Investing in Equity Mutual Funds - A Complete Guide
This episode opens with the basics of mutual funds, with focus on types of equity funds, their selection criteria, things-to-consider and taxation on returns.
All about Equity Mutual Funds
Equity mutual funds investments are one of the most popular investment options to build a huge corpus in the long-term. There are a number of reasons why you should consider investing in mutual funds. Firstly, mutual funds are managed by professional managers, and secondly they offer liquidity and diversify the investment risk. For instance, on an average, a large cap equity fund has given 15% CAGR return in the past 5 years.
However, despite the extensive campaigns from AMFI and funds houses, many newcomers still lack adequate knowledge about equity mutual funds. So let’s try to understand the basics of mutual fund investment.
What are Mutual Funds?
In a mutual fund, money from various investors is pooled together and invested in a portfolio of instruments. A mutual fund may invest only in equities or debt instruments or a mixture of the two, also called balanced funds.
Types of Funds
Fund can be broadly categorized as open-ended funds, close-ended funds and interval funds.
Open-ended funds:
It allows the mutual fund investor to enter/exit the mutual fund scheme at daily NAV, subject to exit load at the time of withdrawal. In other words, the scheme does not have a lock-in period which requires holding money in the scheme for a specified tenure.
Close-ended funds:
These funds are opposite to open-ended funds. It has a lock-in period and you have to compulsorily stay invested in the scheme for the specified tenure say for 3 years or 5 years. Additionally, unlike in open-ended funds, you cannot buy the units of a close-ended fund after its NFO period is over. This means that new investors as well as the current investor cannot enter/exit till the term of the scheme ends.
Interval Funds:
To get liquidity in close-ended funds, there is another category called ‘interval’ funds. Essentially, these are close-ended funds that become open to transactions during preset interval periods, for instance, first 5 days of every quarter.
Types of Equity Mutual Funds
Diversified Equity Funds
Mutual fund schemes that invest more than 65% of the AUM in equities and equity related instruments are treated as equity mutual fund scheme. Equity funds can be further classified as large cap equity funds, mid cap funds and small cap funds. Large cap funds invest in companies which are highly liquid, blue chip companies, possibly market leaders in their respective sectors. Mid-cap funds invest in emerging companies with market capitalization that is lower than large caps, while small/micro funds invest in small companies with market capitalization that is lower than mid caps.
Sector Funds
Sector mutual funds are a type of equity mutual funds which invest in a particular sector like Pharma, IT, Infra and, Banking and Financial.
Balanced Funds
If a balanced fund invests more than 65% of its AUM to equity and equity related instruments, and rest in fixed income securities, it is called ‘Equity-oriented Balanced Fund’.
Things to Consider Before Investing in Mutual Funds
Historical Returns
Once the category of fund has been identified, you should look for funds that have beaten the benchmark returns with higher consistency than other funds over a large period, say 5-10 years. Secondly, you should also consider Sharpe Ratio of the fund. The Sharpe Ratio gives the amount of return generated for each unit of risk. So, higher the Sharpe ratio, more attractive the risk-adjusted return.
| Scheme Name | 1 Year | 3 Year | 5 Years | 10 Years |
|---|---|---|---|---|
| Category Return - Large-cap Funds | 13.6 | 11.4 | 15.0 | 8.9 |
| Category Return - Mid-cap Funds | 16.0 | 17.6 | 23.2 | 12.8 |
| Category Return - Balanced Fund (Equity-oriented) | 11.2 | 10.8 | 14.7 | 10.0 |
| Category Return - Balanced Fund (Equity-oriented) | 10.6 | 5.5 | 10.8 | 6.1 |
1 year returns are absolute; returns above 1 year are CAGR.
Returns as on September 28, 2017
Evaluate Fund Managers
You should compare performance of all the funds managed by the Fund Manager with their respective benchmarks and peers across market cycles. If the funds have given higher return than the benchmarks and peers, then the Fund Manager is worth relying on.
Beta
Beta is a measure that is used to find out the sensitivity of equity funds to market movements. A beta of 1.25 means that fund’s return on an average is 1.25 times the benchmark returns. In bull market, this is a reason to cheer, while in falling markets, your fund will fall more than the benchmark.
Check the Expense Ratio
Expenses make a difference in net returns between two identical schemes. This is because expenses are knocked down from the market value of the investments. Let’s consider two funds, X and Y, with exactly same portfolios, but the first charges 1.50% expense while the second charges 1.0% expense. The second fund will generate an extra 0.50% return over the first one.
Taxation on Mutual Funds
Equity Funds
Profits earned on equity mutual fund investments for a period of less than one year are taxed at 15%. It is known as short-term capital gains tax. However, dividends and long-term gains from equity and balanced funds (that have 65% or more of their assets invested in equity) are tax free for the investor.
Taxation on Equity Mutual Funds for Individual/HUF (2016-17)
Capital Gains Taxation
| Equity Oriented Funds | Tenor | Individual/HUF |
|---|---|---|
| Long term capital gains | Units held for more than 12 months | NIL |
| Short term capital gains | Units held for 12 months or less | 15%* |
*excluding cess and other taxes
Taxation on Dividend (Payable by Investor/HUF)
| Scheme Type | Individual/HUF |
|---|---|
| Equity oriented schemes | NIL |
Dividend Distribution Tax (payable by the MF schemes)
| Scheme Type | Individual/HUF |
|---|---|
| Equity oriented schemes | NIL |
Speaker's Profile
Abhimanyu Sofat
Mr Abhimanyu Sofat is the Vice President of Research at IIFL. He was previously the Co-Founder at AdviseSure.com, a smart wealth management service platform. Mr Sofat has over a decade of experience in research, fund management, personal finance and has appeared/published in top media like CNBC TV18, ET NOW, Forbes, Bloomberg, Economic Times etc.
