What is Equity Mutual Funds (MF)?
An equity mutual fund allows investors to invest in equity shares (stocks). Equity is the investment instrument that gives the ownership of the company the investor has invested into to the extent of percentage allocation (hence the term equity) to that particular stock.
The objective here is to participate in the business (in terms of gaining ownership) which have the potential to grow and hence earn decent/good returns beating conventional/conservative mode of investments.
Equity as an asset class can be used by aggressive investors to generate extra returns over the long term trying to beat the benchmark and earn decent returns than the risk-free rate of return beating inflation.
Whereas even moderate and conservative investors have certain exposure to equity as an asset class to increase the overall returns by investing majority in debt as an asset class and some exposure to equity (satellite part of investment).
Equity Mutual Fund in India – SENSEX (Stock Exchange Sensitive Index) is the oldest index of the country comprising of top 30 stocks whereas another index NIFTY (National Stock Exchange Fifty) launched in 1992 is constituted of 50 stocks.
Indian stock market dates back to 1875 when trading used to happen. Since then the market has evolved a lot and investor’s participation in mutual funds has increased manifold but the overall participation remains very low in our country (approximately 5%).
India as an investment market has been traditionally been conservative where our parents and forefathers have believed in the safety of capital with more emphasis on investment avenues like fixed deposits or real estate (perceived to be safe).
Also, Indians believe in the stacking of gold both as a safer haven and also due to the emotional attachment with the asset class.
Regulators have made many efforts in the recent past with lots of investor awareness programs and educational campaigns such as the “mutual funds Sahi hai” campaign to increase awareness amongst investors and increase the participation of investors especially retail investors.
Equity Mutual Fund Types –
SEBI issued a circular on 6th October 2017 with the subject “categorization and rationalization of mutual fund schemes” with circular number SEBI/HO/IMD/DF3/CIR/P/2017/114
Wherein they have reclassified mutual fund schemes.
We are presenting the list of the reclassification of equity mutual funds for a simple understanding. The image is self-explanatory with the details of each category of funds.
Equity Mutual Fund as an Investment Tool –
Equity participation in India is still quite low as compared to the rest of the world specifically the developed world (we have quite a habit to compare to that world).
It also comes down from our investment behavior as a society where Indians are regarded as conservative investors.
Though we have a great habit of savings mostly our investments are skewed towards traditional methods of investments such as bank deposits or towards safer (or perceived to be safe) options as real estate or gold.
There is no problem with this attitude of investments in terms of safety of capital but when an investor is shying away from an asset class such as equity one thing that he or she is missing is surely an extra return (vs other
conservative asset classes) as well as to participate in the growth and profit of some extraordinary businesses which have huge potential to grow. But things are not that simple, isn’t it!
What is an Equity Mutual Fund?
A mutual fund is an investment tool that invests the pool of money of investors into a fund with a clearly stated common objective.
In the case of equity mutual funds, this pool of money will be invested in a collection of stocks of companies usually in the range of 30 to 60 collection of selected stocks (sometimes even higher)
Key Concepts In Equity Funds –
Though there are multiple important concepts used in equity mutual funds here we are trying to cover a few key concepts which can be used in understanding mutual funds. These concepts are –
Is the measurement of the holding in the mutual fund portfolio that has been replaced in a year.
This varies with different funds, their objectives, and investment styles but usually, a high turnover ratio means higher trading on the portfolio and since every turnover implies a buying and selling of stock hence it will increase the cost and total expense ratio (TER) of the fund as well.
A fund depicts the volatility of the fund vs. the benchmark. Benchmark has a beta of 1 and individual stocks and hence the portfolio has varied beta from the benchmark.
A beta of 1 indicates that the portfolio is in sync with the benchmark and the movement of the funds is in co-relation with the benchmark. A beta of 1.3 means the fund is 30% more volatile than the benchmark and a beta of 0.8 means the fund has lesser volatility than the benchmark.
Alpha (also known as Jensen Alpha)
Is usually referred to as the fund manager’s performance.
It is a measurement of the extra return that the fund can provide up and above the benchmark. It is one of the commonly used tools to understand the fund performance but usually, it is used in conjunction with other fund performance measurement tools.
Is one of the most commonly used ratios. In simple language, it measures the extra return
that the fund has generated over the benchmark or risk-free rate of return.
It can be calculated as = (portfolio return – risk free return) / standard deviation
The higher the Sharpe ratio the better it is as it denotes the better return generated by the fund(higher numerator) for the extra risk taken (the standard deviation in the denominator) whereas a lower Sharpe ratio implies that the
the investor is better off not investing in the fund rather investing in the risk-free option.
