity derivatives are not considered investments due to their risk and short-term nature.

Gold and silver are two widely recognized commodities as investment avenues. They are globally accepted assets due to their consistent prices across the world. Gold has been used as a safe haven asset in case of economic failure or currency failure, but the gold standard has been removed a few decades ago. Central banks still hold gold in their reserves.

Investors in these commodities rely on capital appreciation as they do not generate current income. Gold and silver come in varying degrees of purity, and investors often struggle to determine the level of purity. Opting for a purity certificate increases the cost, and without one, the risk of getting lower-quality metal is high.

Fixed Income

Fixed income refers to the income generated by borrowing money, often through marketable instruments like bonds and debentures. Issuers include companies, union governments, state governments, municipal corporations, banks, financial institutions, and public sector enterprises. Bonds pay regular interest, allowing investors to expect current income. However, holding the bond until maturity typically results in no capital gains. Bonds are generally considered safer than equity but are not completely free from risks. They can be classified into subcategories based on issuer type, maturity date, and type of bond (short term, medium term, or long-term).

Equity

Equity is the owner’s capital in a business, where the owner’s earnings are linked to the company’s fortunes and risks. Equity investing has historically generated returns exceeding inflation, increasing the purchasing power of money over time. Since 1979, the Sensex has grown from 100 to around 66000, compounded annually, a 16 percent p.a. increase. Equity share owners may also receive dividends from the company, which are shared out of the company’s profit. Share prices generally fluctuate, often without regard to business fundamentals. However, over long periods, share prices follow the company’s fortunes, and if the company’s profits continue to grow, the share price follows.

Asset Categories

Asset categories include equity, bonds, real estate, and commodities. Equity and bonds can only be invested in financial form, while real estate and commodities can be bought in both financial and physical form. Real estate and commodities can be bought for investment or consumption purposes, such as renting residential property or buying a flat for residential use. Equity shares may share profits with investors, while real estate can generate intermittent cash flow. Bonds pay interest income, while commodities do not.

Investors in equity, real estate, and commodities are considered owners of the asset, while bonds lent money to someone. The lender’s receipts are agreed upon at the time of instrument issue, making future returns highly uncertain compared to lending assets like bonds or fixed deposits.

International assets, such as shares of companies listed outside India, provide exposure to another currency. For example, buying shares of a company listed on the London Stock Exchange exposes investors to the company’s fortunes and exchange rate changes. Similarly, investing in bonds denominated in different currencies and buying real estate abroad are called international assets.

To assess the impact of currency fluctuation on these investments, one must understand the basic nature of each asset class and assess its impact.

Investment avenue classified under different categories

Categorizes investment avenues into different asset categories, including equity fixed income, blue-chip companies, mid-sized and small-sized companies, unlisted companies, foreign stocks, equity mutual funds, exchange-traded funds, index funds, fixed deposits, endowment policies, money-back policies, public provident funds, SSY, SCSS, SCSS, post office monthly income schemes, company fixed deposits, debt mutual funds, real estate/infrastructure commodities, physical assets, financial assets, gold, silver, gold funds, commodity ETFs, hybrid asset classes, rare coins, art, and stamps. These investment options cater to various financial needs and interests.

Investment Risk

Investment risks involve various types of risks, including inflation risk, which is the erosion of the purchasing power of money due to the general rise in prices of commodities, products, and services. Inflation can lead to a decrease in purchasing power over long periods, making it crucial to account for this in an investment plan. For example, if one could buy 100 units of something with Rs. 10,000 today, assuming inflation of 8% p.a., they would only be able to buy 68 units after 5 years and 46 units after 10 years. To protect purchasing power, the investment return should be at least as much as inflation. If the return is higher than inflation, the purchasing power increases, while if it is lower, the purchasing power drops. In the case of total safety of invested capital and liquidity, investment returns are usually lower than inflation. The “real rate of return” is the ratio of investment returns to inflation, with higher returns indicating a positive real rate and vice versa.

Liquidity Risk

Fixed income assets, such as government securities, are generally considered less risky than equity investments. However, to fully benefit from these investments, the investment must be held until maturity. This risk is particularly associated with real estate, where liquidity is low and it can take weeks or months to sell the investment.

Some investment options, like equity shares on stock exchanges, offer instant access to funds but may be subject to fluctuations. Equity shares are not suitable for funding short-term liquidity needs as they can fluctuate periodically, and investors may need to pay interest before maturity. Public Provident Funds may also offer no liquidity for a certain period, and even after that, there may be only partial liquidity. Overall, investors should carefully consider their investment options and liquidity needs when making investment decisions.

Credit Risk

Credit risk refers to the possibility of a borrower or lender defaulting on their obligations, such as repaying principal and interest on a debt instrument like a debenture, bond, or fixed deposit. The borrower’s ability or intention to repay these obligations can lead to delays or defaults. Stable companies, which may be market leaders, may pose a lower risk compared to new or small-sized companies in the same industry. Lenders assess both factors before lending money and expect compensation in case of low ability.

