What are Equity Mutual Funds and their benefits? Should you invest?

Equity investment is lucrative. But not everyone has the intellect, time, and risk appetite for that! So, does that mean you can’t? Well, you can. Let us explain.

You see, investing in equity demands a lot of research, time, and technical knowledge as well. But even after you throw all of this to the game, you can’t be sure of the safety of your capital, let alone obtaining returns. Besides, there are issues of liquidity as well. So, what’s the solution, you ask?

The secret to equity-like returns without actually investing in it is - Equity Mutual Fund. So, let’s dive deep into this exciting concept.

Equity Mutual Funds - Meaning

Equity Mutual Funds are those funds that invest a significant part of the pool of money into equity securities of companies. These help as an alternative to individuals willing to get returns somewhat like equity without taking much risk. It’s a good option for investors looking to park their funds for more extended periods.

Precisely, if 60% or more of a mutual fund comprises equity securities, it is referred to as an equity mutual fund. The balance is invested in other debt securities like debentures and bonds or money market instruments like commercial papers, certificates of deposit, etc. This diversification protects the fund from the high volatility that equity is exposed to. The fund manager uses various tools and techniques to analyze the stocks before choosing the best stock for its investors.

Types of Equity Mutual Funds

Here's some of the broad categorization of equity mutual funds:

1. Market capitalization based categorization

In this type, securities are chosen based on their market capitalization, whether the company is a large-cap, medium-cap, small-cap, or multi-cap company.

This is one of the primary factors one considers before entering the equity market. Each of these is feasible to different kinds of investors. For example, a risk-averse investor would usually choose large-cap companies. Contrarily, an investor with a high-risk appetite looking for higher returns would prefer small-cap companies. Based on the preference of the investor, the proportion of these securities are allocated.

2. Investment strategy based categorization

Under this, some funds concentrate the investments in specific sectors, like pharmaceutical, IT, etc., which are known as Sector funds.

For some funds, themes like international stocks only become the basis. They are known as Thematic funds.

There is another type of fund known as Contra equity fund, which constitutes underperforming stocks. These are chosen as they are usually cheaper and always have the potential to grow in the long term. 

3. Tax treatment based categorization

Tax treatment is another factor that is crucial while selecting stocks. There is one category of equity funds which includes tax-savers like ELSS funds. These are preferred by investors who want to save their taxes, although these don’t generate as much return.

4. Investment style based categorization

This type is further classified into active and passive funds. Active funds are those curated by the fund manager and actively managed by him. On the other hand, if an investor is looking for a low-cost mutual fund, Passive funds are a good option wherein the manager does not have an active role to play. Passive funds usually follow an index (like the Sensex) to choose securities and invest in.

Benefits of Equity Mutual Funds

There are several benefits that equity mutual funds offer. 

1. Expert management

Trading, in general, is tricky. It needs a lot of market research, knowledge, and time to be spent. The equity segment is especially quite tricky as the options available are significant, and also the equity market is very volatile. This is why equity in the form of mutual funds is an excellent option to consider. There are fund managers who are experts in the field who will monitor your stocks and make rational decisions.

2. Diversification

Mutual funds are the best way for one to diversify their investments. Especially when starting small, one might not prefer to expose their funds to high-risk securities. Equity mutual funds help one to strike a good balance.

3. Capital appreciation

One of the significant advantages of equity is that they provide capital appreciation. Options like debentures and government bonds only give regular returns; there is no scope for capital growth. Equity mutual funds are a good option if one is looking for capital growth.

4. Reduced risk

SEBI supervises the asset management companies (AMCs). Some various norms and regulations are imposed either by SEBI or by the AMC itself to combat various kinds of risks that the funds are exposed to. These norms might not be feasible for an individual investor to follow. 

5. Liquidity

Except for a few funds like ELSS, which have a lock-in period of 3 years, most other equity funds are liquid, meaning that the investor can withdraw his funds anytime. 

6. Beginner-friendly

For an amateur investor looking into investing in the equity market, an equity mutual fund is a good start. Investing can be done for as small as Rs. 500 through Systematic Investment Plans (SIPs). This will give an idea if equity securities are feasible for achieving their financial goals.

7. Lower cost

If an investor intends to invest in the equity market directly, regular trade leads to high brokerage and other operational costs. This can be reduced by investing in equity mutual funds wherein SEBI fixes the ceiling limit for the expense ratio.

If you consider all of the above benefits, you’ll realize why Equity Mutual Funds have the lion’s share in the mutual fund market. For instance:

(Source: Trading Q&A)

Tax applicability of equity mutual funds

We earlier discussed that funds like ELSS are exempted from tax up to the limit of Rs. 1,50,000 per year. But is that all? Are other types of mutual funds fully taxable?

Mutual funds majorly attract tax on capital gains. Short-term capital gains (STCG) when the units are held for a period of less than a year are taxable at 15%. Long-term capital gains (LTCG) when the units are held for more than a year are exempt up to the ceiling limit of Rs.1,00,000. Anything above that is taxable at 10% without indexation benefits.

Also, dividend distribution tax (DDT) is deducted before the investors are paid dividends.   

Should you invest in equity mutual funds?

As we always say, financial planning is quite subjective, and maximum benefits can be reaped only when the instruments used to park the funds are aligned with the financial goals and preferences of an investor. Having said that, equity mutual funds are an excellent way to get a taste of how equity securities work. 

If you are an amateur or are risk-averse, a large-cap mutual fund is the best option as the volatility is less without compromising on the returns.

If you are an experienced investor, you can opt for flexi cap and contra funds as well.

The Bottom Line

Equity mutual funds provide the highest return when compared to other kinds of mutual funds. On average, the pre-tax return is 10%-12%.

But these funds are the most exposed to all sorts of market fluctuations. Therefore, it becomes crucial for an investor to understand their financial goals and preferences well and also communicate the same to the fund manager so that the right combination of stocks is picked to provide maximum returns.

Invest wisely!