FAQs
What is an equity mutual fund?
Equity mutual funds are those mutual funds that primarily invest in equities and equity related instruments. That means equity mutual funds invest in stocks, preferred shares and equity/index derivatives. As per income tax definition, mutual funds which have invested more than 65% of their AUM in equities and equities related instruments are termed as equity mutual funds.
What are the different types Equity Mutual Funds?
There are many types of equity mutual funds. Equity mutual funds can be classified as Diversified Funds and Focused funds. Diversified funds invest across companies and sectors, while Focused funds invest in a particular sector.
Depending on the market capitalization, equity funds are categorized into large-cap funds, mid-cap funds, and small-cap funds. Large-cap funds invest in established companies, mid-cap in emerging companies, and small-cap funds target small companies.
Equity Linked Saving Scheme (ELSS) is also a type of equity mutual funds.
What are open-ended mutual funds and close-ended mutual funds?
Open-ended mutual funds are those funds in which investors can buy or sell mutual funds units to fund houses after New Fund Offerings (NFOs). On the other hand, investors cannot buy units after NFOs in close-ended mutual funds. However, investors can transact with other investors on exchanges. In addition, close-ended funds have maturity dates.
For example Aditya Birla SL Equity Fund is an open-ended equity fund.
What are active funds and passive funds?
In active funds, fund managers actively buy and sell securities in a pursuance to beat the market. Most of the funds like Aditya Birla SL Equity Fund, Axis Focused 25 Fund etc. are actively managed fund.
In passive funds, fund managers don’t actively manage their portfolios; they simply mirror indices like Nifty 50. Therefore, the passive funds that are mirroring the Nifty 50 would invest in all the stocks on Nifty 50 as per their weightage in the index. Aditya Birla SL Nifty ETF and CPSE ETF are some of the example of passive funds.
How to select an equity mutual fund?
An investor should analyse historical performance, fund manager history, investment theme, expense ratio, exit load, beta, and sharpe/sortino ratio of funds to select mutual funds. A thorough analysis of the holding of a mutual funds and its sector allocation can further give some more insight of funds. Generally, investors should select funds which have given consistent returns over long period of time.
What is an NAV and how is it calculated?
The Net Asset Value (NAV) of a mutual fund is the price at which its units are bought or sold. It is defined as the market value of the fund after deducting fund management fees and expenses. NAV of a mutual fund is calculated on daily basis.
What is expense ratio?
Expense ratio is the annual fee that fund house charges for managing investors’ funds. For equity mutual funds, expense ratio is generally between 2-3% p.a. The expense ratio is adjusted in the daily NAV. Thus, investors don’t have to pay expense fee separately.
How capital gains from equity mutual funds are taxed?
Capital gain/profits earned on equity mutual fund investments for a period less than 1 year are taxed at 15%. It is known as short-term capital gains tax. The long-term capital gains are tax free.
| Tenor | Individual/HUF | |
|---|---|---|
| Long term capital gains | Units held for more than 12 months | NIL |
| Short term capital gains | Units held for 12 months or less | 15%* |
*excluding cess and other taxes
What is Exit load?
Exit load is a fee that investors have to pay if they exit from a scheme before a pre-specified period. Mutual fund houses use exit load to discourage investors to exit from a scheme. Most equity mutual fund schemes do not have an exit load. But some funds change exit load if investors exit before 1 year.
Is there a lock-in period?
Open-ended equity mutual funds do not have a lock-in period except for ELSS. There is 3 years of lock-in period on ELSS investments. Close-ended equity mutual funds have lock-in period depending upon their tenor.
What are ELSS schemes?
Equity Linked Savings Schemes (ELSS) are diversified equity funds that have tax benefits up to Rs 1.50 lakh under Section 80C of Income Tax Act. ELSS have lock-in period of 3-year.
How should I invest a lump sum amount in mutual funds in all time high market?
You can either do your own research or invest, or you can simplify the process by investing through a distributor like India Infoline. Distributors help by going through the entire universe of available MF and identifying the right option for you based on your risk profile and investment horizon. Below are some of the current recommendations by the IIFL Research team.
| Sr. No. | Scheme Name | Category | Corpus (Rs cr) | 1 Y (%) | 3 Y (%) | 5 Y (%) |
|---|---|---|---|---|---|---|
| 1 | ICICI Pru Balanced Fund(G) | Balanced Funds | 18,097 | 16.0 | 13.4 | 19.1 |
| 2 | Reliance Top 200 Fund(G) | Large-Cap Equity Funds | 4,589 | 20.4 | 12.9 | 18.2 |
| 3 | Aditya Birla SL Equity Fund(G) | Multi-Cap Equity Funds | 6,916 | 23.3 | 17.8 | 23.2 |
| 4 | HDFC Mid-Cap Opportunities Fund(G) | Mid-Cap Equity Funds | 17,715 | 21.1 | 19.2 | 26.2 |
| 5 | Franklin India Prima Fund(G) | Mid-Cap Equity Funds | 5,984 | 20.1 | 18.8 | 27.3 |
Returns less than 1 year are absolute; Returns greater than 1 year are CAGR.
Corpus as on: August 2017; Returns are as on September 19, 2017
Source: ACE MF
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