Unit 2: Mutual fund products and features

1. Classification by Structure: Open-Ended vs. Close-Ended Funds

Mutual funds are primarily classified by their structure, which dictates how investors can buy and sell units, the liquidity of the fund, and its capital base.

Open-Ended Funds

Open-ended funds are available for subscription and repurchase on a continuous basis. They do not have a fixed maturity date.

• Continuous Entry and Exit: Investors can buy or sell units at any time directly from/to the mutual fund house.
• Pricing: Transactions are executed at the Net Asset Value (NAV) declared at the end of the business day.
• Corpus: The mutual fund's corpus (total pool of money) is variable. It increases when investors buy units and decreases when they redeem them.
• Liquidity: Highly liquid. Investors can withdraw their money swiftly without relying on secondary market buyers.
• Objective: Ideal for systematic investing (SIPs) and wealth creation over flexible time horizons.

Close-Ended Funds

Close-ended funds have a stipulated maturity period (e.g., 3 years, 5 years). Investors can only buy units during the New Fund Offer (NFO) period.

• Restricted Entry and Exit: Once the NFO closes, new units cannot be purchased directly from the fund house, nor can they be redeemed until maturity.
• Exchange Listing: To provide a degree of liquidity, close-ended funds are subjected to mandatory listing on recognized stock exchanges.
• Pricing: Traded on the stock exchange like shares. The market price is dictated by supply and demand, meaning they can trade at a premium or discount to the actual NAV.
• Corpus: The corpus is fixed after the NFO period closes.
• Objective: Provides fund managers with a stable pool of capital, allowing them to invest in long-term strategies without worrying about sudden redemption pressures.

Comparison Summary

2. Broad Types of Mutual Funds (By Asset Class)

Beyond their structure, mutual funds are classified by the underlying asset classes they invest in to meet different risk-return objectives.

A. Equity Mutual Funds

Invest predominantly in equity shares and related instruments.

• Risk/Return: Highest potential returns accompanied by the highest risk and volatility.
• Objective: Capital appreciation over the long term.

B. Debt Mutual Funds

Invest primarily in fixed-income securities such as Government Bonds, Treasury Bills, Corporate Bonds, and Commercial Papers.

• Risk/Return: Lower risk compared to equity; provides steady, predictable returns.
• Objective: Capital preservation and regular income generation.

C. Hybrid Mutual Funds

Invest in a mix of both equity and debt.

• Risk/Return: Moderate risk and moderate returns.
• Objective: To balance risk and return by diversifying across non-correlated asset classes. (Examples: Balanced Advantage Funds, Aggressive Hybrid Funds).

D. Solution-Oriented & Other Funds

• Solution-Oriented: Designed for specific financial goals like Retirement or Children's Education (usually come with a 5-year lock-in).
• Index Funds / ETFs: Passive funds that replicate a specific market index (e.g., S&P 500, Nifty 50).
• Fund of Funds (FoF): Funds that invest in the units of other mutual funds rather than direct securities.

3. Types of Equity Schemes

Regulatory bodies (like SEBI in India, or the SEC in the US) strictly categorize equity funds by market capitalization and investment strategy to ensure "true to label" investing.

Note: Market Capitalization definitions typically follow this structure: Large Cap (Top 100 companies by market cap), Mid Cap (101st to 250th companies), Small Cap (251st company onwards).

