Mutual funds combine fund management expertise, re- duction of volatility and lower costs to give returns to investors. While some investors use mutual funds for a regular source of income, there is a large number of investors who invest in mutual funds for creating wealth.
Here are some basics about which types of mutual funds could be used for building a large corpus over the long run:
As the name suggests, these are the funds which mainly invest in Debt instruments like government securities (gilts) and other bonds, treasury bills, certifi- cates of deposit (CDs), commer- cial papers (CPs), money market in- struments, debentures, etc. If you notice, at the time of investing it- self in each of these instru- ments, an investor usually has some idea about the type of return he/she may get either after a fixed interval (like each year/half-year/ quarter) or at the time of maturity. So naturally Debt schemes also give a return that one could reasonably guess while investing.
The instruments in which these funds invest usually do not show much volatility on a daily basis, as compared to stocks. As a re- sult, Debt funds also show less volatility compared to Equity funds and bring sta- bility to one’s portfolio.
In India, investments in Debt funds usually enjoy in- dexation benefits, which in other terms is the govern- ment’s way of compensating an investor from the loss that accrues to his/her in- vestments in Debt funds be- cause of inflation in the country. This is one of the advantages for Debt funds that helps investors build wealth through these schemes because, to build wealth, one needs to grow money over the long term and the same should beat the rate of inflation over that period of time, financial ad- visers say.
Within Debt funds, there are various types: Liquid Funds, long-, medium- and short-term bond funds, gilt funds, fixed maturity plans, etc. Of these, Liquid Funds are the ones in which you can keep your money if your investment horizon is from a few days to, say, about six months. These are usually used to park your money for the short term. These are not the funds that one can use to build long-term wealth. Compared to Liquid Funds, returns from other types of Debt funds are usu- ally higher.
Equity funds invest most of their corpus in stocks. These are more risky schemes than Debt funds and usually also show a higher level of volatil- ity. But financial planners and advisers always bank on Equity funds for long-term wealth creation. This is mainly because, going by historical data, stocks have always given returns that have beaten the rate of infla- tion in the long run. So when it comes to building wealth, Equity funds are the pre- ferred investment vehicles compared to Debt funds.
In India, all Equity funds also enjoy exemptions from long-term capital gains tax, which make these funds even more eligible to grow one’s wealth. Financial plan- ners and advisers say that if investors have the risk ap- petite and have time on their side, then they should al- ways opt for Equity funds over Debt funds for wealth creation.
Within Equity funds, there are various types of schemes: Diversified, large-, mid- and small- caps, Equity-linked sav- ings schemes (ELSS), sec- toral funds, etc. Of these, large-cap schemes usually show less volatility than mid- and small-cap funds as they are more risky than large-cap ones.
For wealth creation, go- ing by the risk-taking ability of each investor, financial planners and advisers sug- gest a portfolio of funds that is usually a mix of diversi- fied, large-, mid- and small- cap schemes.
An ELSS is often mixed with other types of schemes to give some extra tax advan- tage since these funds are approved by the government for tax rebates under certain conditions.
On the other hand, secto- ral funds — which invest in a particular sector like IT, FMCG, banking, etc — are never used for long-term wealth creation. This is be- cause a particular sector never shows a secular up- ward movement but dis- plays a more cyclical nature.
There are some other types of funds also, like monthly income schemes (MIS), which are mainly used for generating regular income. And then there are bal- anced funds. Although, ide- ally, these should have eq- uity and Debt in equal ratio, most balanced funds have at least 65% Equity to take ad- vantage of income tax rules. They are more vola- tile and risky than they should be, and are not the ideal vehicles for build- ing wealth.