Types of Mutual Funds: Categories and Sub-Categories, Who should invest in which Mutual Fund and Taxation

Retail Mutual Fund Investors are rising rapidly in India. In March 2024, there were 17.8 crore mutual fund accounts, out of these 91.4 percent were those of retail investors as per the Association of Mutual  Funds of India (AMFI). Retail investors are those who have a ticket size of less than Rs.2 lakhs. In this scenario, understanding the types of mutual funds has become more important for investors to diversify their portfolio and reduce the risk. 

But first, let's discuss what Mutual Funds are. A mutual fund is formed when an asset management company (AMC) pools money from several individual and institutional investors to purchase securities such as stocks, debentures and other similar assets. The AMCs have fund managers to manage the pooled investment. Fund units assigned to Mutual fund investors corresponding to their quantum of investment. Investors are allowed to purchase or redeem fund units only at the prevailing net asset value (NAV).

The NAV of mutual funds varies daily depending on the performance of the underlying assets. Mutual funds are well regulated by the Securities and Exchange Board of India (SEBI). A significant advantage of investing in mutual funds is that investors can diversify their portfolios at a relatively lower investment amount.

Mutual funds are broadly classified into Equity Funds, Debt Funds, Hybrid Funds, Solution Oriented Funds and other schemes (Index Funds and Funds of Funds). Based on the underlying assets these funds are categorised. Like Equity Mutual Funds majorly invest in equities, Debt Mutual Funds majorly invest in debt instruments and Hybrid Mutual Funds majorly invest across both equity and debt securities. These major categories have some sub-categories, which are based on their exposure to equities.

Other than the types of mutual funds, on this page, we have also discussed the other aspects of mutual funds like Who should invest in which funds, consideration points before investing and taxation on mutual funds.

Types of Mutual Funds

Here are the major categories and sub-categories of Mutual Funds.

Types of Equity Mutual Funds

Equity mutual funds invest at least 65% of their assets in equity and equity-related instruments. These funds aim for high returns by capitalizing on the growth potential of these companies. The value of investments can fluctuate due to market conditions. Equity mutual funds can be sector-specific, diversified, or thematic, providing various options based on investors' risk appetite and investment goals.

Large Cap Mutual Funds

As the name suggests, Large cap funds invest in large listed companies, the top 100 companies according to market capitalisation. These companies are market leaders in their respective industries like Reliance, TCS, Infosys, Bharti Airtel, HDFC etc. Large cap funds have to invest a minimum of 80% of their assets in equity and equity related instruments of large cap companies. How much they want to invest in which large stock is decided by the fund's strategy. Due to their major exposure to big companies, large cap funds are considered less riskier and more stable. 

Mid Cap Mutual Funds

These Funds buy stocks of top companies between 101 to 250 according to market capitalisation. Mid cap companies have a market capitalisation between Rs.5000 crore to Rs.20000 crore. These companies have a higher potential to grow. Currently, some of these companies are Hitachi Energy India, Bank of Maharashtra, Suzion Energy, Blue Star, etc. Mid cap funds have to invest a minimum of 65% of their assets in equity and equity related instruments of mid cap companies. Mid cap funds are considered more riskier than large cap funds but have chances to surpass the returns of the latter. An average annual return of mid cap funds is 26.95%, as mentioned on ET money. 

Small Cap Mutual Funds 

Stocks of small companies are the major underlying assets of small cap funds. These companies have a market capitalisation of less than Rs.5000 crore. They have a high growth potential but also a lot of risk is aligned with them. SEBI says all the companies ranked from 251 onwards in terms of market capitalisation are by default becoming part of small cap companies. JK laxmi cement, Lux Industries, Edelweiss, Birla corp, etc. Small cap funds have to invest a minimum of 65% of their assets in equity and equity related instruments of small cap companies. Small cap funds can deliver fantastic returns but at the same time, the chances of volatility are very high.  

Large and Mid Cap Funds

These Funds are blend of large and Mid cap stocks. Instead of investing their major amount of money in one category of stocks, Large and Mid cap funds distribute their asset according to the following strategy: a minimum of 35% of assets invested in large cap stocks and a minimum of 35% invested in mid cap stocks. These funds expect to provide returns higher than large cap funds, but less risky than mid and small cap funds. 

