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Types of Mutual Fund Schemes – [by Position Philosophy]

Investors tend to expect mutual fund schemes to perform in all market conditions. This would require fund managers to have the flexibility to take a long or short position in any kind of asset class, without any limitations. “Unconstrained mutual funds” operate with that kind of flexibility. It must be noted that even such funds can take investment decisions that may not work out, and lead to losses.

Indian mutual fund schemes with the exception of Dynamic Asset Allocation / Balanced Advantage funds are typically “constrained”, i.e. they are committed to invest in specific asset classes; the indicative distribution of the portfolio between various asset classes is defined in the Scheme Information Document. The following scheme categories have a distinctive position philosophy:

1.   Sector Mutual Funds

Regular equity funds invest in a mix of equities that are spread across different sectors. Therefore they are often referred to as diversified equity funds. Sector funds, on the other hand, are expected to invest in only a specific sector. For instance, an energy fund would only invest in energy companies. Thus, an investor who is bullish about energy and wants an upside that is linked entirely to this sector (without a dilution arising out of exposure to other sectors) would invest in such a fund. If a sector runs into trouble, then the NAV of sector funds that are based on that sector take a steep hit.

As discussed as part of the SEBI classification scheme, at least 80 % of the investible money of any fund needs to be invested in the concerned sector or type of security, as the case may be.

In India, on account of a mix of legal slackness, fund managers’ lack of guts and investors’ lack of understanding of the concept, we faced situations where a few sector funds ended up becoming diversified equity funds with a bias towards the identified sector! We also saw diversified equity funds managed as if they were sector funds during the dotcom boom of the late 1990s. The recent SEBI measures should address these issues.

2.   Thematic Mutual Funds

These are funds that invest as per a specific investment theme. For instance, a scheme might invest in all sectors where technology has a significant role. Thus, the portfolio of companies of such a fund would be wider than that of a software sector fund (that would invest primarily in software companies) to cover sectors such as education, telecom, financial services retail, etc. Similarly, a real estate sector fund might invest only in real estate companies; an infrastructure theme fund would invest in several sectors of relevance for infrastructure including construction, cement, steel, power, telecom, roads, etc.

On account of the broader spectrum of sectors that they invest in, thematic funds are less risky than sector funds, though they are more risky than diversified equity funds.

The core of an average investor’s mutual fund equity portfolio is meant to be diversified equity funds; sector funds and thematic funds are add-ons that might constitute a minor part of the portfolio of only those investors who can digest the additional risk.

3.   Index Mutual Funds

Index funds seek to have a position that replicates an identified index, say, S&P BSE Sensex or CNX Nifty. SEBI insists that 95% of the total assets should be in such replicating investment for index funds and ETFs.

Patrons of Indian classical music would be aware that the violinist or harmonium player seeks to track the tunes and raga of the Carnatic or Hindustani music vocalist. On similar lines, the index fund manager seeks to track the tone and trajectory of the index.

The replicating position in an index fund can be created through either of two methods:

It can either be done by maintaining an investment portfolio that replicates the composition of the chosen index. Thus, the stocks in such a fund’s portfolio would be the same as those that are used in calculating the index. The proportion of each stock in the portfolio, too, would be the same as the weight of the stock in the calculation of that index.

This replicating style of investment is called passive investing. Index funds are therefore often called “passive funds”. Funds that are not passive, on the other hand, are often called “managed funds”, or “active funds”.

Index schemes are also referred to as “unmanaged schemes”, since they are passive, or “tracker schemes”, since they seek to track a specific index.

Passive investment places lower demands on the time and efforts of the AMC. All that is required is a good system that would integrate the valuation of securities (from the market) and information of sales and re-purchases of units (from the registrar) and generate the requisite buy and sell orders. Management fees for index funds are, therefore, lower than for managed schemes.

Alternately, a mutual fund, through its research can identify a basket of securities and / or derivatives whose movement is similar to that of the index. Schemes that invest in such baskets can be viewed as “active index funds”.

Internationally, mutual funds have proprietary models that help create baskets that seek to outperform the market during a boom, while falling comparatively less in a bearish market.

Globally, there are more equity index funds than debt index funds.