Shows the deviation from the average. In the case of a mutual fund, it shows the risk
of a mutual fund and the variance in the return. a greater standard deviation means higher volatility in a mutual fund.
Determines the extra return that was generated per unit of the risk taken. It uses beta unlike Sharpe and gives an idea of the overall systematic risks involved.
It is calculated as Treynor ratio = (return of the portfolio – risk-free return) / beta of the portfolio
A higher Treynor ratio indicates a better risk/return scenario. The Treynor ratio makes sense only for a positive beta not applicable for the negative beta.
Are Equity Funds Risk-Free?
There is an obvious answer which will come to most of the investors – NO.
In our previous article on Debt Mutual Fund, we have explained why any securities are risky or safe which is primarily because any security or financial asset which can be traded has an inherent amount of risk.
But take a moment to understand what is that risk, are we talking about the loss of capital or deviation from the returns anticipated?
Risks in equity mutual funds are quite evident to investors and rightly so as the risk on capital is quite high and investors might even lose the capital invested.
Since the money invested in equity either in shares or in mutual funds are invested in businesses across various sectors. Hence the money is exposed to the risks that the business faces and hence the losses are similar to that of the business itself.
Though the exposure of Indian investors towards equity as an asset class has been less historically but in recent time’s equity participation has increased and most of this is routed through mutual funds.
This is basically because of two factors.
Firstly, the investors are becoming more aware of equity as an asset class and the benefits of investing in equity as the rates in the fixed income category have come down considerably.
Secondly, most of the intermediaries/distributors/bankers have aggressively pushed equity mutual funds in the recent past and many times unaware investors have also invested in the same.
Equity investment space offers various products right from short term (arbitrage funds) to long term (mid and small-cap funds) or even products involving ownership of stocks directly (PMS schemes) and each of them has varied amounts of risks.
So there is no fooling around the risks involved in equity and equity-related products as far as investments are concerned but one has to also factor in the premium (in terms of risk) that one has to pay to generate that extra returns vs. the other conservative methods of investments which can hardly break the inflation.
Looking at equity only from a standalone point of risk might not be the right approach one has to look at the risk-reward ratio as well.
Isn’t real estate risky or gold as an asset class risky but do we as Indians stop investing in these asset classes. Do we frequently trade in these asset classes – NO.
On the contrary, we stack these assets as much we can with an almost negligible sell viewpoint and end up being net buyers over our lifetime but when it comes to equity we have a different approach with the equity assets mainly due to our lack of understanding.
Indians are even now quite fixated on fixed deposits as an investment tool.
Equity VS Fixed Deposit – A comparison
To start with both are a different asset class. A fixed deposit belongs to debt as an asset class and has a fixed return (as the cash flows are known) and a fixed tenure whereas equity is a share of the businesses/companies and hence are exposed to a higher risk.
One key concept to understand here is that any tradable instrument (which can be bought and sold in the market) has an inherent risk.
Take for example a car that can be bought and sold in the market (hence gives a price loss in time) and is a depreciating asset in nature whereas real estate usually is appreciating in nature. On the contrary, a fixed deposit is a non-tradable instrument hence there is no risk of capital loss and periodic interest is paid (excluding the instances such as PMC Bank!)
Direct Equity (shares) vs. equity Mutual Fund
Equity investment in general means investing into stocks directly whereas a mutual fund is a collection of investments pooled from various investors with a common objective of the fund and is managed by a fund manager professionally.
Investing directly in stock will expose an investor to the risk of that specific company and hence a higher risk though it is often compensated by the higher return as a premium of the risk.
In the case of a mutual fund, the risk is diversified as the inventor’s money is invested in a collection of 25-70 stocks depending on the objective of investments.
While investing in direct stocks an investor either has to do all the research himself or sometimes rely on tips/advice from brokers/relatives or friends hence the risk is higher as an individual will have limited access to
resource whereas in the case of a fund since the fund manager is a professional and has many resources to his disposal there is plenty of research available.
But these advantages come at a cost (expense ratio of mutual funds), in the case of direct stocks the cost is much lesser (brokerage of Demat accounts)
Taxation in Equity Mutual Fund-
Any capital gain before one year is considered as Short Term Capital Gain (STCG) which is taxed at 15% (irrespective of the tax bracket in which an investor falls) and after one year is considered as Long Term
Capital Gain (LTCG) and is taxed at 10% (irrespective of the tax bracket of the investor).
