Best Equity Mutual Funds
A mutual fund is an intermediary that collects funds from investors in small units and then invests them in assets that appreciate over time. An equity fund is a class of mutual fund that invests the corpus in listed equities in the stock markets. An equity fund is defined under the Income Tax Act as any fund that has a minimum exposure of 65% to equities. Therefore equity funds, index funds, sector funds, balanced funds (with 65% equity) and even arbitrage funds will be classified as equity funds for this purpose.
An equity fund offers investors the facility to participate in a diversified portfolio of equities with minimal risk and with the power of professional management. There is a rigorous process that goes into an equity fund investment. The fund manager checks the research ideas from the brokers and the sales traders. Then the fund runs its own due diligence with its in-house team. Finally, the fund managers also run their market intelligence checks to take a final view on the stock based on research inputs, market liquidity, news flows etc.
An equity fund offers three principal benefits to investors which include liquidity, diversification and professional management. The challenge in direct equities is that investors need to understand the stock and the plethora of factors that impact the stock. Above all, most investors have limited resources and hence they can only take exposure to few shares. This results in concentration risk. Mutual funds create a diversified portfolio and one can invest with as small a corpus as Rs.5,000 or even do a monthly SIP with just Rs.500. By buying units into a diversified equity fund portfolio, the equity fund investor automatically gets the benefit of professional management, liquidity and diversification.
Equity funds come in various categories and even the basis for classification of these funds differs. Firstly, equity funds can be classified into open ended funds and closed ended funds.
Open ended funds: These are available for purchase and redemption on all trading days at the previous day’s net asset value (NAV). The corpus of the open ended equity fund keeps constantly changing.
Closed ended funds: Unlike open ended funds, these funds are not available on tap. They come out with NFOs and then the fresh purchase and sales are halted. Such closed ended funds are listed on the stock exchange so there is liquidity in the form of secondary listing. But closed ended funds normally trade at a discount and that is your cost as an investor.
Equity funds can also be looked in terms of their portfolio mix. The definition of an equity fund is a fund that has minimum 65% exposure to equities. Here are some of the popular classifications of equity funds based on their portfolio.
- Diversified Equity funds create a diversified portfolio of normally large cap companies with established business models. Being diversified funds their intent is to reduce the risk and hence the portfolio is designed to minimize correlation between stocks.
- Mid Cap funds have a portfolio of mid cap stocks. These stocks have generated higher returns as they have the potential to become large caps over time.
- Small cap funds are those funds that consist of stocks with lower market capitalization. These are normally risky stocks and tend to be quite vulnerable to shifts in the business conditions and market risk.
- Multi cap funds are funds that are a mix of large cap, mid cap and small cap stocks. These funds give the stability of diversified equity funds and also the added advantage of alpha that small and mid cap stocks provide.
- Index Funds are funds that are benchmarked to an index like the Sensex or Nifty. The endeavour of these funds is to create a portfolio that mirrors the index and earns similar returns. Index funds focus more on replicating the index by reducing the tracking error.
- Sector Funds are equity funds that are focused on just one particular industry group. In India, banking funds, pharma funds, IT funds and FMCG funds are quite popular. Such funds tend to be very cyclical and go against the basic grain of diversification, which is what equity fund investing is all about. Investors need to be conscious of the higher risk that they run in sector funds.
- Thematic Funds are equity funds that are focused on one particular theme, which is a larger grouping compared to industry groups. In India, thematic funds include funds with a focus on commodities, on business cycles, on rate sensitive stocks etc. Such funds also tend to be cyclical and go against the basic grain of diversification, which is what equity fund investing is all about. Investors need to be conscious that any down cycle in the theme can lead to wealth depletion.
Any investor looking to create wealth in the long-term should invest in equity funds. Young investors who are embarking on their careers should use equity funds as a veritable means of creating wealth in the long run. Any investor who has a monthly surplus must look at taking a systematic approach to investing in mutual funds via SIPs. These SIPs not only give the benefit of rupee cost averaging but also sync with your income flows. Even middle aged investors with a 6-10 year perspective should look at equity funds as a serious asset class.
Should businesses also invest in equity funds? Normally, we see large businesses parking their treasury surpluses in debt funds or in liquid funds. Every business needs to create wealth in the long run. Investing in equity funds not only enhances wealth but also gives the business a diversification from their core business. This is more so for small and medium business where the cash flows are comfortable.
There are a variety of reasons for you to invest in equity funds. An equity fund normally represents a diversified portfolio wherein you can buy proportionate units.
- An important reason to buy equity funds is the growth potential. Equities have long been the ideal wealth creators over the longer run and equity funds give you that wealth creation ability.
- Equity funds also give the benefit of diversification. Even with a small investment, you get exposure to a diversified portfolio of equity assets and so you are not exposed to single stock or single sector cycles.
- You can get the benefit of rupee cost averaging via systematic investment plans. These SIPs are not only compatible with equity funds but also with the task of long term wealth creation. Rupee cost averaging ensures that the volatility actually works in your favour.
- It is a hassle-free form of investment for most investors. When you don’t have the time and the wherewithal to track stocks closely, then equity funds are the best option. Apart from diversification, you get the added benefit of professional management and the combined experience of the fund manager and the entire team.
- Equity funds are regulated by SEBI and the functioning is monitored by the Board of Trustees. This puts sufficient checks and balances and makes the product attractive and less risky for the investors.
