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What Are Equity Funds: Types, Benefits, Taxation, Who Should Invest

If you are aiming for long-term wealth creation or want to build a diversified portfolio, equity funds can be a great option. Read this post to know what they are, how they work, and who should invest in them.

Getting Started with Equity Market

The equity market or stock market is known to be one of the most rewarding asset classes. But the high returns potential of the equity market comes at a cost. It comes with the highest level of risk as compared to most other asset classes.

An Introduction of Equity Mutual Funds

One needs to have a lot of knowledge and experience to navigate through the highly volatile equity market and generate significant returns. This is what keeps a lot of investors away from the equity market.

This is where an equity fund comes into the picture. If you do not want to directly invest in the equity market or believe that you don’t have the necessary knowledge or experience, you have the option to invest with equity funds indirectly.

Take a look at what these funds are, how they work, and who should invest in them-

What are Equity Mutual Funds?

Equity funds are a type of mutual fund that invests your money in the stock market. An equity scheme can have several different stocks in its portfolio. The fund enables the investors to indirectly invest in the equity market, eliminating the need for them to pick stocks and make the buying/selling decisions on their own.

To better meet the investment profile of different investors, there are now many different types of equity schemes. The scheme can be categorized based on market capitalization, investment objective, sector, and theme. But as equity is generally for long-term capital growth, only investors with an investment horizon of 3-5 years or more should consider them.

How Do Equity Mutual Funds Work?

Equity mutual funds invest your money in stocks of various companies that the fund manager believes are in line with the investment objective of the scheme. Technically, any mutual fund scheme with more than 65% of its portfolio invested in equity is considered an equity fund.

For instance, Equity Linked Savings Scheme (ELSS) funds that are eligible for tax deduction under Section 80C of the IT Act invest more than 65% of their portfolio in equity and related instruments. Due to this, they are considered as equity-oriented diversified funds. The fund manager is free to invest the remaining portion of the scheme portfolio in equity, debt, or other asset classes.

What are the Different Types of Equity Mutual Funds?

Here is a list of some of the most popular types of equity schemes-

  • Market Capitalization-Based Equity Schemes

    These equity schemes invest your money in stocks based on the market capitalization of the company. For instance, a large-cap scheme will invest your funds in companies that are large and well-established.

    Just like large-cap, there are mid-cap, small-cap, and micro-cap equity schemes. There are also multi-cap schemes that invest in companies with various market capitalizations.

  • Sectoral/Thematic Equity Schemess

    As the name suggests, these schemes invest your money in companies belonging to a particular sector or theme. For instance, some popular sectoral equity schemes invest across industries such as pharma, IT, FMCG, etc.

    Thematic funds invest based on a particular subject, like international stocks or emerging FMCG companies.

  • Equity Linked Savings Scheme (ELSS) Scheme

    ELSS deserves a special mention as it is the only type of equity fund eligible for tax deductions of up to Rs. 1.5 lakh in a year under Section 80C of the IT Act. These are equity-oriented diversified funds with at least 65% portfolio investment in equity.

  • Index Funds

    The equity schemes listed above have an active management style where the fund manager always looks for stocks with great potential. But some funds mimic the composition of indexes such as Sensex and Nifty 50.

    These are passively managed funds where the portfolio is similar, in terms of stocks and proportions, to the index it follows.

Taxation of Equity Mutual Funds

Taxes play a significant role while selecting an investment option. All the different types of equity schemes, including ELSS, have the same tax structure. An investor needs to pay LTCG (Long-Term Capital Gains) tax for redeeming equity funds after 12 months from the date of investment.

Currently, the LTCG rate is 10% (+cess and surcharge) if the capital gains are above Rs. 1 lakh in a year. Capital gains under Rs. 1 lakh a year are tax-free. Unfortunately, equity funds do not come with the indexation benefit. Also, note that ELSS funds have a lock-in period of 3-years. You’ll have to remain invested in them for at least 3-years to claim the tax deduction under Section 80C.

Equity fund investments held for less than 12 months are liable to pay STCG (Short-Term Capital Gains) tax at the rate of 15% (+cess and surcharge).

Benefits of Investing in Equity Mutual Funds

Now that you’ve got a brief understanding of equity funds meaning, here are some of the top reasons why one should consider them-

  • Long-Term Capital Growth-

    In the long run, equity as an asset class has the potential to deliver the highest returns.

  • Professional Fund Management-

    Investors get this long-term capital growth benefit without the need to invest in the stock market directly. There is a professional management team to make decisions on their behalf.

  • Diversification-

    With your investment spread across several companies as per the objective of the scheme; equity funds also help you diversify your investment.

  • Small Ticket Size-

    Even a SIP of Rs. 1,000/month enables you to invest in stocks of multiple companies. Direct investment in various companies would need a considerable lump sum investment.

Who Should Invest in Equity Mutual Funds?

Now to the last question, who should consider investing in equity funds?

As discussed above, equity schemes are for long-term growth. So, they should only be preferred by investors with at least 3-5 years of the investment horizon. Also, equity carries a higher level of risk. Thus, investors looking for steady returns or who are not comfortable with risk should avoid them.

However, even risk-averse investors with a diversified mutual fund portfolio generally do have limited exposure to equity schemes. In most cases, they consider schemes like large-cap equity as they are known to be less risky as compared to mid-cap, small-cap, and thematic/sectoral funds.

Even investors wanting to save income tax can consider ELSS funds. It has the lowest lock-in period as compared to other Section 80C eligible investments and comes with higher return potential. But note that you will have to remain invested in them for at least three years to take advantage of the available tax deduction.

Equity Mutual Funds for Long-Term Wealth Creation

Every individual has several long-term financial goals. It can be retirement planning or purchasing a house for some, while others might want to build a corpus for their child’s education or marriage.

Now that you know what equity fund is, it shouldn’t be difficult for you to understand how these schemes can help you in the process. But as these schemes also come with a considerable level of risk, it is best to invest if you are fully aware of what they are and how they work. You can also consider professional help for selecting the right equity scheme as per your investment profile.