Understanding Equity Mutual Funds and How They Work

Equity mutual funds are an investment option that primarily allocate money to shares of publicly listed companies. By investing in equities, these funds aim to offer investors the potential for long-term capital appreciation. They are suitable for those who are comfortable with short-term fluctuations in exchange for the possibility of higher growth over time.

Equity mutual funds may be actively managed, where the fund manager decides which companies to invest in, or passively managed, where the fund tracks a market index. These funds cater to investors seeking participation in the stock market without having to directly manage individual shares.

Unlike debt-oriented funds, where returns are generated mainly through interest income, equity mutual fund returns come from capital gains, the difference between the buying and selling prices of the underlying shares. Some funds may also provide Income Distribution cum Capital Withdrawal (IDCW) payouts, which represent part of the profits distributed to investors.

Who may consider investing in equity mutual funds

Equity mutual funds are generally suitable for investors with a longer investment horizon and a higher tolerance for market volatility. They may be appropriate for individuals working toward goals such as retirement, children’s education, or wealth creation over time.

Since equity investments tend to fluctuate in the short term, they may be better suited for those who can stay invested for several years. Aligning your investment horizon and risk profile with the chosen fund type helps in managing expectations and outcomes. 

For example, large cap funds may appeal to those seeking relatively stable long-term growth, while mid cap and small cap funds may suit investors comfortable with higher short-term movement for potentially greater long-term returns.

Types of equity mutual funds

SEBI classifies equity mutual funds in India into different categories based on the size of companies they invest in:

• Large cap funds: These funds invest primarily in the top 100 companies by market capitalisation, offering relatively stable returns and lower volatility.
• Mid cap funds: These focus on companies ranked from 101st to 250th, offering higher growth potential but with greater market risk.
• Small cap funds: These invest in companies beyond the top 250 by market capitalisation. While small caps may carry higher risk, they also present opportunities for strong growth over time, as seen in indices such as the BSE 250 SmallCap Index.
• Large and mid cap funds: These balance the stability of large companies with the growth potential of mid-sized firms.
• Flexi cap funds: These can invest across companies of all sizes, allowing the fund manager flexibility to adapt to changing market condition s with a minimum allocation in equity of 65%.
• Multi cap funds: These invest at least 25% each in large cap, mid cap, and small cap stocks, offering a diversified mix across the market spectrum.

Key features and potential benefits

Equity mutual funds may offer several features that make them suitable for growth-oriented investors:

• Professional management: Fund managers use research and analysis to make informed investment decisions.
• Diversification: Investment is spread across different sectors and companies to help manage risk.
• Liquidity: Investors may redeem their units on any business day at the prevailing Net Asset Value (NAV).
• Growth potential: The focus on equities provides an opportunity for long-term capital appreciation.
• Affordability: Investors may start with a modest amount through an SIP or lumpsum contribution.

Taxation on equity mutual funds

Understanding taxation helps investors plan their redemptions effectively.

Income Distribution cum Capital Withdrawal (IDCW): Dividends are added to the investor’s taxable income and taxed as per their income tax slab. 

Capital gains:

• Short-term capital gains (STCG): For units held less than 12 months, gains are taxed at 20% plus surcharge and cess (for redemptions on or after July 23, 2024).
• Long-term capital gains (LTCG): For units held 12 months or longer, gains up to Rs. 1.25 lakh per financial year are exempt. Gains above this are taxed at 12.5%, plus surcharge and cess.

Factors to consider before investing

Before choosing an equity mutual fund, investors may evaluate several aspects:

• • Investment objective: Understand whether the fund’s goal aligns with your financial plan – capital growth, IDCW income, or a mix of both.
  • Risk tolerance: Equity funds carry market-related risks. Assess your comfort with short-term volatility.
  • Fund performance: Review the fund’s consistency in relation to its benchmark and peer group. Past performance may or may not be sustained in future.
  • Fund manager approach: Examine the fund manager’s experience and investment style.

• Diversification level: Ensure the portfolio offers suitable exposure across sectors and company sizes.

How to invest in an equity mutual fund

Investors may start investing through a Systematic Investment Plan (SIP) or a lumpsum mode. An SIP allows you to invest a fixed amount regularly, encouraging disciplined investing without the need to time the market. A lumpsum investment, on the other hand, may be suitable for those with surplus funds ready to deploy.

Both options are available online or offline through fund houses or distributors after completing Know Your Customer (KYC) requirements. It is advisable to review the scheme’s objectives, risk factors, and costs before investing.

Conclusion

An equity mutual fund may be suitable for investors seeking long-term wealth creation through participation in the stock market. With a wide range of categories, from large cap to small cap, these funds offer flexibility to match various risk profiles and goals. However, as equity investments are market-linked, they require patience, discipline, and a long-term outlook. Choosing a suitable scheme aligned with your financial objectives and risk tolerance may help you participate effectively in market growth over time.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.

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