Mutual Fund Product Categorisation: NISM Series II-B Study Notes (Chapter VIII – Part 2)

This study guide (Part 2 of 2) examines the diverse categories of mutual fund products available in the Indian financial market, detailing their specific investment strategies, risk levels, and portfolio structures as defined by SEBI.

1. Debt Mutual Funds (Fixed Income Schemes)

Debt funds invest predominantly in debt and fixed-income securities. These securities are characterised by a fixed term/maturity and pay a specific, pre-determined rate of interest.

Classification of Debt Mutual Funds

The debt market segment consists of several distinct fund categories, grouped by maturity and credit risk:

• Liquid Funds / Money Market Funds: These funds invest in very short-term debt instruments with less than 91 days to maturity. They offer high liquidity and low capital risk.
• Short-Term Debt Funds: These funds invest in debt securities with a slightly longer maturity than liquid funds. The returns are primarily generated from accrual income earned through periodic coupons.
• Income Funds: These funds invest predominantly in a wide range of medium-term and long-term debt instruments issued by corporate entities, the government, banks, and financial institutions.
• Gilt Funds: These funds invest strictly in government securities of medium and long-term maturities. Because the issuer is the government, gilt funds do not carry any default (credit) risk.
• Floating Rate Debt Funds: These schemes invest in a specific class of debt instruments where interest rates are not fixed, but instead change dynamically based on a specified market benchmark.
• High-Yield Debt Funds: These funds seek to earn higher interest income by investing in corporate debt instruments that have lower credit ratings. Consequently, they carry a much higher risk of default.
• Fixed Maturity Plans (FMPs): FMPs are closed-end debt funds that invest in debt instruments whose maturity dates match or precede the maturity date of the scheme itself. The underlying debt securities are held until they mature, redeemed, and the proceeds are paid back to the investors.

2. Equity Mutual Funds (Growth Schemes)

Equity funds invest predominantly in the equity shares issued by corporate entities. The risk associated with equity funds is structurally higher than that of debt funds. However, the level of risk and return volatility varies significantly depending on the investment style and market capitalisation focus of the fund manager.

Core Equity Fund Categories

• Diversified Equity Funds: These funds invest across the broad equity market, without being restricted to any particular sector, theme, or market capitalisation band.
• Large-Cap Funds: These schemes focus on the equity shares of large-sized corporate entities. Large companies are usually well-established, making their shares highly liquid and relatively easy to buy and sell on stock exchanges.
• Mid-Cap Funds: These funds target the equity shares of medium-sized "second-rung" companies. They are selected for their high potential to grow their earnings and profitability, with the ultimate objective of expanding into large companies.
• Small-Cap Funds: These funds focus on equity shares of small, typically new and upcoming companies. While they are purchased for their future growth potential, their shares can be illiquid and difficult to trade in large quantities.
• Thematic & Sector Funds: These schemes narrow their focus to companies operating within a specific theme (e.g., infrastructure) or a specific industry sector (e.g., banking). They are designed for investors who believe that the chosen theme or sector will outperform the broader market.

3. Strategy-Based and Tax-Saving (ELSS) Classifications

An AMC can manage equity or debt portfolios using specific, defined strategies to differentiate their offerings.

A. Strategy-Based Portfolios

• Dividend Yield Schemes: Some equity portfolios are constructed with the objective of generating regular dividend income by investing predominantly in the stocks of high dividend-paying companies.
• Special Situations & Turnaround Schemes: These funds employ a stock selection strategy that targets companies undergoing turnarounds or experiencing special corporate situations.
• Index Funds (Passive Management): These funds are managed passively. Instead of actively choosing individual stocks and sectors, the fund manager simply replicates a given market index by selecting the exact same stocks in the exact same proportion.
• Active Debt Strategies: Some debt fund managers invest a proportion of their portfolio in long-term debt securities to capitalize on capital appreciation if interest rates fall.

B. Equity Linked Saving Scheme (ELSS)

• Definition: ELSS is a specially designated equity mutual fund scheme that provides statutory tax benefits to investors.
• Tax Advantage: Individual investments up to Rs. 1,50,000 per financial year can be deducted from the investor's taxable income under Section 80C of the Income Tax Act.
• Portfolio Requirement: Under SEBI guidelines, an ELSS fund must hold at least 80% of its total portfolio in equity and equity-related securities.