One important point to note here is that LTCG in Equity up to 1 lakh is tax-exempt which means that any capital gain that is realized after 1 year and is less than 1 lakh, no tax has to be paid.
For example, if an investor invests 10,00,000 (10 lakh) and after one year the capital gain is 1,50,000 then he has to pay tax only on 50,000.00 not the entire 1,50,000.00 since 1,00,000.00 is exempted.
How to Choose an Equity Fund –
So the broader selection process remains the same be it any category of mutual funds like one has to look for the risk appetite and what is one’s understanding of the markets, what are the objectives of investments, what is
the overall asset allocation, what is the liquidity requirement.
For an equity mutual fund buying process following important points can be kept in mind –
1. Never look at star ratings of mutual funds
Most of the star ratings give too much emphasis on past returns of the mutual funds and are many times ambiguous in deciding the parameters of these ratings.
Even the star ratings of this fund vary on different websites hence relying solely on these
ratings could be detrimental in choosing the right funds.
2. Compare simple data of the funds
Do not look for too complex data and charts. Just a basic understanding will help in going far while selecting these funds.
Some data points like turnover ratio, Sharpe, standard deviation, beta, and Treynor ratio as mentioned above will help in understanding the overall investment idea of the fund. Also, one can look at the fund house and fund manager and select the ones
of decent repute.
3. Understand the risks
Most of the investors put their effort into chase returns but equally important (if not more) is to understand the risk s involved with the investments in general and equity as an asset
Having an understanding of risks makes the investor more aware of the investments and makes them sleep well without being bothered about the investments, having the right expectation of returns. One has to note that understanding risk is different while facing the risk in the event of any adverse situation is a different thing altogether.
4. Take care of emotions
It’s quite easy to get swayed away by the existing sentiment and make mistakes in investments. When the market is going through a bullish phase (increasing in value) investors turn over optimist and ignore asset allocation and are tempted to increase the equity allocation whereas when markets are bearish (downward movement) investors turn over pessimistic and reduce their equity allocation without understanding the impact of it.
SIP in Equity Mutual Funds-
If I invest today and the markets go down tomorrow what should I do? How to invest so that one has not fear timing the market? Investors face these questions while deciding the right time to invest in Mutual Funds, especially Equity Mutual Funds.
One of the easy, popular, and important tools to avoid the risk and trouble of timing the market is through SIP.
A systematic investment plan (SIP) is used to describe a periodic investment of a certain amount over a predefined duration towards an investment option.
One simple example to understand SIP is that of Recurring deposits of banks.
Banks usually provide two kinds of deposit instruments the first being a Fixed deposit wherein an investor can deposit any amount for the duration of 7 days to 120 months and get a fixed interest on the
The second option that an investor can choose is that of a recurring deposit wherein he can choose to deposit a certain amount over months to years regularly. E.g. a deposit of 5000 per month on the 25th of every month
for 60 months.
Similarly, an investor can participate in an equity market that is more volatile and risky than investing in fixed deposits.
In this case, either an investor can invest a lump sum (like a fixed deposit) for a stipulated period and do a top-up as and when there are funds else he can do a small regular investment for the stipulated time hence investing every
periodic time and mitigating the risk.
There are various benefits of doing investment through the SIP route –
1. Inculcates discipline
For most people investing is not the top priority especially during the early stages of their earning.
Only when they spend a certain time and realize that they have to catch up a lot in terms of their long term goals and hence often make decisions in haste and go for wrong products or are prone to misselling and investing in wrong products which do not suit their needs.
SIP as an investment option creates a sense of discipline as it’s a regular (usually monthly) investment.
Many a time investors schedule the SIP to such dates as it’s just a day or two later than their salary credit date to debit the account as soon as salary is credited so that they are left with the money for their expenses after investing and it becomes a sort of forced saving for them.
2. Timing of the market
Owing to the volatility of the equity market, investors are often skeptical of entering the market at the wrong time.
What if my portfolio goes down immediately after I invest what if I lose an opportunity of buying during correction and many other such questions are there which bothers investors and makes them jittery toward investment.
To all such investors, SIP serves as a tool to average out the buying price and hence reduces the risk of any decrease in the NAV and hence no need of bothering about timing the market. An illustration in the same regard is shown in the table below –
The table shows the SIP amount of 5,000 done per month for 10 months and two comparisons have been made, less volatile (Blue color) and Highly volatile (pink color) with various NAV (Net Asset Value ) at the
time of investment.