Investors expect higher interest from bonds with low safety, with the government-issued bonds being considered the safest for investors due to their high safety of capital. Other bonds and debentures in the country may offer higher interest rates. Lenders aim to assess both factors before lending money and provide adequate compensation in case of low ability.

Market Risk

Market risk and price risk are two types of security risks. Market risk refers to the fluctuation in prices due to rapid opinions, while price risk is the change in facts related to security. For example, a warlike situation could lead to a market-wide fall in stock prices, while a company’s product sales may fall due to technological changes or better products. The stability of a company’s business and profitability play a significant role in determining company-specific risk factors.

Industry-specific factors, such as changes in government policies or the introduction of new technology, can also impact all firms within the same industry. For example, the pager industry disappeared when mobile phones became popular. Diversification across unrelated securities can reduce market-wide risk, but it cannot reduce market-wide risk. The stability of a company and its profitability are crucial factors in determining these risks.

Interest Rate Risk

Interest rate risk is the risk that an investment’s value will change due to changes in interest rates, affecting bonds and debt instruments more directly than stocks. A reduction in interest rates increases the value of the instrument, while vice versa. Bonds are typically bought and held until maturity, with the maturity amount provided by the bond agreement. If an investor sells a bond in the secondary market, the current market price depends on various factors, including the change in economic interest rates. The relationship between interest rates and bond prices is inverse, with existing bonds’ prices decreasing when interest rates increase.

Interest rate risk refers to the market-wide fluctuation in bond prices due to changes in interest rates. This risk affects bonds with different maturities, with longer-term bonds experiencing higher price fluctuations. If the interest rate decreases, the bond’s price would rise. This risk is a significant factor affecting the overall market value of all bonds.

Risk Measure and Management Strategies

Risk measures and management strategies are essential for investors to earn decent returns on their investment portfolio. Some strategies include avoiding certain investment products, taking a position to benefit from events or developments, and diversifying across various investment options. However, these strategies require superior knowledge and are not recommended for a large number of investors due to the complexity and risks involved.

Behavioral biases in investment decision making are another risk that investors must understand. The most dominant emotions are fear, greed, and hope. Some important biases include availability heuristic, confirmation bias, familiarity bias, herd mentality, loss aversion, and overconfidence.

Availability heuristic refers to the tendency to rely on immediate examples or experiences when analyzing data or options, leading to missing out on critical information about various investment risks. Confirmation bias is the tendency to look for additional information that confirms existing beliefs or views, resulting in missed opportunities. Familiarity bias is the preference for familiarity over novelty, which can prevent investors from exploring better opportunities or diversification. Herd mentality is the belief that being against the herd has been the most profitable strategy in financial markets. Loss aversion is the tendency to avoid losses to acquire equivalent gains, often leading to staying away from profitable opportunities due to the perception of high risks. Overconfidence is the belief that one is far better than others at something, despite the reality being quite different.

In conclusion, investors must be aware of and manage their investment risks to ensure they are making informed decisions. By understanding and managing these biases, investors can create a more informed and successful investment portfolio.

Recent events can significantly impact investment decisions, leading to a tendency for investors to overestimate the likelihood of future events. This can result in a preference for safe assets or risky assets, leading to increased risk. Similarly, a rise in equities may lead to more investment in equities, increasing risk, while a fall in an asset may discourage investment.

Behavior patterns also play a role in investment decisions, as individuals’ personality traits can influence their savings and investment habits. Understanding these factors can help make informed decisions.

Investment decisions are often influenced by the investor’s interests, leading to portfolios that may not be suitable for specific individuals. This can lead to concentration of risk and should be avoided.

Ethical standards also play a role in investment behavior, as those who follow ethical principles are more likely to pay attention to their investments and be disciplined. This helps build long-term wealth and avoids shortcuts.

To avoid behavioral biases in investment decisions, it is crucial to conduct detailed analysis without shortcuts. It is also recommended to seek the advice of a third party, such as a Registered Investment Advisor or Mutual Fund Distributor, to detach emotions from investments.

Risk Profiling

Risk profiling is a process used by distributors to assess an investor’s risk appetite, ensuring they do not sell mutual fund schemes with higher risk than they can handle. This involves evaluating the need to take risks, the ability to take risks, and the willingness to take risks. The need to take risks arises when the investor needs higher returns to reach their goals, the ability to take risks refers to financial ability and investment horizon, and the willingness is linked to the psychological capacity to handle risk. Distributors must balance these factors when there is a conflict. Asset allocation is a process of allocating money across various asset categories to achieve an objective. It involves several steps and should not be ignored or skipped. There are two popular approaches to asset allocation: systematic and systematic.

Strategic Asset Allocation

Strategic Asset Allocation is an approach to allocate funds based on an individual’s financial goals and risk profile. It involves maintaining a target allocation across various asset categories, determined by the investor’s needs and risk appetite. This percentage target is also known as strategic asset allocation.

Tactical asset allocation, also known as dynamic asset allocation, is an alternative to strategic asset allocation, which aims to improve the risk-adjusted return of the portfolio. This method is suitable for seasoned investors with large investible surpluses. For example, if the appropriate allocation to equity and debt in a portfolio is 60:40, it may be increased to 65:35 or 70:30. If equity valuations are stretched, it may be reduced somewhat.