Multi Cap funds

There is no restriction on multi cap funds to follow an investment strategy which is confined to specific market capitalisation. These funds invest in any company’s stock irrespective of market capitalisation and diversify their portfolio. Any stock can be a part of their investment portfolio, not matter If it belongs to a large cap company or small cap company. This freedom allows them to make necessary changes in their investment portfolio as the market demands. The only one thumb rule for them is that they have to invest a minimum of 65% of their assets in equities and equity related instruments.

Focused Mutuals Funds

Usually, stocks of 70-80 companies lie under a mutual fund scheme, but this is not the case with Focused Mutual Funds. These funds can purchase stocks of up to 30 companies. Fund managers studiously go through each company’s details before investing. They make a concentrated portfolio with limited stocks, so they can give their maximum attention to each lying asset and grow the investment as much as they can while managing the risk. According to SEBI’s rule, Focused Funds have to invest a minimum of 65% of their assets in equities and equity related instruments.

Dividend Yield Funds 

These funds do not go by their name, they are not under any obligation to pay dividends at regular intervals, which is the opposite of the image we build when we read dividend yield funds. Investing in a kind of companies that payout dividends comparatively with high frequency is a strategy they follow, this is the reason they are called dividend yield funds. Investors of a dividend yield fund receive dividend income consistently and get the benefit of regular income while letting their investment also grow lying in the fund. These funds can also diversify their portfolio since they are obliged to invest a minimum of 65% of their corpus into equity and equity related instruments, while 35% gives them space for different bets. 

ELSS Mutual Funds

Equity Linked Savings Scheme Mutual Funds can be decoded by reading the name only. These funds invest a minimum of 80% of their corpus in equity and equity linked instruments and also provide tax benefits like saving schemes. ELSS funds have a lock-in period of 3 years, LTCG (long term capital gain tax) is applicable on the withdrawal after the lock-in period, which is 10% (on above 1 lakh) without indexation benefit. ELSS allows investors to take a tax deduction of up to Rs.1,50,000 on their investment under section 80(c) of the income tax act. 

Types of Debt Mutual Funds

Debt mutual funds invest in fixed income instruments like bonds, government securities, and money market instruments. These funds aim to provide stable returns and preserve capital. Interest rate changes impact their performance. Debt funds are often chosen by conservative investors or those nearing financial goals. 

Liquid Mutual Funds  

Liquid Mutual Funds invest in debt instruments which have a maturity period of up to 91 days, like Treasury bills issued by the government and Commercial Papers issued by corporate entities. According to these debt instruments, investors will get back the money after the agreed period and meanwhile, issuers will pay them interest, which is also called coupon rate. It is like giving a loan and getting interest on the lending amount. Before investing the money mutual fund houses review the credit rating of the issuer company, which is equivalent to a credit score of an individual. A high credit rating is a sign of a company's good financial health. Liquid Funds have to invest 20% of their corpus in high liquid options (cash or cash equivalent instruments or money market instruments) to meet the redemption demand of investors.

Overnight Mutual Funds 

As liquid funds invest in debt options with a maturity period of up to 91 days, overnight funds invest in securities that mature in a 24 hours window. This security is called Tri-party-repo or Trep and is regulated by the Reserve Bank of India.  Due to this one day maturity window, credit risk is very low. 

Ultra Short Duration Funds

Ultra short duration funds invest in short term securities and money market instruments, ensuring to maintenance of the fund's portfolio Macaulay Duration of 90 to 180 days. Macaulay Duration is the average maturity duration of underlying securities of a fund scheme. In easy language, it is the time taken by investors (mutual fund houses) to recover the invested money after considering the interest payments. 

Low Duration Funds

According to SEBI, low duration funds invest in debt instruments with a maturity period between 6 to 12 months. These debt instruments are commercial paper by corporations, certificates of deposit by banks and Treasury bills issued by the government. Credit risk is higher than the liquid funds, overnight funds and ultra short funds due to longer macaulay duration than the mentioned funds.  

There are other duration funds like short duration funds, medium duration funds and long duration funds that invest in different debt instruments in a way that they can maintain macaulay durations defined by SEBI for these funds. 

Money Market Funds

These funds invest in money market instruments with a maturity period of up to 1 year while maintaining a high level of liquidity. Money Market Funds invest in treasury bills, commercial papers, certificates of deposits and repurchase agreements. They provide better interest rates than traditional fixed income instruments like savings accounts and fixed deposits. 

