Mutual Funds as a financial product have been catching the investors’ fancy. Mutual Funds are professionally-led funds that pool the savings from many investors, which are then invested in securities like stocks, bonds, money market instruments, commodities, etc., known as a mutual fund. Some funds may invest in a single asset class, while others may have a combination of asset classes. Following are the sources of how an investor can earn while investing in a mutual fund –
– Divided : Fund houses distribute dividends or interest when they receive dividend or interest on underlying securities.
– Capital gain : When the fund manager sells a fund holding, they tend to book capital gain/capital loss depending on the type.
Types of Mutual Funds
There are five types of mutual funds category as determined by capital market regulator Securities and Exchange Board of India (SEBI):
This type of fund invests in equities and related securities. They offer the highest returns but come with the highest risk.
This type of mutual fund invests in debt instruments of different maturity, yield, and risk level.
This type of fund invests in a mix of stocks, bonds, and other securities.
These are schemes where a specific goal is aimed at. For example – Retirement, Children’s education, etc.
This includes all funds which are not covered above. For example, Exchange Traded Fund, funds of funds, etc.
Why should you choose mutual funds?
Following are the reasons why a mutual fund is a good investment instrument.
Professional Management of Money
Funds leverage the knowledge and expertise of professionals to earn good returns.
Investing in more than one name is essential to minimize your concentration risk. Also, mutual funds invest in more than one asset class, such as equities, debt, money market, and the likes that bear a different level of risk and return. Thus, the risk can be lowered at the portfolio level.
Buying and selling stocks involve formalities such as the need for a Demat account. It can also be done between specific periods. Thus, mutual funds make more sense because the asset management companies take legal requirements and formalities, and the funds can be bought and sold throughout the day.
Investing in equities directly does not help in saving tax. However, specific mutual fund schemes provide you with tax benefits up to Rs 1.5 Lakhs every fiscal year. These are known as Equity Linked Savings Schemes (ELSS).
Mutual funds operate subject to India’s Securities and Exchange Board (SEBI). SEBI has imposed certain restrictions that regulate the funds’ operations as retail participants are higher in the case of mutual funds, and safeguarding the interest of retail investors has remained a priority for the regulator.
Use of futures and options in a mutual fund
In addition to traditional assets such as equity and debt, a mutual fund utilizes derivatives contracts such as options and futures. The funds that specialize in investing in derivative instruments fall under the ‘speciality fund’ category. These funds could be excellent for investors looking to diversify portfolios with options and futures for various stocks and commodities. However, due to the involvement of derivatives, the funds’ risk increases significantly.
Guidelines around the use of futures and options
Mutual funds are allowed to use derivatives to the extent of hedging (hedging is a strategy to protect against losses) of their cash position.
Hence, mutual funds may not be ideal for participating in F&O.
- If you are looking for hedging options, the arbitrage funds’ category will suit your needs.
- Another category of equity funds – equity savings/equity income scheme partly hedge equity positions and leave the rest unhedged and take some debt.
In both categories, upside returns will be capped as the hedging restricts full equity participation.
Regulatory guidelines around futures and options in a fund
SEBI permits funds to use derivatives for hedging purposes. However, the fund can hedge its equity investments using derivatives. Recently, SEBI has taken measures to allow funds to underwrite call option contracts under certain strict conditions. A call option is an agreement between two parties where the buyer is entitled to purchase the underlying asset in subsequent years at a predecided price. In contrast, the seller must sell. Till recently, mutual funds were allowed only to take positions in derivative contracts but can now write options contracts. However, this is allowed under the covered call strategy and restricted to Nifty50 and Sensex Index constituents. This means they cannot write options without being long on the underlying.
To conclude, mutual funds are a great way of diversifying one’s portfolio and offer professional management, tax savings, and several other advantages. SEBI regulates mutual funds for safeguarding retail investors and has recently seen regulatory clearance to utilize futures and options (derivatives) as a part of hedging the risk. The regulator has ensured that the derivatives are allowed for index constitutes where the fund has a long position. Some categories such as arbitrage are a great way to benefit futures and options.