Rebalancing is another asset allocation approach that may be necessary when the current asset allocation differs from the target allocation. Practitioners argue that the asset allocation was determined by the investor’s needs and risk appetite. Rebalancing reduces the allocation to the risky asset if it has gone up, while correcting the allocation in the asset with potential higher returns. This approach can work well over the years when asset categories go through multiple market cycles.

Rebalancing is required in both strategic and tactical asset allocation. SEBI provides timelines for rebalancing schemes to ensure uniformity across mutual funds. The mandated rebalancing period for all schemes other than Index Funds and Exchange Traded Funds is 30 business days, but this period is not applicable to Overnight Funds.

Do it yourself or taking the professional help

Investors need to invest money in various financial instruments, such as government-sponsored schemes, bank fixed deposits, company debentures, shares of companies, and real estate properties. There are two options: managing investments oneself or outsourcing the entire job to a professional or a company engaged in such a business. Mutual funds are a second option, managed by a team of professionals known as asset management companies.

The question of which choice is better is broken down into three components: Can one do the job oneself? If one has the necessary skills and knowledge to manage their money, they should consider outsourcing it. If one does not enjoy money management, they may need help in managing investments.

Can one afford to outsource? Mutual funds have some costs associated with their professional fees, which SEBI (the securities markets regulator) has issued guidelines on the maximum amount that can be charged to the fund. Most people make the mistake of comparing these fees with zero cost of managing one’s own money oneself, which overlooks the hidden costs of doing the investment management job on one’s own. These costs include time and potential mistakes made by an individual investor.

For most investors, a mutual fund would be a better option than building their portfolio oneself. The next chapter discusses mutual funds and their role in an investor’s portfolio.

Which among the following investment avenues does not offer income on a regular
basis?
a. Real estate
b. Physical Gold
c. Stocks
d. Debentures

2. Which amongst the following asset categories can also be purchased for
   consumption purposes apart from an investment?
   a. Real estate
   b. Stocks
   c. Bonds
   d. Debentures
3. The purchasing power of currency changes on account of which of the following?
   a. Asset allocation
   b. Compound interest
   c. Inflation
   d. Diversification
4. What is the real rate of return?
   a. Return that the investor gets after payment of all expenses
   b. Return that the investor gets after taxes
   c. Return that the investor gets after adjusting the risks
   d. Return that the investor gets after adjusting inflation
5. When the interest rate in the economy increases, the price of existing bonds .
   a. Increases
   b. Fluctuate
   c. Decreases

Concept of Mutual Fund

Mutual funds are professionally managed investment vehicles that provide access to equities, bonds, money market instruments, and other securities that may not be available to investors through traditional investment instruments like equity shares, debentures, and bonds. These funds are regulated vehicles that allow investors to invest in different markets and securities in line with their investment objectives. The growth of the mutual fund industry in India is a result of the professional way of investing, portfolio diversification, and the regulated vehicle. Mutual funds are often perceived as competing with traditional investment instruments, but they are actually a regulated vehicle that allows investors to access these securities and avail of professional fund management services offered by asset management companies.

Role of Mutual Fund

Mutual funds play a crucial role in helping investors earn income or build their wealth by investing in securities markets. They offer various schemes to cater to diverse investors, with the terms “fund” and “scheme” used interchangeably. The money raised from investors benefits governments, companies, and other entities for funding projects or paying for expenses. The projects facilitate employment and income, supporting the growth of goods and services companies. Mutual funds can also monitor the operations of investee companies, their corporate governance, and ethical standards. The mutual fund industry provides livelihood to employees, distributors, registrars, and other service providers. Higher employment, income, and output in the economy boost government revenue collection, promoting economic development and nation-building. Mutual funds can act as a market stabilizer, countering large inflows or outflows from foreign investors. In 2022, when foreign portfolio investors (FPIs) sold heavily in the equity market, the mutual fund industry provided a counterforce by providing fresh inflows into schemes/funds.

Investment objectives of Mutual Fund

Mutual funds aim to mobilize money from all investors, catering to their different investment preferences and needs. Each mutual fund scheme has a pre-announced investment objective, reflecting the investor’s basic needs of safety, liquidity, and returns. Examples of investment objectives include overnight fund, equity fund, hybrid fund, and long duration fund.

• Overnight fund : The scheme intends to provide reasonable income along with high liquidity by investing in overnight securities having a maturity of one business day.
• Equity fund : To generate capital appreciation/income from a portfolio, predominantly invested in equity and equity related instruments
• Hybrid fund : The primary objective of the scheme is to generate long term capital appreciation by investing predominantly in equity and equity related securities of companies across the market capitalization spectrum. The fund also invests in debt and money market instruments with a view to generate regular income.
• Long Duration fund : The primary objective of the scheme is to generate a steady stream of income through investment in fixed income securities.

The investment objectives are a combination of safety, liquidity, and returns, with the scheme deciding the investment universe based on these objectives. Different asset classes serve different purposes, with schemes seeking liquidity investing in money market securities and those seeking capital appreciation investing in equity.

