What are Equity Mutual Funds 2022?

In the Samco Investor Education Series, we will be looking at one of the well-known schemes talked about in the markets - Equity Mutual Funds. 

• What are Equity Mutual Funds?
• How do equity funds invest your money?
• What is risk appetite?
• What are the types of Equity Funds?
• How do the Equity Funds function?
• How does your investment in equity mutual funds work?
• What are the Pros and Cons of investing in Equity Funds?
• How is Taxation & Dividend treated for Equity Funds?

What are Equity Mutual Funds?

Equity mutual funds are funds in which the majority of the pooled money of fund is invested in equity markets. When investing in equity markets, the fund manager may follow an active or passive strategy depending on the investment objective of the scheme.

In an actively managed mutual fund, the pooled money is allocated based on the research conducted by the fund managers and its team on various parameters by conducting fundamental & technical analysis and monitoring of the company’s activities.

While in a passive fund, the corpus is allocated in a portfolio that closely mirrors a popular market index or a benchmark index, like the BSE Sensex or Nifty 50 at a low cost.

How do equity funds invest your money?

An equity mutual fund scheme must invest the total assets of the fund in equities & equity related instruments depending on the category of the scheme it comes under. SEBI in this regard has come out with regulations to provide clear distinction in terms of asset allocation, investment strategy, etc. And to ensure uniformity among similar categories.

The details of the scheme categories under each of the aforesaid groups along with their characteristics and uniform description are given below:

What is Risk Appetite?

The term risk appetite means your own risk-taking capabilities considering the whipsaws that are thrown by the constant deviating market sentiments.

If you're keen on increasing your portfolio in multifold, you need to consider equity funds for a period of no less than 5 years. Equity funds may or may not provide you with the desired wealth accumulation in a short time frame. In a short duration, the market may show negative signs to your portfolio. And if you exit your position from the market at this point, you're committing the same grave mistake that other beginners make. The mantra, '’If you desire good growth, you need good patience.'’, and as the most successful investor of the century, Warren Buffett has correctly said “The stock market is a device for transferring money from the impatient to the patient’’ is what you need to practice. This is applicable in all walks of life and now it's made its presence in the share market as well. Funny how that works!

And if you desire the less risky approach, you may go with the bonds or the debt instruments which aren't directly related to the fluctuating markets and hence give a relatively stable performance. But here's the kicker, these instruments tend to give fewer returns with your investment as compared to compounded returns from the equity over longer periods of time.

What are the types of Equity Funds?

You could select from the buffet of equity fund types that are served to you on a silver platter from the market. These could be an aggressive equity fund, which focuses purely on the equity portion, with 65-90% of the scheme saturated with the equity stocks. And if you wish to switch it up and introduce lighter segments into the scheme, you may go with the hybrid mutual funds. These carry about 40% to 60% weight of the equity stocks and the rest is supplemented by debt instruments.

Now, you've got your equity funds, these are sub-categorized further.

1. Funds based on sectors & themes
2. Funds based on market capitalization

Funds based on Sectors & Themes:

If your focus is to invest in a particular sector, like Pharma, FMCG (Fast-moving consumer goods) or IT, then select a sector-based equity fund. And if you wish to go forward with the thematic structure like emerging companies or international stocks, you have got a choice to choose the thematic schemes which invest in these types of segments.

Here's a caveat, these funds are far riskier than diversified equity funds because the status quo might change any time for a particular sector.

Funds based on Market Capitalization:

So if you're a budding investor, you may look into large-cap equity funds. These funds mostly involve investing in companies that have large market capitalization. These blue-chip large-cap companies are relatively less volatile and with constant growth rates over longer periods of time as compared to mid and small-cap companies. And if you're well-versed with the market twitches, the mid-cap equity funds and small-cap equity funds are the right way for you. These invest in mid-sized and smaller companies around the sectors.

And from years of observation, it's seen that the smaller companies with a smaller market capitalization are prone to volatility in the market. Thus the Mid-cap and Small-cap funds deliver fluctuating & unpredictable returns in the short term.

The equity funds that invest in large-cap, Mid-cap and Small-cap in varying amount are called Multi-cap funds. These funds have a relatively stable track record compared to small-cap or mid-cap funds.

Diversified Equity Funds:

DO NOT confuse Diversified Funds with hybrid funds. A diversified equity fund scatters your money around in companies across all sectors and industries like Pharmaceuticals, IT, Telecom, Real estate, Oil & Gas, Banking, FMCG etc, whereas Hybrid funds place your seed money into both equity & debt securities so as to minimize the risks involved. These Diversified funds too could be categorized as Large-cap Diversified fund, Mid-cap Diversified funds and Small-Cap Diversified fund based on the market capitalization of the companies.

Index Funds:

Apart from the above funds, there are Index Funds. The Equity funds whose portfolio works in line with a specific index are termed as Index funds.

These are passively-managed funds that invest in the same companies that make up the index and the fund growth is mirrored likewise.

For example, the 'Reliance Index Fund- Nifty Plan' scheme will have investments in all the 50 companies which comprises the Nifty index. These are composed in the same proportions as the companies which are given weight in the Nifty Index. These are low-cost funds as they don't require active management by the fund managers.

