A to Z of Equity Mutual Funds

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Mutual funds have changed the way people invest in the better. They promise better returns over the long term, diversify risk, and are liquid assets. Due to these reasons, India has seen an exponential growth of mutual fund investments for the last few years. However, even though a majority of investors have a considerable equity mutual fund portfolio, they are not fully conversant with them. So, here’s Niyo’s complete guide to equity mutual funds.

Contents

  1. What are equity mutual funds?
  2. Risks associated with equity mutual funds
  3. Types of equity mutual funds
  4. Equity Fund Options: Growth, Dividend Payout, Dividend Reinvestment
  5. Plans: Regular and Direct
  6. Modes of investment
  7. Taxation
  8. Redemption

What are equity mutual funds?

As the name suggests, Equity Funds invest in the shares of different companies. The fund manager tries to offer great returns by spreading his investment across companies from different sectors or with varying market capitalizations. Typically, equity funds are known to generate better returns than term deposits or debt-based funds in the long term. 

Risks associated with equity mutual funds.

There is an amount of risk associated with these funds since their performance depends on various market conditions. The risks can be divided into two types.

  • Market risk

Stock markets move up and down based on economic news, corporate performance, and investment sentiment. If the stock markets fall, the value of all equity investments including Equity Mutual Funds also falls (i.e. the NAV of the Mutual Fund goes down). Market risk is also referred to as market volatility and equity mutual funds have a very high market risk as their returns depend on market movements.

  • Concentration risk

Concentration risk deals with the composition of the mutual fund portfolio. If the fund manager allocates a majority of the funds to a single stock or sector, it leads to concentration. Because of this any adverse impact on that stock or sector will have a highly negative impact on the investment’s value and may take time to recover.

Equity mutual funds are categorized into 11 different types of funds by SEBI. This categorization is broadly done on the basis of three parameters.

  1. The market capitalization of the investments in the fund portfolio
  2. Sectors and themes in which investments have been done
  3. Style of investing in the mutual fund portfolio

These are the 11 different categories of equity mutual funds

Table to be updated

Categories of equity mutual fundsComposition of the fundRationale for investment
Large cap fundAt least 80% investment in large-cap equity stocks and equity related instrumentsTo invest in safeblue-chip stocks for less volatile returnsSuitable for equity investments of investors with alow risk profile
Large and Midcap FundAt least 35% investment in large-cap equity and another 35% in mid-cap stocksTo invest primarily in stocks of mid-sized companiesHigher risk and returns than Large & Midcap fundsSuitable for equity investments of investors with a high risk profile
Midcap FundAt least 65% investment allocation to mid-cap companies’ stocksTo invest primarily in stocks of mid-sized companies.Higher risk and returns than Large & Midcap funds.Suitable for equity investments of investors with a high risk profile.
Small cap FundAt least 65% investment allocation to small cap companies’ stocksTo invest primarily in stocks of small companies.High risk & volatility i.e. in bad times can lead to huge losses and in good times huge returns.Suitable for equity investments of investors with a high risk profile
Multicap FundMixed investment in large cap, mid cap and small cap stocks without any restriction of minimum allocations to a specific market-capTo invest in a mix of stocks irrespective of company sizeHigher risk and returns than large cap fundsSuitable for equity investments of investors with a moderate risk profile
Dividend Yield FundPrimarily invest in stocks which pay good dividendsStrategy based fund so have lower flexibility in-stock selectionSuitable for investors looking to specifically invest in a dividend yield strategy
Value and Contra FundsValue funds – primary investments in stocks which are undervalued as per the fund manager’s perspectiveContra funds – investment in stocks which perform contrary to market movementsStrategy based fund so have lower flexibility in-stock selectionSuitable for investors looking to specifically invest in a value or contrarian strategy
Focused FundsInvestment in a maximum of 30 stocksHigher concentration risk because of fewer stocks in the portfolioCan be a part of equity investment portfolio of investors with moderate or high-risk profile
Sectoral or Thematic FundsAt least 80% of investment in the designated sector like banking, pharmaceuticals, information technology, etc.Sector specific funds so high concentration riskOnly suitable for investors looking to invest in a particular sectorNot recommended for general purposes.
Index fundsPrimary investment is done in the stocks of a particular index like Sensex of Nifty in the same weightage as the indexPassive investment to replicate the returns of an index like Nifty or SensexUsed by investors who don’t believe in active management.
Equity Linked Saving Scheme (ELSS)At least 80% of investment is done in equity and equity-oriented stocksFor availing tax advantages under Section 80C on the invested amount.Has lock-in of 3 years

Equity Fund Options: 

Growth, Dividend Payout, Dividend Reinvestment

All equity funds are available in three options. In all three options, the underlying investment portfolio is the same, but they differ in the treatment of profits earned.