Mutual fund schemes are often classified based on their investment objectives and the investment universe, where they invest. The money mobilized from investors is invested in a portfolio of securities, with profits or losses belonging to the investors or unitholders. No other entity involved in the mutual fund participates in the scheme’s profits or losses, and they are paid a fee or commission for their contributions.

Investment objective of Mutual Fund

Mutual fund schemes have an investment objective, which is determined by the returns generated from various asset categories. The scheme’s investment policy includes asset allocation and investment style. For liquidity purposes, schemes invest in money market instruments or short-term debt papers, while for capital appreciation, they invest in equity shares. The scheme’s asset allocation is disclosed in the Scheme Information Document (SID). However, fund managers may adopt different styles within the same asset category or levels of portfolio concentration. The investment policy outlines two aspects: asset allocation and investment style.

Important Concepts in Mutual Funds

Units : Mutual funds involve a system where an investor’s investment is converted into a specific number of units, thereby issuing them to the investor.

Face Value : Mutual funds typically have a face value of Rs. 10, which is crucial from an accounting perspective.

Unit Capital : The Unit Capital of a scheme is determined by the number of units issued multiplied by its face value (Rs. 10).

Recurring Expenses : Recurring expenses, which are fees or commissions paid to mutual fund constituents, are a percentage of the scheme’s assets under management (AUM). Higher expenses lower the NAV and investor returns, so SEBI has strict limits on the number of expenses charged to the scheme. Operating expenses are also incurred for running the mutual fund scheme.

Net Asset Value : The Net Asset Value (NAV) is the true worth of a unit in a mutual fund scheme. It increases when investment activity is profitable, while decreases when losses occur. The NAV also represents the net realizable value per unit in case the scheme is liquidated, indicating the potential for cash generation if all holdings are sold.

Assets under management : Assets Under Management (AUM) is the total amount of investments made by investors in a mutual fund scheme. It can be calculated by multiplying the current NAV with the total units outstanding. The relative size of mutual fund companies is assessed by their AUM. AUM increases when a scheme performs well and is marketed well, and vice versa. If the scheme is open to receiving money from investors post-NFO, it boosts AUM. Conversely, if the scheme pays money to investors, such as dividends or consideration for buying back units, the AUM falls.

Mark to Market : Mark to Market (MTM) is a daily process where each security in a scheme’s investment portfolio is valued at its current market value, resulting in daily fluctuations in the net asset value (NAV) of all schemes.

Mutual funds offer investors several advantages, including professional management, which allows for expert handling of investment decisions and market analysis.

Mutual funds provide investors with the opportunity to earn income or build their wealth through professional management of their investible funds. This involves investing in line with the investment objective, conducting adequate research, and following prudent investment processes. Mutual fund investment simplifies the process of investing and holding securities, including research, selection, and administration tasks like collection of corporate benefits. The daily calculation and publication of NAVs make portfolio accounting easier, which would be too time-consuming for independent investors.

These benefits come at a low cost, even for the smallest investments, and the expenses charged for professional management are reasonable. Additionally, investing in the units of a scheme provides investors exposure to a range of securities held in the investment portfolio in proportion to their holding in the scheme. This allows them to get proportionate ownership in a diversified investment portfolio even for a small investment of Rs. 500.

Diversification helps reduce risk in investment by ensuring that all investments are not in the same basket, reducing the risk of losing money on all investments simultaneously. To achieve the same level of diversification as a mutual fund scheme, investors need to set aside several lakhs of rupees, but can achieve it through an investment of less than a thousand rupees in a mutual fund scheme.

Economies of Scale

Mutual funds offer a cost-saving advantage over direct investments due to economies of scale. By pooling large amounts of money from multiple investors, mutual funds can engage professional managers for investment management, which individual investors cannot afford. This also allows for cost savings in investment research and office space, as well as better negotiation with brokers and service providers. Mutual funds also provide flexibility in organizing investments according to convenience, as direct investments may require a larger investment amount. Additionally, the Income Distribution cum Capital Withdrawal (IDCW) and growth options allow investors to structure returns in a way that suits their requirements. Overall, mutual funds provide a distinct economic advantage over direct investing in terms of cost savings.

Transparency and liquidity

Transparency and liquidity are crucial for investors in financial markets, as they enable them to make informed investment decisions. The structure of mutual funds and regulations by SEBI ensure that investors have access to relevant information, such as scheme-related documents, portfolio disclosures, and the NAV of the scheme. Prospective investors can also access all this information.

Liquidity is essential for investors, as they may face illiquid investments, which are securities they cannot find a buyer or company in. The bond market in India is wholesale, with transactions occurring in large lot sizes, making it difficult for common investors to participate. Mutual funds (MFs) provide a route for investors to participate, even at a small ticket size.

Investors in mutual fund schemes can recover the market value of their investments from the mutual fund itself, depending on the scheme’s structure. Schemes where money can only be recovered from the mutual fund on the scheme’s closure are compulsorily listed on a stock exchange.

If a’material’ development occurs related to investments in a mutual fund scheme, such information is made available on time, enabling investors to take appropriate action, including withdrawing money. This combination of transparency and liquidity enhances safety in financial markets.

