What are Equity Mutual Funds? - Basics & Benefits
As you know, mutual funds are an instrument that pools money from various different investors. This pooled money is then invested in different types of financial instruments based on the investment objective of the scheme.
Here are the different types of mutual funds schemes based on the financial instruments that they invest in:
- Equity Mutual Funds
- Debt Mutual Funds
- Hybrid Mutual Funds
- Thematic / solution-oriented Mutual Funds
- Other Mutual Funds (like Index Funds, and Fund of Funds)
Today we will study the most popular mutual fund category - Equity Mutual Funds.
In this article you will learn:
- What are Equity Mutual Funds?
- Types of Equity Mutual Funds
- Benefits of Equity mutual Funds
- Risks Associated with Equity Mutual Funds
- Who Should Invest in Equity Mutual Funds?
What are Equity Mutual Funds?
For a mutual fund to be qualified as an equity mutual fund, it must invest a minimum of 65% of its assets in equity and equity related investment schemes and the balance can be maintained as cash for immediate liquidity requirements.
The main focus of an equity mutual fund is to make investment in equities or stocks of companies listed on the stock exchanges. This helps them earn inflation-beating returns from the market.
As equity mutual funds invest in the stocks of companies, they carry very high-risk compared to other types of mutual funds. But you can minimise the riskiness of equity mutual funds through diversification. Diversification is the process of investing in multiple stocks. This way, the loss in certain stocks is offset by profit in other stocks.
The universe of equity mutual funds is further divided based on the investment objective and risk appetite of the investor.
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Types of Equity Mutual Funds
Equity mutual funds can be further bifurcated based on:
- Portfolio Management Style
- Market Capitalisation
- Sectoral and Thematic
- Organisational structure
- Investment Objectives
1. Portfolio Management
Every mutual fund portfolio has a management style; it can be either actively or passively managed.
a. In an active mutual fund, the fund manager plays an important role in the performance of the mutual fund. The fund manager does all the research and analysis regarding t he selection of the stocks. He is responsible to take all the decisions on behalf of investors. The aim of an active mutual fund manager is to beat the benchmark index and create alpha.
b. In passive mutual funds, the fund manager just has to copy the benchmark index and there is no active participation of the fund manager in the selection of the stocks.
2. Market Capitalisation
The total market value of a company's shares is referred to as market capitalisation. According to the Securities and Exchange Board of India (SEBI), there are many equity mutual funds schemes based on market capitalisation. These are broadly classified as:
- Large Cap Equity Funds: They invest their money in the top 100 companies listed on the stock exchange. Typically, these companies have a market capitalisation of ₹20,000 crore or more. They must invest a minimum of 80% in equities of blue-chip companies. This means large cap funds carry low risk, making them perfect for conservative investors.
- Mid Cap Equity Funds: These funds invest in companies ranking between 101st and 250th in terms of market capitalisation. Typically, the market capitalisation of midcap companies is between ₹5,000 to ₹20,000 crore. A minimum investment of 65% must be done in mid cap companies and the risk associated with it is high.
- Large & Midcap Equity Funds: They invest in stocks of both blue chip companies and mid cap companies. Minimum investment of 35% must be done in blue chip stocks and another 35% in mid cap stocks. The risk associated with them is moderate-high in compared with large cap fund.
- Small Cap Equity Funds: They invest in 251st onwards companies with market capitalisation of less than ₹5,000 crore. Minimum investment of 65% in small cap companies and the risk associated with them is very high.
- Multi cap Equity Funds: It is a mixture of all the three types of market capitalisation - large cap, mid cap, and small cap. The minimum investment must be 75% in equity with minimum 25% allocation in large cap, mid cap, and small cap stocks.
3. Sectoral and Thematic
- Sectoral: These funds concentrate their investment on a single market or sector and invest in specific markets. For example: Pharmaceutical, Banking etc. Sectoral funds are extremely risky as different sectors go through different cycles. So, tracking sectors and entering them at the correct time is very difficult.
- Thematic: These funds invest the pooled corpus based on a particular theme. So, let’s say a mutual fund is bullish on the infrastructure sector. Now it will invest in companies in the cement, steel sector etc. Even thematic funds carry very high risk. As if the infrastructure sector fails, all other dependent themes will be hit. This is similar to a domino effect.
4. Organisation structure
- Open Ended Scheme: Investors have the flexibility to buy and sell their investment at any point in time.
- Close Ended Scheme: Investors don't have the flexibility to buy and sell the investment at any point in time. They are allowed to buy units at the time of the NFO and sell the units on maturity date only.
- Interval Scheme: In this investors get combination of open ended and close ended scheme. During a specific time period, investors can redeem their funds.
5. Investment Objectives
- Growth Funds: Investment is done in stocks that have high growth potential. These funds help investors earn higher returns over a long term period of time.
- Value Funds: Value funds are ones that follow the value investing strategy and invest in undervalued that show a lot of promise due to their strong fundamentals.
- Contra Funds: Investors of this fund don’t believe in following the herd. They take contrarian approach to investing. So, they aim to find value in stocks which is rejected by the stock market.
Benefits of Equity mutual Funds
- Diversification: Diversification helps to reduce the risk involved in equity mutual funds by spreading your investment across stocks of different companies.
- Affordable: Investment in equity mutual funds starts from as low as ₹500 via a Systematic Investment Plan.
- Liquidity: In equity mutual funds you can redeem your investment at any point in time and the money gets credited to your bank account within 3 days’ time normally.
- Returns potential: Historically Equity mutual funds had provided high returns as they invest most of the pooled money in stocks. However, the past performance may or may not sustained in future.
- Fund Manager: Equity mutual funds are supervised by a professional fund managers who have vast knowledge of finance and the market. They conduct in-depth research and analysis before buying stocks.
- Convenience: Investors can invest in equity mutual funds at their convenience. They can invest through lumpsum or monthly SIPs.
Risks Associated with Equity Mutual Funds
- Short Term Period: In order to profit from your investment in equity mutual funds, you must have a long-term investment horizon. Short term investment in equity is very risky due to the uncertain ups and downs in the market.
- Expense Ratio: The expense ratio is paid from the fund’s NAV irrespective of whether you make a profit or a loss.
- Returns Not Guaranteed - Investors should be aware that by investing in a mutual fund, there is no guarantee of any income distribution, returns or capital appreciation.
- General Market Risk: Any purchase of securities will involve some element of market risk. Hence, a mutual fund may be prone to changing market conditions as a result of global, regional or national economic developments, governmental policies or political conditions, broad investor sentiment and external shocks (e.g. natural disasters, war and etc.)
- Security specific risk: There are many specific risks which apply to the individual security. Some examples include the possibility of a company defaulting on the repayment of the coupon and/or principal of its debentures, and the implications of a company's credit rating being downgraded.
Who Should Invest in Equity Mutual Funds?
· Investors with a long-term investment horizon, who want to get better returns on their investment.
· Investors who are willing to take a high risk and will not lose sleep when the markets fall.
· Equity mutual funds must be considered by young investors as they have the availability to face high risk and can stay invested for a long time.
· Investors who have a strong understanding of the market and a keen awareness of the market's unpredictability.
So, if you understand and are prepared to face all the risks of equity funds, then you are ready to begin your investment journey.
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