When it comes to Mutual Funds there are different schemes or funds available for an investor to choose between. One can choose a particular type of fund based on his investing needs and risk profile. The schemes can be classified as :Growth Funds : They promise pure capital appreciation with equity shares. They buy shares in companies with high potential for growth (some of which might not pay dividends). The Net Asset Value - NAV of such a fund will tend to be erratic, since these so-called growth shares experience high price volatility. They also make quick profits by investing in small cap shares and by investing in initial public. However, growth strategies may differ from one fund to another. Not all growth funds operate similarly.
Income Funds : They aim to provide safety of principal and regular (monthly, quarterly or semi annually) income by investing in bonds, corporate debentures and other fixed income instruments. The Asset Management Company(AMC) in this case will also be guided by ratings given to the issuer of debt by credit rating agencies. Wherever a debt instrument is not rated, specific approval of the board of the AMC is required. Since most of corporate debt is illiquid, the fund tries to provide liquidity by investing in debt of varying maturity.
Money Market Fund : Also known as Liquid Plans, these funds are a play on volatility in interest rates. Most of their investment is in fixed-income instruments with maturity period of less than a year. Since they accept money even for a few days, they are best used to park short-term money, which otherwise earns a lower return in a savings bank account.
Gilt Fund : They generate returns commensurate with zero credit risk, by investing securities created and issued by the central and/or the state government securities and/or other instruments permitted by the Reserve Bank of India. Since they ensure zero risk, instant liquidity, tax-free income, their return is lower than an income fund.
Balanced Fund : The idea is to get the best of both worlds: equity shares and debt. Investing in equities is supposed to bring home capital appreciation, while that in fixed income is to impart stability and assure income for distribution. The proportion of the two asset classes depends on the fund managers' preference for risk against return. But because investments are highly diversified, investors reduce market risk. Normally about 50 to 65 per cent of a balanced fund’s funds are invested in equity shares.
Sector Fund : The goal is once again pure capital appreciation, but the strategy is to buy into shares of only one industry. And not diversify like a growth fund. Such funds forgo the principle of asset allocation for high returns. That's why they are also the riskiest.
Tax Plan : Also known as Equity Linked Saving Schemes, they operate like any other growth fund (and that's why are as risky). However, an investor in these schemes gets an income-tax rebate of 20 per cent (for a maximum of Rs. 1 lakh) under section 80C.
Essentially, it is an incentive for the investor (who is otherwise investing in fixed-income instruments like the Public Provident Fund, National Savings Scheme, life insurance policies etc under the same section can also include tax saving mutual funds under the Income Tax laws) to participate in capital appreciation that can be delivered by investing in equity shares. That's also why these schemes also come with a three-year lock-in period. Also while other tax planning schemes guarantee returns, an ELSS offers no such assurance.
Index Fund : Their goal is to match the performance of the markets. They do not involve stock picking by so called professional fund managers. An index fund essentially buys into the stock market in a way determined by some market index (BSE Sensex or S&P CNX Nifty) and does almost no further trading. Index funds are optimally diversified portfolios and only carry along with it the due to economy-wide factors.
But remember that the term 'growth' is often used in a very generic sense to denote every equity mutual fund. Also 'growth' in fixed income funds, comes from reinvesting dividends. That's why in such fixed income funds, investors have an option: they can choose either growth through reinvestment of dividends, or regular income by ticking on the income option. If you understand the types of funds, you should have a decent grasp on how funds invest their (our!) money.