Tax deferral and tax benefits

Mutual funds offer tax deferral options, allowing investors to defer their tax liability for several years. This allows them to build their wealth faster than if they had to pay tax on the same income each year. Special schemes like Equity Linked Savings Schemes (ELSS) provide investors with a deduction of up to Rs. 150,000 in a financial year under Section 80C of the Old Tax Regime, reducing their taxable income and tax liability. This allows investors to legally build their wealth faster than if they had to pay tax on the same income each year.

Convenient Options, Investment Comfort and Regulatory Comfort

Mutual funds offer convenient options for investors, allowing them to structure their investments according to their liquidity preference and tax position. Transaction conveniences include withdrawing only part of the money, investing additional amounts, and setting up systematic transactions. Mutual funds also provide investment comfort, allowing further purchases with minimal documentation, and regulatory comfort, as the Securities and Exchange Board of India mandates strict checks and balances in their structure and activities.

Systematic approach to investment

Mutual funds provide a systematic approach to investments, enabling regular investment through a Systematic Investment Plan (SIP), regular withdrawal through a Systematic Withdrawal Plan (SWP), and regular transfer between schemes, promoting investment discipline and long-term wealth creation and protection.

Limitation of Mutual fund

Mutual funds have several limitations, including a lack of portfolio customization, choice overload, and no control over costs. Portfolio Management Services (PMS) provide investors with better control over securities bought and sold on their behalf, while unit-holders in mutual funds are just one of several thousand investors in a scheme. The choice overload is due to the numerous schemes offered by different mutual fund houses and the multiple options within those schemes. To overcome this, SEBI introduced the categorization of mutual funds to ensure uniformity in characteristics.

Costs are shared by all unit-holders in proportion to their holding of units in the scheme, so an individual investor has no control over the costs. However, SEBI has imposed limits on expenses for schemes, which vary with asset size and scheme nature. Market forces also push costs down, and many schemes operate at lower expenses than the limits allowed by the regulator.

Mutual funds are not guaranteed returns, but rather a pass-through vehicle that passes on risk and return to investors. The performance of investments impacts the returns generated by the mutual fund scheme, with the fund manager working towards improving their skills.

Classification of Mutual Fund

Mutual funds can be classified based on investment objectives, such as growth funds, income funds, and liquid funds. They can also be classified by their structure. Some schemes are open-ended, which remain open for purchase and repurchase on a perpetual basis, while others have a fixed maturity date, operating for a predetermined period until the maturity date and ceasing to exist. Close-ended schemes have a predetermined closure date. Other variants of mutual funds are also discussed.

Open-ended funds : Open-ended funds allow investors to enter or exit at any time after the NFO7. They can buy additional units, buy units for ongoing transactions, and redeem their investments. Existing investors can redeem their investments by selling units back to the scheme. The scheme continues operations with remaining investors, and there is no set closure timeframe. The unit capital in an open-ended fund changes regularly, with new units created when an investor invests and units cancelled when someone exits, causing the unit balance to decrease.

Close-ended funds : Close-ended funds have a fixed maturity and investors can only buy units from the fund during its NFO period. After the NFO, the scheme is wound up, units are cancelled, and money is returned to investors. The fund provides liquidity post-NFO through listing units on a stock exchange, which is compulsory for close-ended schemes to provide liquidity. Post-NFO, investors must find a seller or buyer for units in the stock exchange. The unit capital of the scheme remains stable or fixed, and every close-ended scheme must be listed on a recognized stock exchange under SEBI’s conditions. Post-NFO, transactions occur between different investors, and the transaction price may be higher or lower than the prevailing NAV. The units usually trade at a discount to the NAV, as the buyer has money and options, while the seller has the units of the fund. This enhances the buyer’s bargaining position.

Interval Funds : Interval funds combine features of both open-ended and close-ended schemes, becoming open-ended at pre-specified intervals. This allows investors to buy or sell units without complete dependency on the stock exchange. However, units must be listed on stock exchanges to provide liquidity between these intervals. Transaction periods are the periods when an interval scheme becomes open-ended, with a minimum duration of 2 days and a maximum duration of 15 days. No redemption or repurchase is allowed during these periods.

Liquidity in close-ended and interval funds may be poor due to the demand-supply situation for the units. Exchange Traded Funds (ETFs) address this liquidity issue by closely tracking the NAV through the market price.

Exchange Traded Funds : Exchange Traded Funds (ETFs) are passive mutual fund schemes traded on stock exchanges, tracking an index or fixed portfolio strategy based on an index. They offer multiple opportunities and prices for investors to enter or exit the fund, providing additional liquidity and allowing them to benefit from price changes during the day. However, ETF prices may fluctuate and there may be a significant gap with the fund’s NAV.

Investing in ETFs is easy and requires a minimum investment of small amounts. Investors who already transact on stock exchanges and have a demat account can use these funds for ETF investments. There is a wide variety of indices on which ETFs are based, providing investors with a wide range of investments and exposure options. Mutual funds are increasingly offering different variants with varying strategies for their ETF offerings, such as the recently introduced Silver ETF by SEBI.

