By Muthukumar K
ET Intelligence Group

Mutual Funds are increasingly becoming the preferred choice of investment. Know all there is to them...

Contrary to popular belief, mutual fund investing is not akin to equity investing. In fact, equity is just one of the various asset classes mutual funds invest in. They also invest in debt instruments such as bonds, commercial paper and government securities based on fund mandates.

Each scheme is bound by the investment objectives outlined in its prospectus, which broadly determines the class of securities it can invest in. Based on the asset classes, broadly speaking, there are three types of mutual funds.

Equity funds: Equity funds invest in stocks of companies and as a fund class are higher on the risk scale since stock prices are more volatile. Most equity funds try to reduce the risk by diversifying investments across a basket of stocks available in the market. If invested properly, equity funds should give higher returns commensurate with the risk taken.

Remember the investment principle: Higher return comes from higher risk. Besides, there are speciality equity funds, such as index funds and sector funds, which invest only in specific categories of stocks.

Debt funds: Debt funds, in contrast, invest only in debt instruments like corporate bonds and government securities; an ideal option for investors averse to the risk associated with equities. Here too, there are specialised schemes, like liquid funds and gilt funds. While the former invests predominantly in money market instruments, gilt funds do so in risk-free central government bonds.

Balanced funds: Then for the fence-sitters there is the balanced fund, which is a hybrid fund that functions as both an equity and debt fund. It invests both in debt and equity-oriented securities and on the risk scale falls between an equity and debt fund. Balanced funds could be the best investment vehicle for investors who prefer spreading their risk across various debt and equity instruments.