What are Equity Mutual Funds? Features, Types and Taxation of Equity Funds

What is an Equity Mutual Funds?

Equity mutual funds mostly invest in the stocks of companies across all market cap to get higher returns. Equity mutual funds are considered as the riskiest class of mutual funds as they hold the potential to provide higher returns than debt and hybrid funds. The performance of business activities of the company plays a vital role in deciding the investors’ returns.

As the name indicates, Equity Funds invest in the shares of various companies. The fund manager tries to generate greater returns by diversifying the investment across companies from various sectors or with different market capitalization. Typically, equity funds are known for generating greater returns than term deposits or debt-based funds. The risk factor is associated with these funds as their performance depends on market conditions and movements.

How do Equity Funds work?

Equity mutual funds invest more than half of their funds in equity stocks of different companies in suitable proportions. The allocation of assets will be in line with the investment goal. The asset allocation can be made in the stocks of large-cap, mid-cap, or small-cap companies, according to the market conditions and movements. The investing strategy may be value-oriented or growth-oriented. After investing a significant portion of funds in the equity segment, the rest of the amount may be invested in debt and money market instruments. This is to take care of instant redemption requests as well as to bring down the risk level to some extent. The fund manager makes buying or selling related decisions to take advantage of the changing market movements and to get maximum returns.

What are the types of Equity Mutual Funds?

Based on Investment Objective

As the main objective of all equity funds is generally capital growth, it is the risk taken to achieve this objective that differs. This further depends upon the types of stocks in which the funds are invested. Some types of equity mutual funds according to their investment goal are:

Small-cap Equity Funds

These equity mutual fund schemes invest in companies whose ranks are above 250 by their full market capitalization (as per SEBI guidelines). These funds are considered to be riskier than mid-cap or large-cap equity funds but can also have potential to provide the higher returns. The minimum exposure for such stocks is 65% of the total funds.

Mid-cap Equity Funds

Mid-cap equity mutual fund schemes generally invest in the companies whose ranks are between 101 and 250 by their full market capitalization. These funds are considered as less risky than small-cap funds, but more than large-cap funds. The minimum exposure to such stocks is 65% of the total funds.

Large-cap Equity Funds

These equity mutual fund schemes invest in companies whose ranks are between 1 and 100 according to their full market capitalization. These funds are considered to be the least risky in terms of equity fund-picking. The minimum exposure for such stocks is 80% of the total funds.

Large- & Mid-cap Equity Funds

These equity mutual funds allocate between large-cap and mid-cap equity and related instruments and hold the potential to offer high returns. The required minimum exposure to both large-cap and mid-cap stocks is 35% for each of the total funds. 

Multi-cap funds

Multi-cap equity funds invest in stocks across large-cap, mid-cap and small-cap companies. According to the market conditions, the fund manager decides the main investments. Their minimum exposure to such stocks is 65% of the total funds.

Based on Investment Strategy

As an investor, you must understand the investing strategy followed by the fund house, i.e. the methodology for selecting the stocks. The main investing strategies include the following four strategies:

(A) Top-down strategy : The sector is chosen first and then the stocks of that sector are purchased in the portfolio.

(B) Bottom-up strategy : The well-researched stocks are bought irrespective of the sectors.

(C) Growth strategy : Growth strategy indicates that the fund will invest in companies that have a consistent track record of profitability and growth and are likely to sustain on this path.

(D) Value strategy : This strategy indicates that the fund will invest in companies that have the potential to grow exponentially in the future and are currently available at a lower value.

Based on Asset Allocation

There are a few funds that split their investment portfolio between primarily equity (at least 65%) and the rest amount in debt or between domestic and international equity. It is important to see asset allocation from a tax perspective according the provisions of the Income Tax Act, 1961. International equity funds that have a primary foreign equity allocation are classified as debt funds for tax purposes.

ELSS (Equity linked savings scheme)

Equity-Linked Savings Schemes (ELSS fund) are a tax-saving mutual fund investment scheme that invest primarily in equity and equity-related schemes. Under this scheme, the funds collected are invested majorly in equity and the rest in debt related securities. An individual can claim up to Rs 46,800 (according to the highest slab of income tax (i.e. 30%) and education cess 4%) annually by investing in ELSS funds.

(Also Read: Best Mutual Funds to invest in 2021)

Features of Equity Funds

(A) Cost of investment

The repeated buying and selling of equity shares often affect the expense ratio of equity funds. The Securities and Exchange Board of India (SEBI) has capped the expense ratio of 2.5% for equity funds. A lower expense ratio will result into higher returns for investors.

(B) Holding period

Investors redeem their fund units and get capital gains which are taxable in the hands of investors. The rate of taxation depends on investment period which is also called the holding period. Equity holdings of less than one year are called short-term, and tax rate for short-term capital gains is 15%. Equity holding of more than a year are termed long-term, and the long-term capital gains are taxed at the rate of 10% if the gains exceed Rs 1 lakh a year.

(C) Cost-efficiency & diversification

By investing in equity funds, you get exposure to various stocks, and you get this benefit by investing a nominal amount. However, your portfolio may face the lack of focus.

Taxation of Equity Funds

Tax rate for Short-term capital gains (STCG) is 15%. The Union Budget of the year 2018-19 brought back the long-term capital gains (LTCG) tax on equity holdings which is 10% if the gains exceed Rs 1 lakh a year.

Choosing between Lumpsum Investment and SIP

When you decide to invest, a big question you face is choosing between a lump sum and SIP investment plan.

Lumpsum investment means that you invest the whole amount together. For example, if you want to buy units worth Rs 5 lakh, then you can pay through your bank account and purchase the units. On the other hand, Systematic Investment Plan (SIP) means that you invest a fixed amount of money at regular intervals.

Both lumpsum and SIP investing have their different advantages and disadvantages. A lumpsum investor requires to invest at the right time to earn good returns. There is a risk that if the timing is wrong, then the returns can be lesser or he might even face losses. SIP investing helps reduce this risk by letting you invest the same amount spread across a large period. This makes SIP affordable and flexible while improving the habit of investment discipline in you. Further, SIP investing also benefits you from Rupee Cost Averaging (RCA) where the average cost of purchasing a single unit reduces with time and you are safeguarded from market fluctuations.