In our various articles we have discussed how Mutual Funds are the best investment option for not only creating your long term wealth it can also take care of your short term needs and help you achieve your various financial goals. When we talk about Mutual Funds, we tend to think mostly about Equity Mutual Funds and ignore the other categories of Mutual Funds which are equally important and a must have in your portfolio.
The investing pattern of each investor is different due to his risk profile, future needs, income levels and understanding of the various avenues of saving and investing options. Therefore, we cannot have a standard portfolio or set of schemes or products suiting the needs of each investor. However, when it comes to Mutual Fund investing, we feel that there are some categories of funds which each and every investor must have in their respective portfolios. We will discuss these today in our article.
Diversified Equity Mutual Funds
This is the simplest type amongst all equity Mutual Funds and must have in a portfolio especially for the beginners. Diversified Equity Mutual Funds invest across market capitalizations and sectors. The fund manager invests in stocks across various sectors and thus this active diversification ensures the negative performance of one sector does not affect the entire portfolio and increases the possibility of making a sustainable return. These funds aim for medium to long term capital appreciation and suitable for investors having moderate to high risk profile with an investment horizon of at least 3 - 5 years onwards.
Having Diversified Equity Mutual Funds in your portfolio is much more relevant in today's markets conditions where frequency of changes in stock prices and the volatility has made difficult to predict future prices considering the impact of global financial and economic events and local corporate fundamentals and business cycles. As we have seen in the past, at any given point in time, some sectors of the market might do well during some periods while others may lag behind. For example, during the technology bubble of early 2000, lacs of investors ignored this basic principle and were significantly invested in the technology sector and thus made huge losses.
Therefore, the Diversified Equity Mutual Fund Schemes manage concentration risks effectively through investments in diversified stock portfolio while pursuing a specific investment style.
Apart from diversification, long term capital gains (investment period of more than one year) of Diversified Equity Mutual Funds are tax free. The dividends received from Diversified Equity Mutual Funds are also tax free.
To know more about The Diversified Equity Mutual Funds, you may like to read this - Mutual Funds: Investing in Diversified Equity Funds is a safer option
Liquid Funds are short-term Mutual Fund schemes meant for your short-term needs. These funds are an alternative to your savings bank account. Liquid funds are money market mutual funds that invest primarily in money market instruments like treasury bills, certificate of deposits and commercial papers and term deposits. The objective of the Liquid Funds is to provide investors an opportunity to earn returns, without compromising on the liquidity of the investment. Typically Liquid Funds invest in money market securities that have a residual maturity of less than or equal to 91 days. While a liquid fund cannot be used for wealth creation it can of course be used for regular expenses like savings bank account. The redemption from Liquid funds is credited to your bank account in one day i.e. transaction + 1 day (provided it is a working day)
Liquid funds can also be treated as your emergency funds too. Top Financial planners suggest that, you should have six to nine months of your expenses as emergency funds. But sometimes we have much more than that in our savings bank account. Investors also keep funds parked in their savings bank account waiting for a suitable investment opportunity or just because they do not know what to do with the extra surplus. Therefore, if you are not sure when you will require the funds, then liquid funds are better options than your savings bank account in terms of return on your investment. Liquid funds give pre-tax returns of 8 - 9%, compared to the 4 - 6% interest rate offered by savings bank accounts.
Apart from generating superior returns than your savings bank account, Liquid Funds have other benefits as well. Liquid Funds are not volatile like equity funds or long term debt funds as Liquid funds invest only in money market securities which have e residual maturity of less than or equal to 91 days. Liquid Funds are also tax efficient compared to savings bank interest.
To Check how the Liquid Funds can be a better investing option than keeping your money idle in savings bank account, you make like to read - Top Liquid Mutual Funds: Better options than savings bank for parking your surplus cash
Equity Linked Saving schemes or ELSS
Equity Linked Saving Schemes or ELSS Funds are suitable for those investors who pay taxes and need to save taxes under Section 80C of the Income Tax Act. This tax saving instrument, which gives a tax benefit of upto Rs. 150,000 per annum, under Section 80C of the Income Tax Act, has the shortest lock in period of just three years when compared to other instruments like NSC and Public Provident Fund.
The best part about an ELSS funds is that investors can generate tax free long term capital gains on their investments and also the dividends received in their hands are totally tax free. Tax experts and advisors are of the opinion that these funds should be the core investment element in an investor’s mutual fund portfolio if he is a tax payer.
However, when it comes to investments made for the purpose of tax savings under Section 80C of Income Tax Act, Public Provident Fund (PPF) and various type of Life Insurance policies are amongst the popular choices. However, as far as wealth creation is concerned, there is simply no comparison between ELSS and the rest of the 80C investment options including PPF and Insurance policies. To check, how? You may like to read - Why is Mutual Fund ELSS the simply best tax saving investment for young investors
Balanced Funds are hybrid equity oriented mutual fund schemes and must have in the Mutual Fund portfolio of all kind of investors. Balanced Funds usually invest 65 – 75% of their portfolio in equities or equity oriented securities and the remaining portion in debt or money market securities. Since at least 65 - 75% of the portfolio is invested in equity or equity related securities, the balanced funds are excellent investment options even for investors with moderate risk tolerance. The portfolio mix of debt and equity moderates the fund volatility to a great degree while enabling potential wealth creation in the long term. Investors in balanced funds, thus enjoy the return of both asset classes – Equity and Debt.
We have suggested balanced funds here as investors must have some allocation towards debt. Most of the investors opt for bank fixed deposits due to low awareness and less popularity of debt funds. If you invest in pure debt funds, then the long term capital gains are taxed at 20% rate after allowing indexation, but to avail the long term capital gain benefits the investors have to hold the debt funds for more than 3 years. Therefore, we have suggested Equity Oriented Balanced Funds, as these funds invest in debt portfolios upto the extent of 25 – 35% of the total portfolio, yet it offers the benefit of long term capital gains like pure equity funds. The other benefit is that the balanced fund portfolio gets rebalanced according to the mandated ratio of debt and equity.
To know more about the debt funds investing benefits, we suggest reading Can Mutual Fund Balanced Funds be Your Best Bet and Optimize your Asset Allocation with Balanced Mutual Funds
In this article, we have discussed the 4 categories of Mutual Fund Schemes that investors must have in their portfolio. The selection of the categories was based on various simple factors like – keeping the equity portfolio simple yet diversified by investing in only one kind of equity fund i.e. Diversified Equity Funds, to get superior tax advantage, if you are paying tax, by investing in ELSS funds, to have asset diversification by taking some exposure in debts without worrying about taxes by investing in Balanced Funds and planning your emergency fund or get superior return than savings bank account on money lying idle in savings bank account by investing in liquid funds. The selection of these categories is for general purpose and by no means suggesting any portfolio construction based on these types of funds.
Mutual Fund investments carry market risk and therefore knowing your risk profile and selecting funds based on that and also on the basis of your term goals should be the key parameters of selection of Mutual Fund schemes. To know more about various Mutual Fund categories and if they are suitable for you, you must consult a Mutual Fund advisor or a Financial Planner.