4.   Enhanced Index Mutual Funds

According to Hall, “The enhanced index fund is a managed index fund that seeks to beat the performance of its benchmark index by at least 0.1 %, but no more than 2 %. If the index fund’s performance were


to exceed this 2 % cap, it would then be considered an equity mutual fund.”

In India, there are mutual fund schemes that invest 80-90% of the portfolio as per a pre-specified index. Fund managers have flexibility in investing the balance.

5.   Exchange Traded Funds (ETFs)

Exchange traded funds are open-end funds that trade on the exchange. Like index funds, ETFs are normally benchmarked to a stock exchange index, although globally, these days, synthetic ETFs have gone well beyond indices.

ETFs differ from index funds in the following respects:

>>           Post-New Fund Offer (NFO), the ETF only receives securities (for sale of new units) or releases securities (for units redeemed). The securities are received or released in the same mix as the index that the scheme is tracking. This is completely different from open-end index schemes, which receive and pay cash for their transactions with investors.

>>           An ETF does not offer sale and re-purchase prices for the units since it only receives or releases a basket of securities comprising the index. Such transactions in the index basket are a realistic option only for large investors. In order to offer liquidity for small investors, the AMC appoints designated market intermediaries (market makers) who buy from or sell units to the investors for cash. This constitutes the secondary market for the ETF.

​Thus, a small investor who wants to invest in an ETF would go to a market maker who is expected to offer two-way quotes at all times. She would know precisely how many units in the ETF she will get against her investment.

​The market maker can transfer its own holding of ETF units to the investor. Alternatively, the money collected from investors will have to be invested in the index basket by the market maker, and transferred to the ETF. The ETF will issue units against this investment, which can be given to the investor.

​Similarly, based on the market makers’ two-way quotes, the small investor would know how much she can recover if she were to exit from the ETF. The market maker can choose to hold these units purchased from the investor. Alternatively, the market maker can offer the ETF units for re-purchase. In that case, the ETF will cancel the units and release index scrips from its portfolio, which the market maker would sell to pay the investor.

>>           The market maker makes money based on the spread in the two-way quote. Competition between market makers is expected to keep the bid-ask spread low. “Bid price” is the maximum price at which the market maker is prepared to buy the ETF unit from the investor; “Ask price” is the minimum price at which the market maker is prepared to sell ETF units to the investor.

​ The ETF structure also ensures that the AMC does not need to pay a commission to market intermediaries for bringing investors into the fund on an ongoing basis. Similarly, there are no loads recovered by the AMC. Thus, a significant element of cost is eliminated for the investors. Investors only bear a cost that is implicit in the bidask spread and the normal cost associated with stock exchange transactions. Low expense ratio is an attraction for any investor. Absence of commission income is a reason why mutual fund distributors do not promote ETFs.

>>           Returns in an open-end fund can be affected by significant churning of unit holding. Suppose, for example, that many large applications are received in the fund on a particular day, followed by several large redemptions the following day. The fund manager would then be under pressure to buy and sell securities in the market to match such sudden inflows and outflows. Besides, most openend funds maintain 5-10% of corpus in liquid assets to meet the cash flow requirements for possible redemptions. Extreme flows can pull down returns in an open-end index fund.

​ ETFs only receive securities (if an investor invests) and give securities (if an investor disinvests). Since such transactions are effected in kind, short-term investments and disinvestments do not affect the performance of the fund. Long-term investors appreciate this feature in ETFs.

>>           A single NAV is applicable for the day in the case of open-end funds. Therefore, a single price would be applicable for all investors who buy units of an open-end index fund on any particular day. Similarly, a single price would be received by all investors who exit from an open-end index fund on any particular day

​ An ETF, on the other hand, is traded in the stock market. Therefore its unit price keeps changing during the day. This intra-day fluctuation in ETF’s unit price appeals to short-term investors.

An investor desirous of taking an exposure to an index has the following options:

Invest directly in the basket of securities representing the index. But, this will entail a large outlay of funds.

Invest in an index fund. But management expenses and liquidity maintenance could lead to gaps in tracking the market (tracking error).

Invest in the index using futures and options that are traded in the derivatives segment of the stock exchange. These are, however, short duration instruments. The actively traded derivative contracts are for periods up to 3 months in India. Repeated rolling over of positions would increase the cost and uncertainty of creating a long term position.

