Mutual funds are of different types, but can be broadly categorized into three–debt, equity and hybrid. Among these, the most popular category of mutual funds are equity mutual funds.
As the name suggests, equity mutual funds are those which invest in the stock market. These funds buy shares of companies in large quantities with to generate high returns by participating in the companies’s growth.
The primary objective of an equity mutual fund is to generate higher returns than fixed income investments like debt funds or fixed deposits. This makes equity funds ideal for fulfilling long-term goals as well as building wealth.
How do equity mutual funds work?
A mutual fund invests in the asset class that is mentioned in its investment mandate.
In the case of equity funds, the asset class is stocks of companies. Equity funds can also invest in bonds and papers, and can also keep a certain part of their corpus in cash, but the primary asset class remains stocks.
An equity fund is managed by a fund manager who has the experience, expertise and knowledge required to take buy or sell decisions on stocks. The fund manager is also backed by a research team, so as to be able to invest in the best stocks that have the highest probability of turning profitable.
It is the fund manager and his team who decide which stocks to invest in and which stocks to sell. You get this professional fund management service for a nominal annual fee, which the fund deducts from your invested money.
Types of equity mutual funds
Equity mutual funds is a broad category of funds, but there are several types of equity funds. Equity funds can be further categorised based on their investment mandate and the kind of stocks and sectors they invest in.
Diversified equity funds
These are equity funds that invest across sectors and market capitalisation. This means that these funds are not restricted to invest in only a particular type of stock.
They can invest in large-cap/mid-cap/small-cap companies in varied proportions. These funds are also diversified across sectors and industries; they are not confined to investments within any particular part of the economy.
Sector and thematic funds
Equity funds that focus their investments on a particular sector or theme fall under this category. Sector funds are those that invest in one particular industry, like FMCG or Pharma or Technology. Thematic funds are those that follow a particular theme, like emerging consumer companies or international stocks.
Since sector funds and thematic funds are concentrated in a particular sector. They tend to be riskier than diversified equity funds because their performance is entirely dependant performance of the particular sector of the economy.
However, sector and thematic funds can be diversified in terms of market capitalisation.
Large-cap, mid-cap, small-cap and multi-cap equity funds
Large-cap equity funds invest primarily in large-cap stocks. Different fund house categorises stocks differently, but large-cap stocks are stocks of the biggest listed companies of the economy. Typically, large-cap companies are well-established companies, which makes large-cap funds stable and reliable investments.
Mid-cap equity funds and small-cap equity funds are funds that invest in mid-sized and smaller companies respectively. There are even funds that invest in both mid-cap as well as small-cap funds. They are called mid- and small-cap funds.
Since smaller companies are prone to volatility, mid-cap and small-cap funds deliver fluctuating returns.
Equity funds that invest across market capitalisation, which is in large-cap, mid-cap and small-cap stocks, are called multi-cap funds.
Equity funds that follow a particular index are called index funds. These are passively-managed funds that invest in the same companies, in the exact same proportions, that make up the index the fund follows.
For example, a Sensex index fund will have investments in all 30 Sensex companies in the same proportion in which the companies form part of the index. Index funds are low-cost funds as they don’t require the active management of a fund manager.
Benefits of investing in equity funds
The benefits of investing in mutual funds are many:
- Expert money management
- Low cost
- Systematic investments
The major benefit of investing in equity funds is that you don’t need to worry about choosing stocks and sectors to invest in. Successful equity investing requires a lot of research and knowledge. You need to dig deep through the financials of a company before you invest in it.
You also need to have an understanding of how a particular sector is expected to perform in the future. Of course, all of this requires a lot of time and effort, which most common investors don’t have. Hence, the solution is to leave the stock picking to an expert fund manager by investing in an equity fund.
By investing in equity funds you can get exposure to a number of stocks by investing a nominal amount.
For example, if you have Rs 2,000 to invest, you will be able to buy one stock of a large-cap company or one stock of 2-3 mid-cap companies. However, your portfolio will face concentration risk. But with the same amount you can get exposure to a lot many stocks when you invest in equity funds. This allows you to diversify and benefit meaningfully.
Lastly, investing in equity mutual funds provides you taxation benefits. All returns earned on investments held for over one year i.e. long-term capital gains (LTCG), become completely tax-free in your hands.
However, owing to recent changes in budget 2018, LTCG in excess of Rs 1 lakh will be taxed at 10% without the benefit of indexation.
Short-term gains from equity funds, on investments held for less than one year, still continue to be taxed at 15%.
SIP – The best way to invest in equity funds
The most effective way of investing in equity funds is through a systematic investment plan (SIP). An SIP is usually a monthly investment that happens automatically on a pre-decided date. You give a mandate to the fund company to deduct the investment from your bank account.
SIPs give you the benefit of rupee-cost averaging. This means that when the markets are high, you will be allotted fewer units. And when the markets are low, you will get more units for the same amount. This way, you invest at different levels of the market.
SIPs make investing a regular habit. SIPs are automated investments that ensure you save the designated amount every month. This way you can invest before you spend, since the SIP date is in the beginning of the month for most investors.
Click here to start an SIP in equity mutual funds.