Equity mutual funds invest in stocks of companies listed on the stock exchange. They invest across market capitalizations using multiple strategies to earn a high return. Equity funds have to invest at least 65% of their assets in equity to qualify as equity mutual funds. Hence they earn a higher return than debt or hybrid funds. The risk in these funds is higher than any other asset class as well as their performance is dependent on the market conditions. Equity mutual funds best suit investors who have medium to high-risk appetite and have an investment horizon of at least five years.
How do Equity Funds Work?
Equity mutual funds should invest at least 65% of their assets in equity. The rest can be invested in debt or held in cash to meet redemption requests. Equity mutual funds are actively and passively managed. Passively managed funds mimic the benchmark index and hence need no asset allocation strategies to decide the portfolio. Whereas, actively managed funds follow multiple approaches to earn high returns. Based on the objective and strategy, the assets can be invested in large cap, mid cap, small cap, large and mid cap, or the fund can follow a multi cap strategy. The investment style can be concentrated (focused) or value or growth-oriented.
The fund manager uses multiple strategies like the top-down approach and the bottom-up approach to analyze the stocks for the fund‘s portfolio. Using these strategies, the fund manager aims to maximize the returns of the fund. Given that the fund‘s performance is market-linked, the risk is equity finds is high. The fund‘s risk is usually managed by allocating a small portion of assets to debt.
Market Capitalisation refers to the total rupee value of a company’s outstanding shares of stock.
Large Cap Equity Funds: Minimum 80% of total assets invested in large cap companies. Large cap companies are
Mid Cap Funds: Minimum 65% of total assets invested in mid cap companies.
Large and Mid Cap Funds: Minimum of 35% of total assets invested in large cap stocks and a minimum of 35% of total assets invested in mid cap stocks.
Small Cap Funds: A minimum of 65% of total assets is invested in mid cap companies.
Multi Cap Funds: A minimum of 65% of total assets is invested in large, mid, and small cap stocks.
Based on Sector
Thematic Funds: Minimum 80% of total assets invested in equity and equity-related instruments of a sector or theme.
Focused Funds: A minimum of 65% of total assets invested in equity and equity-related instruments. They focus on the number of stocks they invest in (maximum 30).
Contra Equity Funds: Follow a contrarian investment strategy by investing a minimum of 65% of total assets in equity and equity-related instruments. These funds pick under performing stocks and sectors at their low points, with a view that they will perform well in the long run.
Based on Investment Style
Dividend Yield Funds: Minimum 65% of total assets invested in equity and equity-related instruments. Predominantly investing in dividend-yielding stocks.
Value Funds: Funds follow a value investment strategy. Invest a minimum of 65% of total assets in equity and equity-related instruments. The primary goal is to invest in stocks that are undervalued based on fundamental characteristics.
Growth Funds: Funds follow a growth strategy. Invest a minimum of 65% of total assets in equity and equity-related instruments. The primary goal of these stocks is capital appreciation.
Index Funds: Funds mimics a particular index. These are passively managed funds. These funds invest in companies in the same proportion as that of the index composition.
Based on Tax Benefit
ELSS Funds: Minimum 80% of total assets invested in equity and equity-related instruments. These funds have a statutory lock-in period of three years and eligible for tax benefit under Section 80C.
Based on Geography
Domestic Funds: All the above funds investing in Indian equity and equity-related instruments.
International Funds: Also known as foreign funds, primarily investing equity and debt securities in the overseas markets. These funds are taxed like debt funds.
Who Should Invest in Equity Funds?
All fingers are not the same. Similarly, not all investors are the same. Not all mutual funds suit all investors, and each investor is unique. They have their investment objectives and have different requirements. Hence the mutual funds that best suit each of them shall be different. For investors looking to invest for long term (5 plus years), equity mutual funds best suit them. Long term horizon gives funds enough time to combat market fluctuations.
For an investor looking to invest in tax saving, ELSS is the best option available. For new investors just stepping into the market, large cap funds are a better call as they invest in the top 100 companies and hence are less prone to market fluctuations. For investors with very long term goals like retirement, diversified equity funds are a good call. These funds invest across market capitalizations as they have a higher return and low risk. For investors with high-risk appetite, small and mid caps help in earning high returns.
Hence, depending on the investor’s objective, horizon, and understanding of risk, the fund choices vary. But one thing stays common for all equity investors, and that is the investment horizon. All equity investors need to have a minimum of 5 years as their investment tenure. This is because equity funds are affected by market fluctuations, and they need enough time to combat these and grow. For shorter tenures, there are always debt funds that investors can turn to.
Things to be considered before investing
Before investing in equity mutual funds, investors have to ensure that they have examined the following.
Financial goals: Investors have to define their goals and segregate them in terms of time taken to achieve the goal. Equity mutual funds give their best results in the long term (5 plus years).
Fund’s performance: Measuring the fund’s performance against the benchmark and peers is crucial. This helps understand how the fund is performing in the market. A fund’s performance can be measured by seeing the consistency of its performance over time. A consistently good performing fund is better to choose.
Risks: Equity mutual funds are affected by market fluctuations. Hence they are risker than debt and hybrid funds. Investors with medium to high-risk appetite can choose equity funds.
Lock-in period: ELSS is the only category of equity funds that has a lock-in period of 3 years. But equity funds, in general, require long investment horizons. Hence investors looking for shorter investment periods shouldn’t invest in equity.
Costs involved: Expense ratio and exit load are the costs involved in investing in equity funds. Investors should compare the costs of multiple funds before choosing the ones to invest.
Fund manager and fund house: A well-experienced fund manager from a reliable and well-established fund house are just cherry on top for investors. Investors have to choose a fund that’s managed by an experienced manager from a good fund house.
Advantages of Investing in Equity Funds
High Returns: Equity mutual funds earn potentially higher returns compared to debt mutual funds. Equity funds also carry higher risk. Over the long term, equity mutual funds have good capital appreciation chances. With the prices of the stocks rising, the mutual fund returns are higher.
Professional Management: Professionals manage mutual funds, making it easy for investors without any stock knowledge to invest in equities. The manager analyzes various factors and makes the stock-picking decisions to meet the investment goal of the scheme.
Portfolio Diversification: Mutual funds are a collection of stocks. Diversification across market capitalizations and sectors reduces the magnitude of risk. A diversified portfolio will help in spreading the risk.
Systematic Investments: Equity mutual funds are suitable for all kinds of investors. Be it a first-timer, or an investor veteran, equity mutual funds are for all. Investors seeking to invest small amounts regularly can also invest in equity mutual funds through Systematic Investment Plans (SIPs).
Convenience: Investing in equities can be done either through SIP or Lumpsum. This gives the investor the comfort to choose an option that best suits their investment need.
Liquidity: Redemption of equity mutual funds is also very easy. Most of the equity mutual funds have an exit load of 1% for withdrawing before 12 months of investment. However, the investor is free to redeem the units, and the amount gets credited to the bank account within a week.
Taxation of Equity Funds
Equity mutual funds are taxed based on the holding period of the investment. If the investment is sold before one year (in the short term), a short term capital gains tax of 15% (plus 4% cess) applies to the gains. If the investment is sold any time after one year, a long termcapital gains tax of 10% (plus 4% cess) is applicable on gains above Rs 1 lakh. Effective from 1st April 2020, dividends are taxed in the hands of investors at the income tax slab rate. And dividends above INR 5,000 are subject to TDS of 10%. Equity mutual funds are subject to securities transaction tax of 0.001% if investors sell the units. Investors should take advantage of investing for longer horizons and earn higher returns and enjoy tax benefits.