4. Hybrid Mutual Funds (Asset Allocation Schemes)

Hybrid funds invest in a combination of different asset classes, such as equity and debt, within a single scheme. The objective is to provide investors with the strategic benefits of both asset markets within a single product.

Key Hybrid Categories

• Predominantly Debt-Oriented Hybrids: These funds invest the majority of their assets in the debt market, but maintain a small allocation of 5% to 35% in equity. This allows investors to enjoy the growth potential of equity alongside the steady income generated by debt securities.
• Predominantly Equity-Oriented Hybrids (Balanced Funds): These funds focus primarily on the equity market but allocate up to 35% in debt to generate a steady, periodic income component.
• Dynamic Asset Allocation Funds: These schemes have the flexibility to shift their asset allocation dynamically across a wide range, representing 0% to 100% in equity or debt. When equity market risks are high, the fund switches its assets to debt; it switches back to equity when markets start trending upward.
• Dual Advantage Funds: These are closed-end hybrid funds structured with a higher debt orientation (60% to 70% debt) and a lower equity orientation (25% to 35% equity). Because their equity exposure is kept below the statutory threshold of 65%, they are classified as debt funds for taxation purposes.

5. Specialty and Other Mutual Fund Structures

SEBI permits several other specialty fund structures designed to meet unique investment objectives:

• Fund of Funds (FoF): A FoF does not invest in direct securities; instead, its portfolio is made up of units of other mutual fund schemes. For taxation purposes, a FoF is always treated as a debt fund, regardless of whether its underlying holdings are equity schemes.
• Commodity Funds: While commodity funds abroad can invest directly in physical commodities or futures contracts, Indian commodity funds are restricted and predominantly invest in the shares of commodity-linked companies.
• Real Estate Funds: These funds invest directly in real estate properties, extend loans to real estate developers, or buy securities of corporate housing and property companies.
• Gold Exchange Traded Funds (Gold ETFs): A Gold ETF purchases physical gold, which is safely stored in the custody of an independent custodian. It allows investors to buy gold in quantities as low as 1 gram, which is represented in the form of demat units. These units are offered during the NFO, after which they are listed and traded on stock exchanges at real-time prices.
• Capital Protection Funds: These are closed-end hybrid funds that combine debt and equity investments. The debt component is calculated to grow over the scheme's tenor to match the initial principal invested, thereby protecting the investor's capital.
• Infrastructure Debt Funds: These schemes invest predominantly in debt securities or securitised debt instruments issued by infrastructure developers, infrastructure capital companies, or special purpose vehicles (SPVs).

6. Taxation and Key Formulas for Exams

A. Scheme Taxation Rules

For tax purposes, mutual fund schemes are divided into two categories based on their equity allocation:

\[\text{Equity-Oriented Fund Status} = \text{Minimum 65% of assets invested in equity shares of corporate entities}\]

• Equity-Oriented Funds: Must maintain a minimum of 65% in equity shares.
• Non-Equity/Debt Funds: Any fund holding less than 65% in equity shares is treated as a debt fund for tax purposes. This category includes liquid funds, pure debt funds, debt-oriented hybrids, Fund of Funds, and Dual Advantage funds.

B. Investor Return Options

Mutual funds offer three standardized options for receiving returns:

1. Growth Option: Allows capital gains to accumulate and remain invested within the scheme, which can be booked on redemption.
2. Dividend Option: Periodically pays out accumulated profits to investors as dividend income.
3. Dividend Reinvestment Option: The declared dividend is not paid out in cash; instead, it is automatically reinvested to purchase additional units of the scheme.

7. Key Terms & Exam-Relevant Summary

Important Terms

• Gilt Funds: Default-free mutual funds that invest exclusively in government-issued securities.
• ELSS 80% Rule: The statutory requirement that an Equity Linked Saving Scheme must hold at least 80% of its assets in equity.
• Gold ETF 1gm Unit: A dematerialized unit of an exchange-traded fund that represents the value of approximately 1 gram of physical gold.
• Fund of Funds (FoF): A scheme that invests in units of other mutual funds and is always taxed as a debt fund.

Chapter Summary Table: Product Comparison