Dynamic Funds 

Dynamic funds have the freedom to alter their macaulay duration to earn maximum returns from their investment. In dynamic funds, fund managers change their portfolio’s duration by altering their allocation between short and long term debt instruments. Interest rates of the market and returns of the debt instruments are inversely related, so if the interest rates rise the return of short debt instruments will not be impacted by it, while in a falling rates regime, the long term debt instruments will have a better chance to earn a good return. The risk associated with this fund lies in the fund manager’s decision to alter the portfolio and not fulfil the payment obligation by the debt instrument’s issuer. 

Credit Risk Funds

These funds go after high returns by taking as much risk as possible. This fund used to be called Credit Opportunities Fund but the name was changed by SEBI in the year of 2017. SEBI has mandated that credit risk funds have to invest 65% of their corpus in AA* and below rated corporate bonds, and there is no rule for the rest 35%. These funds lend money to corporate entities with low credit ratings and may have bad repayment records, in return for high rates of interest. 

Banking and PSU Funds

Banking and PSU Funds are considered one of the low risk funds due to their major investments in banks and government-owned entities. According to SEBI, Banking and PSU Funds have to invest a minimum of 80% of their corpus in banks, public sector undertakings, public financial institutions and municipal bonds. The remaining 20% without any controlling strap, is where the risk lies. Investing in a high risk corporate entity in the hope of getting handsome returns could hit the NAV of the fund if the result of that investment will come as a default.   

Gilt Funds 

Gilt funds invest a minimum of 80% of their corpus in Government securities, hence considered one of the safest debt investments, but the remaining 20% can go anywhere. There is another type of Gilt Funds that is obliged to maintain a macaulay duration of 10 years while keeping a minimum of 80% of their corpus in government securities. Because of the macaulay duration obligation, Gilt funds with 10 year constant duration can face the interest rate risk in a rising interest regime. 

Types of Hybrid Funds 

Hybrid mutual funds combine investments in both equity and debt instruments. This mix helps balance risk and reward. They are designed to provide growth from equities and stability from debt. Examples include aggressive hybrid funds (more equity) and conservative hybrid funds (more debt). They offer a middle ground for investors not comfortable with full equity exposure.

Conservative Hybrid Funds 

A conservative hybrid fund combines both equity and debt investments. These funds must allocate 75% to 90% of their assets to debt instruments, like bonds, debentures, and treasury bills, while the remaining 10% to 25% can be invested in stocks. Fund managers of conservative hybrid funds regularly rebalance the portfolio to maintain the required proportion of debt and equity as mandated by SEBI regulations. Risks aligned with these funds are the equity exposure due to its volatile nature and the debt portion still comes with its risks, such as interest rate risk, credit risk, liquidity risk, and inflation risk.

Balanced Hybrid Funds 

Balanced Hybrid Funds invest in a mixture of both equity and debt in a defined ratio. According to SEBI, a balanced fund has to invest 40% to 60% of its assets in equity and equity-related instruments, and 40% to 60% of its assets in debt instruments. Arbitrage is not allowed, meaning a fund can not purchase and sell the same or similar assets in different markets to take profit from the minor difference in the asset’s listed price in different markets. Balanced funds can be a good option for those who are looking for an investment opportunity that can provide capital appreciation and lower risk in an equal manner.

Multi Asset Allocation Funds

Multi Asset Funds diversify their portfolio and reduce risk by investing across several asset classes. According to SEBI, these funds invest at least in three asset categories and invest a minimum of 10% of their corpus in each category. Equity and Debt are two major asset classes and third could be real estate, gold and more. Having ownership in various asset classes, these funds take advantage of the market whenever the circumstances change. 

Arbitrage Funds 

Arbitrage funds are a type of hybrid mutual fund that aims to generate returns by taking advantage of price differences in different markets. The fund manager buys and sells securities simultaneously to earn a profit from these price differences. Essentially, they make money from the gap between the buying and selling prices of the same share. As per SEBI regulations, arbitrage funds must invest at least 65% of their assets in equity and equity-related instruments.

Types of Solution Oriented Funds 

Solution-oriented mutual funds are designed to provide specific financial goals like retirement planning and children's education. These funds have a lock-in period of at least five years or until the goal is achieved. They offer a disciplined approach to investing towards long-term goals. These funds may invest in a mix of equity and debt based on the goal's time horizon.

Retirement Mutual Funds 

These funds are long term funds, also known as pension funds. People invest for their retirement and funds provide a regular income to investors after their retirement until the corpus is there or withdrawn by the investor. These funds have a lock-in period of 5 years or retirement age, whichever is earlier. Retirement Funds invest in lower risk options like government securities, to ensure the stability of the fund and regular income to retirees. 