Invest in ETFs which do not suffer from the above noted weaknesses of direct investment, index funds and derivatives. It is for this reason that ETFs have taken off in a big way in the United States. In India, although ETFs have been in existence for over a decade, they are yet to emerge as a frontline investment vehicle for any class of investors.

6.   Hedge Funds or Leveraged Funds

While the name “hedge fund” gives a psychological comfort of a fund being low on risk, nothing can be further away from the truth.

A feature of hedge funds is the extreme risk they take in the market, including shorting of stocks, i.e. selling stocks that they do not own, with the hope of buying them back later at a lower price. Shorting is an extremely risky investment strategy because the short-seller has an unlimited downside.

Many hedge funds are leveraged funds where the fund manager invests a mix of funds belonging to its investors (unit capital and reserves) and funds from lenders (borrowed funds). A leveraging of two would mean that for every  1 of unit capital, an additional  2 is borrowed, thus investing  3 in the market.

Borrowed funds have interest and repayment obligations that are independent of how the market performs. Thus, in bad market conditions, a non-leveraged fund only needs to bear a loss; a leveraged fund would also need to generate additional resources to meet the interest and repayment obligations on its borrowed funds.

However, when the returns on the investment portfolio are higher than the cost of borrowed funds, investors in a leveraged fund earn super-normal returns.

The following illustration will explain the concept better:







1 Time

2 Times

Unit Capital (Rs.)




Loans (Rs.)




Investible Funds (Rs.)




Interest Rate on Loan




Portfolio Return




Earning before Interest (Rs.)




Interest (Rs.)




Profit (Rs.)




Return on Unit Capital





Hedge funds are, therefore, extremely risky funds; the level of risk being a function of the extent of leveraging and the nature of exposure taken. They are also less regulated, across the globe. Why then the name “hedge fund”? Why, indeed?

Suppose an investor has a short-sold position of Rs. 100 in the market. If the market goes up by 20%, then the investor effectively loses Rs. 20.

If such an investor wanted to neutralise this short-sold position, she can purchase shares worth Rs.  100. Or, if she invests in Scheme B in the above example, she only needs to invest Rs. 80 to fully reverse her short-sold position of Rs. 100. The 25% gain on Rs. 80 invested in Scheme B will give her Rs.  20 — precisely the amount she would lose in her earlier short-sold position.

Thus, a hedge fund can help a person to reverse her existing exposure with minimum capital outlay (and therefore cost). Hence the name “hedge funds”.

As seen in Scheme C, it is also easy for hedge funds to wipe out their profits or even report significant losses.

David Faber states that “The average hedge fund charges a 1% management fee, just as a mutual fund does, but also takes 20% of any profits it generates within the funds in a given year.”

In the words of Lawrence Cunningham — Warren Buffett is a conservative decision maker. Explaining Berkshire’s conservative financial policy of using little debt, Buffett says that if there were a 99% probability that higher leverage would produce something good and a 1% chance of a surprise that would produce something between anguish and default, he would not bite that bullet: “We wouldn’t have liked those 99:1 odds — and never will. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns.”

SEBI regulations have limited the right of mutual fund schemes to borrow. This has kept out hedge funds in the mutual fund sector. They are however available as Alternate Investment Funds (AIF) for large investors.

7.   Option Income Fund

Let us consider a situation where you would like the right but not the obligation (an option), to buy 100 shares of Company Z from me at a price of  15 sometime in the future. I will give you that option only if you pay me an option premium. In option market terminology, I would be the writer of that option.

The option premium would be my income, because it is not refundable to you. There are two implications for me as the option writer:

(1)          If the stock of Company Z rises above  15 in the market, you would exercise your option, in which case I would lose out on the opportunity of gaining from that appreciation (opportunity loss).

(2)          If I operate on a fully hedged basis, then I will retain 100 shares of Company Z in my portfolio, so that I can offer them if you exercise your option. Thus, I effectively lose my right to sell the shares (dead asset). During the period that I hold the share, the dividend would belong to me (holding income).

A typical option income fund will earn option premium through writing options on securities where the holding income is attractive enough to retain the security as a dead asset. The underlying view of the fund is that holding income plus option premium more than covers for the opportunity loss.

Since mutual funds in India are not permitted to write options, there are no option income funds in India yet.

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