- When you opt for the Growth Plan of an equity fund, the power of compounding works perfectly in your favour. What is the power of compounding? When you start early, you invest longer and therefore your principal earns for longer and the returns on your principal also earn for longer. This is called the compounding effect and has a multiplier effect on equity funds returns in the long run.
Investing in a mutual fund can be quite complex as there are nearly 40 AMCs, hundreds of fund schemes and thousands of unique offerings if you factor in the growth plans, dividend plans, direct plans, regular plans, reinvestment plans etc. Here is what you need to consider before investing in equity funds.
- How does the fund compare with other funds in the peer group over time? Short term underperformance is understandable. But if the fund is consistently underperforming, then you have a problem on hand.
- Focus on the consistency of performance than the average returns. A fund that earns (13%, 14%, and 15%) in the last 3 years is consistent. However, an equity fund that earns (6%, -3% and 44%) would have also earned the same CAGR returns as the first fund. The latter fund is too volatile and hence less predictable.
- Prefer equity funds where the CEO, CIO and the fund managers have been largely consistent over time. Consistency of team is a sign of consistency of investing philosophy. Too much of churn in the top team is not a good sign.
- Is the fund manager taking on too much risk? For example, would you prefer a fund with 15% return and 20% standard deviation or a fund with 18% returns with 60% standard deviation? Obviously, in the second case, the higher returns are not justified by the substantially higher volatility risk in the equity fund.
- Finally, does the equity fund fit into your financial plan? If it is skewing your equity mix or if it is skewing your sectoral mix then that equity funds should be avoided. This is the most important factor consider before investing in equity funds.
There are different ways to invest in mutual funds. Let us look at investing in mutual funds from the point of view of frequency of investing.
Frequency of investing in equity funds
- The most common method of investing is via SIPs. Hey give the added advantage of rupee cost averaging and also sync with your income flows.
- Lump sum investment is when you have a large corpus to invest and can work very well if you invest at the bottom of the market. In this case, the timing of your entry matters a lot to your returns.
- STP (Systematic transfer plan) is a mid way between the SIP and lump sum investing. In an STP, you invest the lump sum in a debt fund or liquid fund and then regularly sweep a fixed amount into equity funds. You get the benefits of SIP and better returns on idle funds.
There are different ways to judge the performance of an equity funds. Here are some common ways to judge the performance of equity funds.
- Funds can also be judged on a comparative basis by benchmarking with the index returns or the peer group returns. To get a better idea of relative performance it is better to use Total Returns Index (TRI) rather than the absolute returns.
- Equity funds are also judged based on consistency of returns. This is quite straight forward. An equity fund gives average CAGR returns of around 14-15% annualized. But what also matters is the variance from the median returns in all the years. Prefer funds with greater consistency in returns as they are more predictable.
- Ideally, equity funds should be judged based on their risk adjusted returns. Risk adjusted returns calculate returns per unit of risk and are very useful in gauging whether the fund manager is taking on unnecessary risk to generate higher returns. Measures like Sharpe Ratio and the Treynor ratio are very useful risk adjusted measures of returns.
- Rolling returns are one more method of gauging the equity fund performance. Rolling returns actually smoothen out the ups and downs of the NAV. It should not happen that the equity fund returns are very vulnerable to the point of entry and exit as those defeats the purpose. When rolling returns are consistently high it means that equity funds are generating positive returns irrespective of the point of entry.
It is hard to arrive at benchmark annual returns for equity funds, but we can have benchmarks for a longer time frame. Here is what you need to know.
- Over a longer period of 5-7 years, the fund should be able to generate CAGR returns of above 13-14% on a post tax basis. That takes care of the risk free returns and also the additional risk that you are taking.
- Ideally, returns have to be benchmarked to an index or to the sectoral index or the peer group. This is important. If you benchmark a mid cap fund with the Nifty then the fund may appear to be outperforming. Mid cap index will be a better bet in this case.
- Returns should be never seen in isolation but in comparison to the peer group. If all the equity funds are generating -3% returns in the last year and if Fund X has generated 2% returns then it is a commendable performance as it is outperforming the peer group by almost 500 basis points. This may be lower than the bank savings rate but that does not matter.
- Ideally, don’t look at mutual fund returns over time frames like a week, fortnight, month or even a year. Five years and above is the ideally time frame for assessing equity fund returns. But as mentioned earlier, post tax returns of about 13-14% should be a good return if you are consistently able to earn it on your equity fund.
An asset management is the company that sponsors the fund. For example, HDFC AMC is the asset management company for all the HDFC funds. The asset management company or the AMC manages the day to day operations of the fund, takes all fund management decisions, manages the buying and selling of units through the registrars like Karvy and CAMS and also reports to the Board of trustees and SEBI. Board of trustees is called the conscience keeper of the AMC and it tries to protect the interests of the individual investors. An AMC collects a fee from the fund for these services and is charged as a percentage of the corpus. This cost is called the total expense ratio (TER) and is apportioned to the fund in a daily basis and the NAV is reduced accordingly.
No, returns from mutual funds are not guaranteed. Investors need to remember two things here. Firstly, SEBI regulations do not allow the AMC or the brokers to assure any returns from a mutual fund. It has to be clearly specified to the investors that mutual funds are subject to market risks. Secondly, equity markets being volatile, it is not practically possible to assure returns of any kind. The best that investors can do is to rely on the past performance of the fund and use that as a benchmark. Having said that; it needs to be remembered that such returns are only indicative and cannot be construed as a guarantee of returns of any kind.