By the management of the portfolio

Actively Managed fund : Actively managed funds allow fund managers to select investment portfolios within scheme objectives, increasing their role and resulting in higher expenses. Investors expect these funds to perform better than the market, despite the increased expenses.

Passive Funds : Passive funds invest based on a specific index, tracking its performance. For example, a passive fund tracking the S&P BSE Sensex would buy shares in the same composition as the index. The fund’s performance mirrors the index, and it’s not designed to outperform the market. These schemes, also known as index schemes, have low running costs as the fund manager has no role in investment decisions.

By the investment universe

This classification categorizes investment schemes into equity, fixed income, money market, gold, and international funds. The categories can be further specific, such as large-cap, mid-cap, and government securities funds, or corporate debt funds, depending on the investment universe being narrowed.

Mutual fund scheme categorization and SEBI regulation

In 2017, SEBI issued a circular on Categorization and Rationalization of Mutual Fund Schemes to standardize the classification of mutual funds and ensure they are distinct from one another. The circular categorized schemes into five broad categories: Equity, Debt, Hybrid, Solution-Oriented, and Other. These categories have numerous sub-categories for investors to objectively evaluate the schemes they choose for investment.

A. Equity Schemes (11 sub-categories)
B. Debt Schemes (16 sub-categories)
C. Hybrid Schemes (6 sub-categories)
D. Solution Oriented Schemes (2 sub-categories)
E. Other Schemes (2 sub-categories)

A. Equity schemes

1. Multi Cap Fund: An open-ended equity scheme investing across large cap, mid cap, small
   cap stocks. (See Box 2.2)
   As per SEBI, the Multi Cap Fund must have the minimum investment in equity and equity
   related instruments as 75 percent of total assets distributed in the following manner*
   :

• Minimum investment in equity & equity related instruments of large cap companies
• 25% of total assets
• Minimum investment in equity & equity related instruments of mid cap companies –
  25% of total assets
• Minimum investment in equity & equity related instruments ofsmall cap companies
• 25% of total assets
  For this purpose, SEBI also defined the various market capitalization categories as under:

Definition of Large-cap, Mid-cap and Small-cap Large cap, mid cap and small cap companies are defined as follows:

1. Large Cap: 1st-100th company in terms of full market capitalization
2. Mid Cap: 101st-250th company in terms of full market capitalization
3. Small Cap: 251st company onwards in terms of full market capitalization

The same definition applies in case of other scheme categories, too, as applicable.

• LargeCap Fund: An open-ended equity scheme predominantly investing in large cap stocks.
  The minimum investment in equity and equity related instruments of large cap companies shall be 80 percent of total assets.
• Large and Mid-Cap Fund: An open-ended equity scheme investing in both large cap and mid cap stocks. The minimum investment in equity and equity related instruments of large cap companies shall be 35 percent of total assets. The minimum investment in equity and equity related instruments of mid cap stocks shall be 35 percent of total assets.
• Mid Cap Fund: An open-ended equity scheme predominantly investing in mid cap stocks. The minimum investment in equity and equity related instruments of mid cap companies shall be 65 percent of total assets.
• Small cap Fund: An open-ended equity scheme predominantly investing in small cap stocks. Minimum investment in equity and equity related instruments of small cap companies shall be 65 percent of total assets.
• Dividend Yield Fund: An open-ended equity scheme predominantly investing in dividend
  yielding stocks. Scheme should predominantly invest in dividend yielding stocks. The
  minimum investment in equity shall be 65 percent of total assets.
• Value Fund or Contra Fund: A value fund is an open-ended equity scheme following a value investment strategy. Minimum investment in equity & equity related instruments shall be 65 percent of total assets. A contra fund is an open-ended equity scheme following a contrarian investment strategy. Mutual Funds will be permitted to offer either Value fund or Contra fund.
• Focused Fund: An open-ended equity scheme investing in maximum 30 stocks (the scheme needs to mention where it intends to focus, viz., multi cap, large cap, mid cap, small cap).Minimum investment in equity & equity related instruments shall be 65 percent of total
  assets.
• Sectoral/Thematic: An open-ended equity scheme investing in a specific sector such as
  bank; power is a sectoral fund. While an open-ended equity scheme investing in line with an investment theme. For example, an infrastructure thematic fund might invest in shares of Definition of Large-cap, Mid-cap and Small-cap
  Large cap, mid cap and small cap companies are defined as follows:
• Large Cap: 1st-100th company in terms of full market capitalization
• Mid Cap: 101st-250th company in terms of full market capitalization
• Small Cap: 251st company onwards in terms of full market capitalization
  50 companies that are into infrastructure, construction, cement, steel, telecom, power etc. The minimum investment in equity and equity related instruments of a particular sector/ theme shall be 80 percent of total assets.
• Equity Linked Savings Scheme: An open-ended equity linked saving scheme with a
  statutory lock-in of 3 years and tax benefit. The minimum investment in equity and equity
  related instruments shall be 80 percent of total assets (in accordance with Equity Linked Saving Scheme, 2005 notified by the Ministry of Finance).
• Flexi-cap Fund: An open-ended equity scheme where the minimum investment in equity
  and equity related assets are 65% of the total assets. This would be a dynamic fund where there can be investment across large cap, mid cap as well as small cap stocks.

