Why invest in Equity Mutual Funds?

What are Equity Funds?

Equity Mutual Funds invest in stocks as per the fund’s investment mandate. The advantage of investing in Equity Funds is that you hold a diversified portfolio.

There are more than 3,000 listed companies on BSE. It is practically difficult for novice investors to track so many companies and decide which stocks would do well in the future. Thus, Equity Funds are ideal for retail investors as they are managed by experienced fund managers. Fund managers are supported by analysts who keep a hawk’s eye on sectors, stocks, economy and, comb through company balance sheets to study important trends shaping the market.

Why invest in Equity Mutual Funds?

Equity Mutual Funds invest in shares of publicly listed companies across market capitalization based on the fund’s investment objective. Equities reward investors through dividends, bonus shares and capital gains through rise in stock price, which is linked to company’s earnings growth. As opposed to investing in bonds, which rewards investors largely through coupon interest and carries relatively less risk as compared to equities, equities provide a high-risk high-return potential as stock prices swing up and down due to a variety of reasons linked to the company, industry and economy in general.

That said, equities may offer the potential to beat inflation in the long run. India’s retail inflation as measured by Consumer Price Index (CPI) has hovered around 6.04% average over the last ten years. (Source: Trading Economics.) Over the last ten years, Nifty 100 Total Return Index (TRI) has grown by 13.23% CAGR as of January 23, 2023. During the same period, S&P BSE 500 Index has grown at a CAGR of 13.18%. (Source: Bloomberg)

In the above example you can see that equities have the potential to beat inflation over the long run. For a long term goal like retirement or children’s higher education/wedding, equities can have the potential to compound your wealth. Since equities can be volatile in the short run, one should preferably invest in Equity Mutual Funds only if the investment horizon is at least five years or more.

Are Equity Mutual Funds Risky?

The risk is mitigated in equity funds over a long period of time. Equity Funds are inherently volatile as the underlying holdings are stocks that tend to react to news and other events daily. You would be familiar with the correction we witnessed in 2008-09 (global financial crisis) and 2020 (pandemic-induced slowdown) and how markets have recovered from the crisis. Thus, patience is key to creating wealth in Equity Funds.

There are broadly two types of risk inherent in any security:

• Systemic Risk: This risk affects the entire sector or the economy. For instance, the 2008-09 global financial crisis impacted economies around the world. This risk is difficult to diversify.

• Unsystematic Risk: This risk affects one company; the entire industry is not impacted. This risk can be diversified by holding multiple stocks from different industries.

In addition to these two broad types of risks, other risks include Business Risk, Credit Risk, Country Risk, Foreign Exchange Risk, Interest Rate Risk, Political Risk, Counterparty Risk, Liquidity Risk, among others.

To mitigate these types of risks, Equity Funds typically hold 40 to 50 or even more stocks across sectors. (Focused Funds can only invest in up to 30 stocks.) Further, mutual funds are bound by regulations that prevent them from taking overexposure to a single stock and sector which helps in minimizing risk. For instance, a fund cannot hold more than 10% of its net assets in a single stock.

What is the ideal investment horizon For Equity Funds?

Investors should have at least five years investment horizon while investing in Equity Funds. The long-term returns from equities are a function of corporate earnings and fundamentals. Thus, it pays to stay invested for longer in Equity Funds. The returns from Equity Funds tend to be volatile in the short run but the risk is reduced over a longer tenure.

Types of Equity Funds

Equity Funds can be classified as active or passive. Actively managed Equity Funds aim to outperform their benchmark through active stock and sector selection. In simple words, an actively managed fund will try to generate returns in excess of the benchmark, which can be S&P BSE 100 or S&P BSE 500 as per the fund’s investment mandate. On the other hand, a passively managed Equity Fund will mimic its benchmark. In other words, the returns generated by a passively managed equity fund will be close to the benchmark, subject to tracking error.

Equity Funds are ideal to meet long-term goals like retirement, buying a house, saving for a kid’s higher education, and so on. There are 11 categories of actively managed Equity Funds.

