Complete Guide to Investing in Equity Mutual Funds
Get started with Equity Mutual Funds
Have you ever wondered as to what exactly is a mutual fund? You can understand a mutual fund as a pool of resources managed by an expert fund manager so as to diversify your risk and help you earn consistent returns over time. That looks confusing right? Things will be a lot simpler as we go along.
What are the advantages of mutual Funds?
Mutual fund investing proffers the following advantages to an investor.
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Mutual funds help to diversify risk as the funds are spread across a larger number of stocks or debt paper. This reduces the risk because even if some of the stock are not doing well, other stocks would be performing well, so overall returns will be good.
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Mutual funds are managed by an expert fund manager. Normally, the fund manager is a professional money manager and supported by a team of dealers, analysts, sell-side research etc. This ensures that the benefits of all this rigor comes to the investor.
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Mutual funds offer a wide choice of asset classes. You have mutual funds that invest in equities, debt, combination of debt & equity, gold, liquid assets etc. This not only reduces your risk but also gives you a choice as per your needs.
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Mutual Funds also offer choice within an asset class. For example, under equity funds you can choose from large cap funds, mid cap funds, small cap funds, sector funds etc. In debt funds, you can choose from G-Sec funds, corporate bonds funds, liquid funds etc.
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Mutual Funds are the best fits to your long term financial plan. You can design systematic investment plans for each unique need and peg mutual fund SIPs to them. These are a ticket to your long term dreams and goals.
So, you understood why mutual funds can make a difference to your long term goals as well as to your risk and returns. However, let us now go a step back and understand what each of these fund categories really are?
What are equity funds and how do they help?
Equity mutual funds are a class of mutual funds that invest majorly into equity and equity-oriented instruments. Equity funds are required to invest at least 65% of its portfolio in equity instruments. There are further rules for large cap funds, mid cap funds etc but we will not get into all that now. So, the investor does not have to worry about choosing the stock, choosing the timing in the market etc. The fund manager does all that for them.
Let us understand how the equity fund operation is structured. Each equity fund has a fund manager, although there is normally one fund manager handling 2-3 funds. Most mutual funds have a support team, although they rely on sell side research analysts for giving them the insights into the stock market. Fund managers are continuously looking for investment opportunities that can help them generate higher returns.
Small confusion; Is Equity Fund and Equity Hybrid Fund are the same?
There are two aspects you need to understand. First is the taxation aspect. From the tax perspective any fund with more than 65% exposure to equities is classified as an equity fund and the tax rates are applied accordingly. It is 15% for short term gains and 10% for long term gains in the case of equity funds. That is one side of the story.
The other side is the actual construction of an equity fund and an equity hybrid fund. The equity fund typically invests over 90% in equities and especially in the stocks that meet the fund criteria (large cap, small cap, mid cap etc). An equity hybrid fund invests about 65-70% in equities and the rest in debt. Due to the debt component, the equity hybrid fund has lower risk than an equity fund but also gives lower returns. Equity hybrid funds are also popularly called aggressive hybrid funds.
Can you tell me about Large Cap,Mid Cap and Small Cap Funds?
In the past, the large cap, mid cap and small cap stocks were divided based on the market cap cut off. However, that became a difficult affair as it entailed constant changes in the rankings. It was just too dynamic. Post 2018, SEBI changed the definition of capitalization based on the rankings. This is how large cap, mid cap and small cap are defined.
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Large cap mutual funds invest in the Top 100 companies with the largest market capitalization. They normally give slightly lower returns than mid cap funds but these are stable companies with long pedigrees so the overall risk is much lower.
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Mid-Cap Mutual Fund would typically invest in 101st to 250th exchange-listed companies based on market capitalization. In comparison to large caps, they are higher on the risk scale, but they also offer higher returns as is the case in India quite often.
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Small-Cap Mutual Fund typically invests in companies below the 250th spot based on market capitalization. They have the potential to generate the highest returns and multi-baggers but also come with risks as there is not much research on small caps.
How do you Distinguish between Diversified Fund,Elss Funds and Index Funds?
These 3 categories may have a lot of common stocks and that is perfectly logical. However, there is different investment logic to each of them, although all are equity funds. Let us look at how these 3 categories of fund differ.
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Diversified Equity Funds typically invest your funds in companies across market capitalisations and are a combination of large-cap, mid-cap, and small-cap companies.
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Equity-Linked Savings Scheme (ELSS) funds are equity funds that come with a 3 year lock-in and give you benefit of tax exemption under Section 80C of the Income Tax Act. An ELSS fund has to be an equity fund only after 3 years it is like any normal fund.
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Index Funds are passive funds in that they just try to mimic an underlying benchmark, index like the Sensex or Nifty. Their portfolio composition is similar to the index they follow. They only focus on reducing tracking error and the costs are much lower.
Are Sector Fund and Thematic Fund one and the same?
They often tend to overlap, but they are not one and the same. Thematic funds are much broader in definition compared to sector funds. Here is the difference.
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Thematic funds follow a theme that can be a set of industries. Some of the popular themes are Commodities, Alternative Energy, Digital etc. A commodity fund can have stocks from the oil sector, steel sector and even copper and aluminium stocks.
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Sectoral Funds on the other hand, are narrower than thematic funds and just refer to a specific sector of industry group. Typical examples of sector funds are Pharma funds, FMCG Funds, Banking Funds, IT funds etc.
Both sectoral funds and thematic funds are concentrated in a particular story and hence returns can be volatile. You must keep that in mind.
Can you tell me the difference between Regular option and Direct Option in Mutual Fund?
Regular Option is when you invest through a broker, on whom you rely for advise on which funds to buy. On the other hand, if you are confident of doing the investment in funds on your own, you can opt for the Direct Plan. In a direct plan, you can directly buy the funds from the AMC, either online or offline. The advantage here is that you don’t have to pay the marketing and distribution commissions.
That is a lot of saving as it typically saves about 120-150 bps in an equity fund. When you compound that over a period of 15 or 20 years that is a lot of money. Currently, in India, nearly 45% of the mutual fund investments come through the Direct route while the balance 55% come through the Regular route. You can even opt for a Direct Option and then pay an advisor separately to get help on how and where to invest in mutual funds.
How do I Know if Equity Muture Funds are suitable for me?
Equity investment is a long-term investment. So, when you invest in equity funds then keep a longer term perspective of over 5 years and ideally more than 8 years. That is when you get the best benefit of investing in equity funds. Equity funds are risky in the short term but over a longer period of over 8 years, the risks tend to get neutralized.
The second question is why are you investing in equity funds. People typically invest in equity funds to meet their long term financial goals like retirement, children’s education etc. Equity funds are the best bets in such cases. However, it would be best to adopt the systematic investment plan or SIP approach in such cases.