B. Debt schemes

• Overnight Fund: An open-ended debt scheme investing in overnight securities. The
  investment is in overnight securities having a maturity of 1 day.
• Liquid Fund: An open-ended liquid scheme whose investment is into debt and money
  market securities with a maturity of up to 91 days only.
• Ultra-Short Duration Fund: An open ended ultra-short-term debt scheme investing in debt and money market instruments with Macaulay duration of the portfolio between 3 months and 6 months.
• Low Duration Fund: An open-ended low duration debt scheme investing in debt and money market instruments with Macaulay duration of the portfolio between 6 months and 12 months.
• Money Market Fund: An open-ended debt scheme investing in money market instruments having maturity up to 1 year.
• Short Duration Fund: An open-ended short-term debt scheme investing in debt and money market instruments with Macaulay duration of the portfolio between 1 year and 3 years.
• Medium Duration Fund: An open-ended medium-term debt scheme investing in debt and money market instruments with Macaulay duration of the portfolio being between 3 years to 4 years. Portfolio Macaulay duration under anticipated adverse situation is 1 year to 4 years.
• Medium to Long Duration Fund: An open-ended medium-term debt scheme investing in
  debt and money market instruments with Macaulay duration of the portfolio between 4
  years and 7 years. Portfolio Macaulay duration under anticipated adverse situation is 1 year
  to 7 years.
• Long Duration Fund: An open-ended debt scheme investing in debt and money market
  instruments with Macaulay duration of the portfolio greater than 7 years.
• Dynamic Bond: An open-ended dynamic debt scheme investing across duration.
• Corporate Bond Fund: An open-ended debt scheme predominantly investing in AA+ and above rated corporate bonds. The minimum investment in corporate bonds shall be 80 percent of total assets (only in AA+ and above rated corporate bonds).
• Credit Risk Fund: An open-ended debt scheme investing in below highest rated corporate bonds. The minimum investment in corporate bonds shall be 65 percent of total assets (only in AA (excludes AA+ rated corporate bonds) and below rated corporate bonds).12
• Banking and PSU Fund: An open-ended debt scheme predominantly investing in debt
  instruments of banks, Public Sector Undertakings, Public Financial Institutions and Municipal Bonds. The minimum investment in such instruments should be 80 percent of total assets.
• Gilt Fund: An open-ended debt scheme investing in government securities across maturity. The minimum investment in G-secs is defined to be 80 percent of total assets(across maturity).
• Gilt Fund with 10-year constant duration: An open-ended debt scheme investing in
  government securities having a constant maturity of 10 years. Minimum investment in G-secs is 80 percent of total assets such that the Macaulay duration of the portfolio is equal to 10 years.
• Floater Fund: An open-ended debt scheme predominantly investing in floating rate
  instruments(including fixed rate instruments converted to floating rate exposures using
  swaps/derivatives). Minimum investment in floating rate instruments (including fixed rate
  instruments converted to floating rate exposures using swaps/derivatives)shall be 65 percent of total assets.

C. Hybrid Scheme

• Conservative Hybrid Fund: An open-ended hybrid scheme investing predominantly in
  debt instruments. Investment in debt instruments shall be between 75 percent and 90
  percent of total assets while investment in equity and equity instruments shall be between 10 percent and 25 percent of total assets.

Balanced Hybrid or Aggressive hybrid fund:

i. Balanced Hybrid Fund: An open-ended balanced scheme investing in equity and debt
instruments. The investment in equity and equity related instruments shall be
between 40 percent and 60 percent of total assets while investment in debt
instruments shall be between 40 percent and 60 percent. No arbitrage is permitted
in this scheme.
ii. Aggressive Hybrid Fund: An open-ended hybrid scheme investing predominantly in
equity and equity related instruments. Investment in equity and equity related
instruments shall be between 65 percent and 80 percent of total assets while
investment in debt instruments shall be between 20 percent and 35 percent of total
assets.

Mutual funds in India are permitted to offer either Aggressive Hybrid Fund or Balanced Fund.

• Dynamic Asset Allocation or Balanced Advantage: It is an open-ended dynamic asset
  allocation fund with investment in equity/debt that is managed dynamically.
• Multi Asset Allocation: An open-ended scheme investing in at least three asset classes
  with a minimum allocation of at least 10 percent each in all three asset classes. Foreign
  securities are not treated as a separate asset class in this kind of scheme.
• Arbitrage Fund: An open-ended scheme investing in arbitrage opportunities. The
  minimum investment in equity and equity related instruments shall be 65 percent of total
  assets.
• Equity Savings: An open-ended scheme investing in equity, arbitrage and debt. The minimum investment in equity and equity related instruments shall be 65 percent of total assets and the minimum investment in a debt shall be 10 percent of total assets. The minimum hedged and unhedged investment needs to be stated in the SID. Asset Allocation under defensive considerations may also be stated in the SID.
  