Growth option

Under this option, the fund keeps on growing as per the market returns. The profits earned are reinvested further thus leading to compounding. In order to take money out, you need to sell your Mutual Fund units, it’s profitable in long term investment.

Dividend Payout option

Under this option, the profits earned by the mutual fund are paid out to the investor either fully or partially (via NEFT or bank cheque) on a periodic basis and the principal amount stays invested. This option does not lead to compounding and hence is generally not recommended.

Dividend Reinvestment option

Under this option, the profits earned are not paid out but are reinvested as fresh units into the same fund. So the final outcome is the same as that of growth option but instead of NAV increase, there is an increase in the number of units held.

Types of Plans

Regular plan

These plans are provided by Mutual Fund distributors like your bank. It’s the same Mutual Fund but with a small additional distribution fee (0.1-1% typically) in lieu of the service provided by the distributor (platform, convenience, customer service, fund recommendations, financial planning advice, etc).

This distribution fee is included in the expense ratio of these funds and hence the expense ratio is slightly higher by that amount.

Direct plan

Direct plans can be purchased from Niyo Wealth directly. Niyo Wealth provides direct plans without any commission and still provides customer service, whereas other distributors charge a commission for it.

Since there is no distributor commission involved their expense ratios are slightly lower.

You can read about the difference between both plans in detail here.-
https://www.goniyo.com/blog/direct-vs-regular-mutual-funds/

Modes of investment

For investment into mutual funds, you can choose to invest lump sum amounts as and when you have the money or invest in regular monthly instalments.

Monthly installments are called Systematic Investment Plans (SIPs) and they can be started with very small amounts of even Rs.100 per month. SIPs are affordable and give you the benefit of rupee-cost averaging because they invest on a fixed date of each month at the NAV prevalent as on that date. Rupee cost averaging means more units are bought when the market price of shares is low and lesser units are bought when the price is high.

Taxation 

The returns and dividends earned from equity mutual funds are taxable, whether you are investing for the short term or long term. And tax is only applicable on realised/booked gains, i.e. it is only applicable on the gains that you have redeemed to your bank account.

Tax on investment in equity mutual funds

The principal amount invested in equity mutual funds generally comes from your income which has already been taxed so there is no further tax on it during redemption.

In addition to that, in case you are investing in an Equity Linked Saving Scheme (ELSS), even the principal amount is allowed for income tax deduction under Section 80C. The maximum amount eligible for deduction under this section is limited to INR 1.5 lakhs in a financial year. 

Tax on returns earned from equity mutual funds

The returns earned from equity mutual funds are categorized as short term capital gains or long term capital gains depending on the period for which you stayed invested in the fund.

If you sell the investment or any part of it within 12 months of investment, the resulting gains from that sale are called short term capital gains. If, however, the period of investment was at least 12 months, the gains are called long term capital gains and will be taxed at a lower rate.

Let’s understand how these gains are taxed –

Short term capital gains (STCG) : Short term capital gains earned from equity mutual fund investments are taxed at a flat rate of 15% of the gains (irrespective of your income slab). 

Long term capital gains (LTCG) : Long term capital gains are tax-free if they are limited to INR 1 lakh. If, however, the LTCG from equity mutual funds exceeds INR 1 lakh in a financial year, a flat rate of tax of 10% is applied on the LTCG amount exceeding INR 1 lakh.

This means that if the total LTCG earned from equity mutual funds is Rs 1.5 lakhs, you would have to pay a tax of 10% on Rs 50, 000 i.e. Rs 5,000.

(Note: Till FY 2017-18 tax on LTCG was 0. It was increased to 10% from FY 2018-19. To give some relief from the new LTCG taxation rule, any LTCG accrued up to 31st January 2018 have been grandfathered i.e. considered as tax-exempt). 

Tax on dividends earned

The dividend declared under equity mutual funds is taxed at the rate of 10% under the Dividend Distribution Tax. This tax is deducted at source by the Mutual Fund company and the remaining amount is paid out as the dividend. Hence the amount you receive is tax-free in your hands (since the tax has already been paid).

Exit load

Exit load is a percentage-based fee deducted by the Mutual Fund if you withdraw the money within a short period of time after investing.

The exit load varies from fund to fund but generally, most Equity Mutual Funds have an exit load period of 1 year before which they charge an exit load fee of 1% on the amount being redeemed.

Hence it is generally not advisable to redeem your Equity Mutual Funds before 1 year unless there is some emergency. 

So, this is what equity mutual funds are and how they work. Understand these details of equity mutual funds before you invest in them so that you know how they work and what to expect from them. 

Niyo Wealth is here for the best experience with your investment. 

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