Children’s Mutual Funds

It is a specific category of mutual funds which lets people invest for the education, marriage and welfare of their children. These funds are part of long term financial planning, and have a lock-in period of a minimum of 5 years or until the child reaches adulthood, whichever is earlier. Mutual fund child plans invest in both, equity and debt securities and investors have an option to choose the asset ratio according to their risk tolerance. 

Other Mutual Funds

Index Funds 

As the name suggests, index funds track a specific index like Nifty or Sensex. These funds are passively managed, meaning the fund manager invests in the same securities as the underlying index, in the same proportion, without changing the portfolio composition. An index can include a mix of equity, equity-related instruments, and bonds. Index funds ensure they invest in all the securities tracked by the index, aiming to either match or outperform their benchmark.

Who Should Invest in Mutual Funds?

Mutual funds are an excellent investment vehicle for a variety of investors, offering a wide range of options to suit different financial goals, risk tolerances, and investment horizons. Here’s a detailed look at who should consider investing in different categories of mutual funds, including Equity Mutual Funds, Debt Mutual Funds, Hybrid Mutual Funds, Solution-oriented Mutual Funds (like retirement funds and child schemes), and Index Funds.

Who should invest in Equity Mutual Funds?

Equity mutual funds are ideal for investors seeking long-term capital growth and who have a higher risk tolerance. These funds invest primarily in stocks and are suitable for those with a time horizon of five to seven years or more.

Considerations:

• Risk Tolerance: Equity funds are subject to market volatility. Investors should be comfortable with short-term fluctuations in their investment value.
• Investment Horizon: A longer time frame (5+ years) can help mitigate the risks associated with stock market investments.
• Financial Goals: Ideal for goals like retirement, buying a house, or funding children's education, where substantial growth is desired over the long term.

Fact: Historically, equity mutual funds have delivered higher returns compared to other investment types over the long term, making them a popular choice for wealth creation.

Who should invest in Debt Mutual Funds?

Debt mutual funds are suitable for conservative investors looking for regular income with lower risk. These funds invest in fixed-income securities like bonds, debentures, and treasury bills.

Considerations:

• Risk Tolerance: These funds are conservative investors who do not want to experience stock market volatility. Still, debt funds carry interest rate risk, credit risk, and inflation risk.
• Investment Horizon: Ideal for short to medium-term goals (1-3 years), such as buying a car or creating an emergency fund.
• Liquidity Needs: Debt funds offer better liquidity compared to fixed deposits, making them suitable for investors needing periodic withdrawals.

Fact: Debt mutual funds often provide better post-tax returns compared to traditional fixed income instruments like fixed deposits, especially for investors in higher tax brackets.

Who should invest in Hybrid Mutual Funds?

Hybrid mutual funds are designed for investors looking for a balanced approach between growth and income. These funds invest in a mix of equity and debt instruments.

Considerations:

• Risk Tolerance: Suitable for moderate risk-takers. The equity component provides growth potential, while the debt component offers stability.
• Investment Horizon: Suitable for medium to long-term goals (3-5 years).
• Diversification: Provides diversification across asset classes, reducing overall portfolio risk.

Fact: Hybrid funds offer the best of both worlds, making them an attractive option for investors who want to benefit from equity growth while having the safety net of debt investments.

Who should invest in Solution-oriented Mutual Funds?

Solution-oriented mutual funds, such as retirement funds and child education schemes, are tailored for specific financial goals. These funds typically have a long-term investment horizon and come with a lock-in period.

Considerations:

• Goal-based Investing: Ideal for investors with specific long-term goals like retirement or child’s education.
• Risk Tolerance: The risk level varies based on the fund’s asset allocation. Typically, these funds shift from aggressive to conservative as the target date approaches.
• Lock-in Period: Be prepared for a lock-in period, which ensures disciplined investing towards the goal.

Fact: These funds often come with tax benefits, providing a tax deduction of Rs.1.5 lakh under section 80(c), making them an attractive option for long-term financial planning.

Who should invest in Index Funds?

Index funds are suitable for investors looking for a low-cost, passive investment strategy. These funds track a specific market index, like the Nifty or Sensex, and aim to replicate its performance.