  • D. Solution Oriented Schemes
• Retirement Fund: An open-ended retirement solution-oriented scheme having a lock-
  in of 5 years or till retirement age (whichever is earlier). This is meant for long term
  planning related to acquiring a corpus for retirement.
• Children’s Fund: An open-ended fund for investment for children having a lock-in for
  at least 5 years or till the child attains the age of majority (whichever is earlier). This is
  meant to invest to build a corpus for the child and their needs in the coming years.
  
  • E. Other Schemes
• Index Funds/Exchange Traded Fund: An open-ended scheme replicating/tracking a
  specific index. This minimum investment in securities of a particular index (which is
  being replicated/ tracked) shall be 95 percent of total assets.
• Fund of Funds (Overseas/Domestic): An open-ended fund of fund scheme investing
  in an underlying fund. The minimum investment in the underlying fund shall be 95
  percent of total assets. There can be only one scheme per category, except in the following cases:
• Index funds and ETFs replicating or tracking different indices,
• Fund of Funds having different underlying schemes, and
• Sector funds or thematic funds investing in different sectors or themes
  Apart from the above, let us also take a look at certain other categories:
  Fixed Maturity Plans are a kind of close-ended debt fund where the duration of the
  investment portfolio is closely aligned to the maturity of the scheme. AMCs tend to structure the scheme around pre-identified investments. Further, being close-ended schemes, they do not accept money post-NFO. Therefore, the fund manager has a little ongoing role in deciding on the investment options. Such a portfolio construction gives more clarity to investors on the likely returns if they stay invested in the scheme until its maturity (though there can be no guarantee or assurance of such returns). This helps them compare the risk and returns of the scheme with alternative investments.
  
• Capital Protection Oriented Funds are closed-end hybrids funds. In these types of funds, the exposure to equity is typically taken through the equity derivatives market. The portfolio is structured such that a portion of the principal amount is invested in debt instruments so that it grows to the principal amount over the term of the fund. For example, Rs.90 may be invested for 3 years to grow into Rs.100 at maturity. This provides protection to the capital invested. The remaining portion of the original amount is invested in equity derivatives to earn higher returns.
  Infrastructure Debt Funds are investment vehicles that can be sponsored by commercial
  banks and NBFCs in India in which domestic/offshore institutional investors, especially
  54 insurance and pension funds can invest through units and bonds issued by the IDFs.
  Infrastructure Debt Funds (IDFs), can be set up either as a Trust or as a Company. A trust based IDF would normally be a Mutual Fund (MF), regulated by SEBI, while a company based IDF would normally be an NBFC regulated by the Reserve Bank.

The SEBI Mutual Fund Regulations define IDF as a close-ended mutual fund scheme that primarily invests in debt securities or securities of infrastructure companies, projects, or special purpose vehicles. IDF-MFs can be sponsored by banks and NBFCs, but only banks and Infrastructure Finance companies can sponsor IDF-NBFC. The scheme aims to facilitate investment in infrastructure and other permissible assets.

The Real Estate Mutual Fund scheme, as per the SEBI (Mutual Funds) Regulations, 1996, invests in real estate assets or other permissible assets. It requires at least 35% of the portfolio to be physical assets and at least 75% of net assets to be in real estate assets, mortgage-backed securities, equity shares, or debentures of companies involved in real estate assets or development projects. The fund’s assets are valued every 90 days by two accredited credit rating agencies, and the lower value is used to calculate the NAV.

SEBI has introduced a separate ESG investment sub-category under the equity schemes category, allowing schemes to launch with strategies such as exclusion, integration, best-in-class screening, impact investing, sustainable objectives, and transition-related investments.

Moneys collected under ESG schemes shall be invested in the manner as specified by the
Board from time to time.

Real Estate Investment Trusts and Infrastructure Investment Trusts

Real Estate Investment Trusts (REITs) are registered SEBI trusts that invest in commercial real estate assets. They raise funds through initial offers, follow-on offers, rights issue, and institutional placements. The initial offer value must not be less than Rs. 500 crore, and the minimum offer size must not be less than Rs. 250 crore. The minimum subscription amount is Rs 10,000-15,000.

Infrastructure Investment Trusts (InvITs) are registered SEBI trusts that invest in the infrastructure sector. They raise funds through an initial offer of units, with a minimum subscription size of Rs 10,000-15,000. The units are listed on a stock exchange, with each traded lot being one unit.

A fund investing in international Real Estate Investment Trusts (REITs) offers exposure to both international funds and the commercial real estate sector, especially in India, where the number of REITs listed is decreasing.

Growth of the mutual fund industry in India

India has seen a significant increase in mutual fund assets under management (AUM) from Rs. 8.46 lakh crores in June 2013 to Rs. 44.82 lakh crore in June 2023, with a 10-year growth of 18.13 percent p.a. compounded annually. The number of folios has also increased, from 4.80 crore to 14.91 crore as of June 2023. The share of mutual funds in overall financial investments in India has risen from 10% in March 2016 to 14% in March 2018, while the share of bank deposits has dropped from 71% to 69% and finally to 65%. The Indian mutual fund industry’s share has also grown significantly compared to the global market.