Categorization by Market Capitalization

1. Large Cap Funds:
   • Mandate: Must invest a minimum of 80% of total assets in large-cap equities.
   • Profile: These companies are well-established, industry leaders with stable earnings.
   • Risk: Lowest risk among pure equity funds; provides steady compounding.
2. Mid Cap Funds:
   • Mandate: Must invest a minimum of 65% of total assets in mid-cap equities.
   • Profile: Medium-sized companies in their growth phase. They offer higher growth potential than large caps but are more susceptible to economic downturns.
   • Risk: High volatility and risk.
3. Small Cap Funds:
   • Mandate: Must invest a minimum of 65% of total assets in small-cap equities.
   • Profile: Startups or smaller companies in early development stages. Many multi-bagger stocks are born here, but the failure rate is also high.
   • Risk: Very high risk and highly volatile. Illiquidity during market crashes is a major concern.
4. Multi Cap Funds:
   • Mandate: Must invest a minimum of 75% of total assets in equities, with a strict allocation of at least 25% each in Large, Mid, and Small Cap stocks.
   • Profile: Forces the fund manager to maintain systemic exposure across all market caps regardless of market conditions.
5. Flexi Cap Funds:
   • Mandate: Must invest a minimum of 65% of total assets in equity.
   • Profile: A highly dynamic fund. The fund manager has complete freedom to allocate 0-100% across large, mid, or small caps based on their macroeconomic outlook and valuations.

Categorization by Investment Strategy

6. ELSS (Equity Linked Savings Scheme):
   • Profile: Tax-saving mutual funds that allow investors deductions under specific tax codes (e.g., Section 80C in India). They come with a mandatory 3-year lock-in period (the shortest lock-in among all tax-saving instruments).
7. Dividend Yield Funds:
   • Profile: Invest predominantly in dividend-yielding stocks. Favorable for conservative investors seeking a mix of capital appreciation and regular cash flow.
8. Value / Contra Funds:
   • Value Fund: Follows a value investing strategy—buying fundamentally strong companies currently trading below their intrinsic value.
   • Contra Fund: Takes a contrarian view, betting against prevailing market trends to buy out-of-favor sectors or highly beaten-down stocks.
9. Sectoral / Thematic Funds:
   • Sectoral: Invest at least 80% in a single sector (e.g., Technology, Pharmaceuticals, Banking). Extremely high concentration risk.
   • Thematic: Broader than sectoral. Invests around a central theme (e.g., "Infrastructure", which could include cement, steel, power, and logistics companies).

4. ESG Mutual Funds

ESG stands for Environmental, Social, and Governance. ESG mutual funds integrate these three non-financial factors into traditional financial analysis to identify risks and opportunities. This is synonymous with sustainable, responsible, or ethical investing.

The Three Pillars of ESG

• Environmental (E): How a company acts as a steward of nature.
  • Metrics mapped: Carbon footprint, energy efficiency, waste management, water usage, greenhouse gas emissions, and impact on biodiversity.
• Social (S): How a company manages relationships with employees, suppliers, customers, and communities.
  • Metrics mapped: Labor standards, workplace health and safety, diversity and inclusion (D&I), human rights, data privacy, and community involvement.
• Governance (G): How a company is led and managed.
  • Metrics mapped: Board diversity and independence, executive compensation fairness, business ethics, anti-corruption policies, and protection of minority shareholder rights.

ESG Investment Strategies

Fund managers use various methodologies to construct ESG portfolios:

1. Exclusionary (Negative) Screening: The oldest and most common method. The fund deliberately strips out companies involved in controversial sectors like tobacco, gambling, weapons, fossil fuels, or alcohol.
2. Positive (Best-in-Class) Screening: Actively selecting companies that score the highest on ESG metrics relative to their industry peers.
3. ESG Integration: Combining ESG data alongside traditional financial metrics (P/E ratios, cash flows) to calculate a more accurate risk-adjusted valuation.
4. Thematic ESG Investing: Investing directly into companies solving specific ESG issues (e.g., a fund solely dedicated to clean energy or water purification companies).

Why ESG Funds are Gaining Popularity

• Risk Mitigation: Companies with poor governance or severe environmental liabilities (e.g., oil spills) carry massive regulatory and reputational risks. ESG screening helps avoid these "black swan" value-destroyers.
• Long-Term Outperformance: Data increasingly shows that companies treating their workers well and operating sustainably are more resilient during economic downturns and deliver superior long-term shareholder value.
• Value-Aligned Investing: Modern investors (particularly Millennials and Gen Z) prefer allocating capital to businesses that align with their personal ethical values regarding climate change and social justice.