Considerations:

• Risk Tolerance: Suitable for investors comfortable with market risks but looking for lower management fees and stable performance.
• Investment Horizon: Best for long-term investors (5+ years) who believe in the growth potential of the overall market.
• Cost Efficiency: Lower expense ratios compared to actively managed funds, making them cost-effective.

Fact: Over the long term, many actively managed funds struggle to outperform their benchmark indices.

Points to Consider Before Investing

When deciding which mutual funds to invest in, consider the following factors:

1. Risk Appetite: Assess your comfort level with risk and choose funds that match your risk tolerance.
2. Investment Goals: Align your fund selection with your financial goals and investment horizon.
3. Diversification: Spread your investments across different fund categories to reduce risk.
4. Expense Ratios: Consider the cost of investing in mutual funds, as higher fees can erode returns over time.
5. Past Performance: While not indicative of future results, analysing a fund’s historical performance can provide insights into its potential.

Investing in mutual funds can be a powerful tool for achieving financial goals. By understanding the different categories and their unique characteristics, investors can make informed decisions that align with their individual needs and objectives.

Taxation Rules for Mutual Funds in India

Mutual funds in India are subject to different taxation rules based on the type of mutual fund and the holding period. Here is a detailed overview:

1. Equity Mutual Funds

• Definition: Funds that invest at least 65% of their assets in equity and equity-related instruments.
• Short-Term Capital Gains (STCG):
  • Holding period: Less than 12 months.
  • Tax rate: 15%.
• Long-Term Capital Gains (LTCG):
  • Holding period: More than 12 months.
  • Tax rate: 10% on gains exceeding ₹1 lakh per financial year.
• Dividends:
  • Dividends received from equity mutual funds are taxed at the investor’s applicable slab rate.

2. Debt Mutual Funds

• Definition: Funds that primarily invest in fixed income securities like bonds, government securities, and money market instruments.
• Short-Term Capital Gains (STCG):
  • Holding period: Less than 36 months.
  • Tax rate: Added to the investor’s income and taxed as per their income tax slab.
• Long-Term Capital Gains (LTCG):
  • Holding period: More than 36 months.
  • Tax rate: 20% with indexation benefit.
• Dividends:
  • Dividends received from debt mutual funds are taxed at the investor’s applicable slab rate.

3. Hybrid Mutual Funds

• Definition: Funds that invest in a mix of equity and debt instruments.
  • Equity-Oriented Hybrid Funds (equity allocation of 65% or more):
    • Taxation similar to equity mutual funds.
  • Debt-Oriented Hybrid Funds (equity allocation less than 65%):
    • Taxation similar to debt mutual funds.
• Dividends:
  • Taxed at the investor’s applicable slab rate.

4. Solution Oriented Mutual Funds 

• Definition: Funds designed to meet specific goals like retirement and child’s education.
• Applicable Tax: Due to 5 years lock-in period, applicable tax would be the same as on the long term capital gains on any equity and debt mutual funds. Your mutual fund scheme would attract the right tax as per the underlying asset of the fund. 
• Tax Benefits: Investments in certain retirement funds may qualify for tax deductions under Section 80C of the Income Tax Act, up to Rs.1.5 lakh per year.
• Dividends:
  • Taxed at the investor’s applicable slab rate.

5. Index Mutual Funds

• Definition: Funds that replicate and track the performance of a specific stock market index like Nifty 50 or Sensex.
• Short-Term Capital Gains (STCG):
  • Holding period: Less than 12 months.
  • Tax rate: 15%.
• Long-Term Capital Gains (LTCG):
  • Holding period: More than 12 months.
  • Tax rate: 10% on gains exceeding ₹1 lakh per financial year.
• Dividends:
  • Taxed at the investor’s applicable slab rate.

Tax Benefits of Investing in Mutual Funds

• Equity-Linked Savings Scheme (ELSS):
  • Investments up to ₹1.5 lakh per year in ELSS are eligible for tax deduction under Section 80C.
  • Lock-in period of 3 years.
• Tax Deferral:
  • Taxes on capital gains are deferred until the units are sold, allowing potential for compounding.

Additional Considerations

• Securities Transaction Tax (STT):
  • Applicable on equity mutual funds at the rate of 0.001% on the redemption of units.
• Tax Deducted at Source (TDS):
  • Not applicable on mutual fund gains for Indian resident investors, but NRIs are subject to TDS as per applicable rates.

By understanding the types of mutual funds, Goals, investment horizon, risk related to these various mutual funds and the taxation rules, investors can make informed decisions about their mutual fund investments and make their financial journey a better one.