Each category follows a distinct mandate in terms of the quantum of exposure to equities, market capitalization, theme/sector allocation, tax benefits, and more. They are broadly classified into:

• Multi Cap:This fund invests a minimum of 25% each in Large, Mid and Small-Cap stocks.
• Large & Mid Cap: This fund invests a minimum of 35% each in Large and Mid-Cap stocks.
• Flexi Cap: Unlike Multi Cap Funds that have a fixed exposure to each market cap (Large, Mid, and Small), Flexi Cap Funds can freely manoeuvre across market capitalisation as per the fund manager’s discretion.
• Retirement: This fund invests at least 75% in equities. It has a lock-in of at least 5 years or till retirement age, whichever is earlier. This fund is categorised as a solution-oriented fund under SEBI’s categorisation rule.
• Large Cap: This fund invests a minimum of 80% of assets in large-cap companies, which are the top 100 companies by market capitalisation.
• Equity Linked Savings Scheme (ELSS): This fund invests at least 80% of assets in equity and qualifies for tax saving under Section 80C of the Income Tax Act. One can save tax of Rs 46,800 (assuming the highest tax bracket) on investment of up to Rs 1,50,000 in a financial year, under the old tax regime. It comes with a lock-in period of three years.
• Mid Cap: This fund invests at least 65% of assets in mid-cap companies.
• Small Cap: This fund invests at least 65% of assets in mid-cap companies.
• Dividend Yield:These funds invest at least 65% of assets in dividend-yielding stocks.
• Value: These funds invest at least 65% of assets in equities with a focus on a value investing strategy. Contra Funds: These funds invest at least 65% of assets in equities with a focus on contra investing strategy.
• Focused: These funds invest a minimum of 65% of assets in equity and invest in a maximum of 30 stocks.
• Sectoral/Thematic: These funds invest a minimum of 65% of assets in equity with a focus on a particular sector or theme like Pharma/Healthcare, Technology, Banking, Financial Services, Infrastructure, Consumption, PSU, and so on.

How to invest in Equity Mutual Funds?

You can invest in Equity Funds through lumpsum or Systematic Investment Plan (SIP). You can also use features like Systematic Transfer Plan (STP) and Switch.

Depending on your cash flows, you can choose to invest through one of the modes. Since markets tend to be volatile, retail investors should ideally stagger their investments in equity, which helps in averaging out investments. Whether you invest through SIP or lumpsum, it is advisable to have a long-term horizon while investing in equity mutual funds.

What are the tax benefits of Equity Funds?

Investments redeemed on or after 23rd July 2024.

• Holding Period (To qualify for LTCG): 12 months

• Short Term Capital Gains Tax: 20%

• Long Term Capital Gains Tax: 12.5% (with an exemption up to INR 1.25 lakhs)

Plus surcharge and cess as may be applicable on the above rates.

Benefits

• Liquidity: Except for ELSS, solution oriented funds like Retirement and Children’s Funds which come with a lock-in period, investors get the credit of money on the number of units redeemed at the applicable Net Asset Value (NAV) from Domestic Equity Mutual Funds in 3 business days.

• Start Small: You don’t need much money to invest in Equity Mutual Funds. You can start with an investment of Rs 1,000 to Rs, 5,000 depending on the minimum investment required in a scheme.

• Flexibility: You can choose to invest monthly or quarterly through SIPs as per your cash flows. You can redeem your money at any time (except for ELSS and solution oriented funds which have a lock-in).

• Transparency: The portfolios of the schemes are published monthly on the AMC website. You get to see where your money has been invested.

• Investment Value: You can see the latest value of your investments as against your original investment on AMC websites.

• Growth: Equity Funds can help you build long-term wealth as they may beat inflation.

Investments made in Equity Linked Savings Scheme (ELSS) can be only redeemed after three years as they qualify for tax-saving under Section 80C of the Income Tax Act.

Who should invest in Equity Mutual Funds?

The decision to choose the type of Equity Mutual Fund would depend on your goal, risk appetite, and time horizon. Investors who have long term goals like buying a house, retirement, children’s higher education, etc. and are comfortable with the volatility associated with equities can consider Equity Funds.

To conclude, a financial advisor can help you recommend funds based on your life goals, asset allocation and risk appetite.