ELSS (Equity Linked Savings Scheme):

These are a little riskier than equity diversified funds as the companies associated with the portfolio are expected to perform over a longer time frame.  These funds invest across all sectors, thereby diversifying your risks and giving you the benefits of both capital gains and tax savings.

ELSS has a lock-in period of 3 years which is lowest among all the tax saving instruments available in the country. Thereafter you can either withdraw your money or leave it as it is where it will continue to earn returns. These funds invest at least 80% of their corpus in the equity segment. As a result, the returns can be highly volatile and hugely influenced by market swings.

Arbitrage funds:

Arbitrage funds are equity-oriented mutual funds that take advantage of the difference in the price of a stock and its derivative counterparty. Opportunities are made by buying stocks at a lower price in one market and unloading them at a higher price in another market.

These arbitrage funds are relatively safer funds. For the purpose of taxation, these can be treated as equity funds.

How do the Equity funds function?

All the above-mentioned funds, like large-cap equity funds, mid-cap equity funds, small-cap equity funds, diversified funds tend to be managed actively by the fund manager who modifies the portfolio to streamline with the market movements. It's the job of the Fund Manager to make decisions that align the fund's growth with its future financial goal. He decides which companies should be bought and which all should be thrown or reduced from the pool of portfolios. He decides this after examining the risks involved, its financials and the fundamental growth record for the past several years. So, in a way, you are investing in the fund manager's capabilities.

How does your investment work?

Whenever you go for purchasing a scheme, your eyes are bound to search for the NAV (Net Asset Value) of that scheme. It indicates the current value of each unit on that given day. To understand what NAV is, we shall consider a simple example.

An XYZ fund is introduced in the market and 1000 investors are ready to invest Rs.10,000 in it thus making a corpus of Rs. 1 crore. This amount of Rs. 1 crore is then utilized to pick up shares of companies in bulk amount. This XYZ fund is divided into units of certain values. Thus, the NAV is rounded off to Rs.10 at the very beginning, and you personally, as an investor in this scheme, hold 1000 units (your investment of Rs. 10,000 garners 1000 units).  All the 1000 investors involved in the scheme have 1,00,000 units.

Now, let's say that a year has gone by and the fund has done well, and the Rs. 1 crore invested grows to Rs. 1.5 crore. The NAV of each unit is Rs. 15 (Rs. 1.5 crores divided by 100,000 units). You own 1000 units, so the value of your own investment of Rs.10,000 has grown to Rs. 15,000 in a year. The total assets in the scheme have grown by 50 percent and therefore your investment has also made a gain of 50 percent.

Whenever you invest or redeem your money, you either buy fresh units or sell them at the NAV at that given time. Some funds allow you to enter and exit at any time while others allow entry only at the launching period and exit only after a predetermined period.

What are the Pros and Cons of investing in Equity Funds?

If you're ready to list the columns for the pros and cons associated with the Equity funds, let's get to it.

-The pros of investing in equity mutual funds are as follows:

1. Accrual of substantial wealth
2. Low Cost of investment
3. Investor's Convenience
4. Diversification benefit/limited exposure to a single company
5. A systematic influx of investment amount
6. Flexibility
7. Liquidity

Of course, the other side of the coin too needs to be reviewed before taking a step forward. Let's look at the cons of the Equity Mutual Funds.

-The cons of investing in equity funds are as follows:

1. Fees and high expense ratio as compared to debt mutual funds
2. Stocks in the portfolio cannot be adjusted by you, an expert fund manager takes the call on how the assets are to be allocated.
3. High risk involved in whipsaws

You need to thoroughly vet the schemes before latching on to one. If you're ready to accept the pros and cons involved with this type of funds, you may proceed with your investments.

How is Taxation & Dividend treated for Equity  Mutual Funds?

1. If the equity mutual funds have an exposure of 65 percent or higher in the equity of companies, it is treated as an equity scheme for the purpose of taxation.
2. If you redeem your equity mutual funds investments within a year, you're subject to an exit load of 1% on the market value of investments to be redeemed. Apart from it, if it is redeemed within a year, returns or gains are treated as short-term capital gains and taxed at 15%.
3. Gains on the equity mutual funds held for more than a year are treated as long-term capital gains. You would end up paying a 20% tax with indexation benefits on gains exceeding Rs. 1 lakh a year on equity investments.
4. Even the Arbitrage equity mutual funds, which invest in arbitraging structures of cash and derivative segments of the equity markets, are treated as equity mutual funds for the purpose of taxation.
5. Also, if you had invested in equity mutual funds before 31 January 2018, gains till that date will be considered as "grandfathered" and will be exempt from tax.
6. Dividends from equity mutual funds are tax-free in your hands. Alas, the dividends from equity mutual funds are paid up after deducting a dividend distribution tax (DDT) of 11.6% (including surcharge & cess), which reduces your returns.

That covers the vast subject of Equity Mutual Funds. For more useful articles on Equity Mutual Funds, trading, investing and market knowledge, visit our Investor Education section.

(Note: This content is for information purpose only. Avoid trading and investing based on the information given above. Before investing in stocks or equity mutual funds, please conduct proper due diligence)