How Do Equity Mutual Funds Work?

Mutual funds that predominately invest in the shares/stock of companies are called equity mutual fund. More and more people are getting into investing in equity mutual funds for wealth creation or for realising financial goals such as kids’ education, marriage, retirement plans etc. Equity mutual funds have shown good growth and potential over the last two decades amongst other financial instruments. Today, investment in mutual funds has been made easy through SIP (Systematic Investment Scheme) mode of investment. This article will explain how mutual funds work.

Equity mutual fund buys equity shares and stocks of companies in the range of 60% or more as per the pre-decided investment mandate. The investment can be large cap, mid cap, small cap or a mixture of market capitalisation. The investment pattern can be as per the objective of the fund which can be value or growth oriented.
Once the majority of the portion is used to buy equity shares, the rest of the amount will be used to buy debt or money market financial instruments. This is done to address the redemption request of the investors from time to time. To take advantage of the volatile market conditions the fund manager will buy and sell equity stocks. The trading of stocks involves expenses thus it affects the expense ratio of the equity mutual fund. Presently, SEBI has set the upper limit of expenses ratio at 2.5% for equity funds. SEBI is planning to reduce it which will help translate into higher returns for the investor.

Types of Equity Mutual Funds
Equity funds are classified into many categories based on their investment mandate and the kind of companies and sectors they invest in.
Sector and theme-based equity mutual funds
Equity mutual funds that base their investment on a particular sector or theme come under this category of mutual funds. Funds that invest in one particular industry like real estate, pharma, retail, information technology, etc. are called sector mutual funds. Thematic funds invest in particulars like international stocks or emerging consumer companies.

Sector and thematic equity mutual funds tend to be riskier as they have all their stakes on that particular sector or theme. For example – If the funds are invested in real estate companies and if the real estate market crashes it will directly impact the performance of the equity mutual fund. The diversification option can be done by market capitalisation.

Equity funds based on Market Capitalisation
Equity mutual funds that invest primarily in large-cap stocks are called large-cap equity funds. This category can be slightly based on different mutual fund houses, but predominately large-cap stocks are stocks of blue-chip companies which are well established and offer stable and consistent returns on investments.
Equity mutual funds that invest in midsized or smaller companies are called mid-cap equity funds. The market positions of these companies are a little bit volatile and due to this the returns on the investment also keeps fluctuating sometimes high and sometimes low.
Equity mutual funds invest their money in a mix of large-cap, mid-cap and small-cap stocks are called multi-cap mutual funds.

Active funds are those where the fund manager makes the portfolio by doing research on companies and their performance before investing. Inactive or passive funds are those where the investment is done in the companies listed on Sensex in a set proportion. Index funds have low management cost as there is not much work required from the fund manager.
Taxation of Equity Funds

Equity mutual funds offer capital gains when you redeem the units after a specific duration. The capital gains are subject to tax and it depends on how long you have stayed invested in the equity fund. This period is called the holding period.

There are two types of capital gain, one is a short-term capital gain (STCG) and other is a long-term capital gain (LTCG). If the holding period is less than 12 months in the equity mutual fund then it will be treated as SCTG. If the holding period is more than 12 months then it will be treated as LTCG. STCG is taxed at 15% and LTCG as per the new rule in 2018 is taxed at 10% if the capital gains are more than INR 1 lakh.
Equity funds under ELSS (Equity linked saving scheme) can also save you taxes as per section 80C of the Income Tax Act, 1961. You can avail deduction of INR 1.5 lakh by investing in ELSS and save taxes of up to INR 45,000. ELSS although come with a lock-in period of 3 years.

SIP (Systematic Investment Plan)
SIPs have been the best investment model for equity mutual funds. People of all income categories can avail the benefit of mutual funds returns. SIP in a mutual fund can be started for as little as INR 100 per month. SIP is usually an investment mandate that automatically is set on a pre-decided date. You can instruct the AMC to deduct a specific amount from the bank account every month.
Through SIP you can avail the benefit of rupee cost averaging. When the markets are performing well you will be allotted fewer units and then when the market is performing poorly you will be allotted higher units for the same amount. This way you can invest automatically at different market conditions and avail the benefit. SIP helps with the investing and savings habit. This way you can also manage your expenses well as most SIP dates are set at the beginning of the month when your salary is credited in the bank account.

Investing in Mutual funds
The decision to invest in mutual funds is based on the risk appetite and investment scope. Equity funds need a long-term commitment for investment. It gives you the best results when you have kept your money for at least 5 years or more. A shorter period of investment in equity mutual funds might not pay you expected returns due to volatile market conditions. In the case of ELSS you can save tax and at the same time invest in equity mutual funds. They are the best option for salaried employees who want to save tax and at the same time get capital gains on their investment. For beginners, investment in large-cap equity mutual funds are the best bets to start the dice rolling. When you get well-versed with the market conditions then you can take your chances with mid-cap and small-cap funds which are riskier but can offer high returns.

Best performing equity mutual funds can be found by doing some research and even taking help of mutual funds calculator online. Before you invest in equity mutual funds try to know about it in detail so you when you do choose the mutual fund for the investment you have a fair idea of its working and return. Mutual funds are a safe investment, but as they are linked to volatile market conditions the risk of unpredictability always exists.