We can draw the following inferences from the above table –
1. Less Volatile – clearly shows that from the period of Jan 2018 to Oct 2018 the markets were slightly volatile (reflected by a change in the price of per unit) hence the investor has a risk of buying at a higher price if he enters with the entire investment corpus at a single go.
But if he does a systematic investment plan spread throughout 10month his average cost of acquisition/buying the NAV’s i.e. the average price that he pays instead of all the volatility throughout 10monthhs is only 99.58.
2. Highly Volatile – in this scenario, we can observe that there is very high volatility over a 10month period where the NAV fluctuates from a high of 113 (buying at this price can be a costly affair) to a low of 73 (buying at this point could be a smart move).
As an investor, it is very hard to predict when the markets will bottom out hence in such a situation a SIP will result in an average buying price of 92.71.
3. Building a large corpus by small contribution –
For example, if one has to buy a house worth 2cr not many would be able to pay the entire amount at one go, instead, we would look to take a home loan where we can pay some amount monthly (EMI) in installments over a
a period which varies from a few years to as high as 20-30 years.
Through this approach, we are getting ownership of a house without having paid a huge amount.
Similarly, not every investor has a huge investment corpus to invest at one go (lump sum), and even when one has so, investing the entire amount at one time poses a risk to the investor if the market goes down the investor has a risk of negative return or an opportunity loss of getting a better price point.
SIP helps such investors to build a huge corpus by investing small amounts at regular intervals.
The above table clearly shows that even for a Conservative Investor (return of 8%) and for a short term time horizon (5 years) a contribution of 10,000 per month will amount to 7.34 lakh whereas for a long term aggressive investor with an average return of 16% with a time horizon of 20 years a monthly contribution of 10,000 will result to a total corpus of 1.72 crores.
Whereas if we take an average return of 10% (moderate) over different periods the returns would look as depicted in the table below –
In the long term, one can easily observe that total interest earned is more than twice the amount invested hence amounting to a considerable total amount at maturity (75.93 lakh) which comes from the fact over long-term compounding also plays a huge role.
Two important hacks for SIP-
1. Do a SIP in the last week of the month – It has been observed historically that the stock market ( BSE and NSE) tend to correct during the last week of the month since last Thursday of the month is when future and options contract expires hence the markets remain volatile and it’s prudent to do the purchase of SIP during that period to get the cheapest buying point.
2. Step-up SIP with time – one mistake that an investor does (especially those who are in their late 20’s or early 30’s) is to continue with the same amount of SIP for the duration that they have decided.
But as one’s income increases they should allot an increased proportion to the SIP portfolio as well. For example, an investor can opt for the “Step up SIP” option and select the percentage that he wants to increase every year (say 10%) and it automatically increases the allotment from the next year.
Similarly, an investor can opt for perpetual SIP which means that the SIP will continue to exist until it is manually stopped which makes sense for a long-term investor and he is saved from the hassle of forgetting the SIP re-allotment once the duration is finished.
For example, if an investor opts for a 5 year(60 months) SIP he might forget to restart the same after maturity but in the case of a perpetual SIP, it continues until he stops.
Cost (Expense Ratio) of Equity MF in India-
Let’s take an example of e-commerce websites such as Amazon, the reason why they sell the goods at a discounted price is that they avoid the middlemen and procure the products directly from the manufacturers.
It is the same with Mutual Fund Industry wherein various intermediaries/distributors such as bankers, distributors, people from fund houses, financial planners, relationship managers, wealth management companies, independent financial advisors act as middlemen and get a heavy commission for “advising” on investments which are not more than a mere push for the products.
Often these people are considered or projected as the “financial doctors”. So it’s fair to draw a parallel between a doctor and the person who is advising you for your financial or investment needs.
There are broadly three kinds of doctors –
1. He charges you upfront fees as consultancy fees and then prescribes your medicines according to the diagnosis and then you can buy those medicines from any medical shop that you want. He is not bothered where you buy the medicine from.
2. This kind will not charge you any consultancy fees or minimal fees but he will ask you to buy medicines from a shop that he suggests (which usually will be owned either by him or will be nearby).
3. He will charge you consultancy fees as well as ask you to buy medicine from a certain specified shop only; sometimes he will prescribe in such a way that no other shopkeeper can read.
By now you must have already made your mind as to who is a better-suited doctor for you, similarly happens with your investment. There are three kinds of “advisors” or so-called “financial doctors” –
1. He will charge you a small consultancy fee and then you are free to buy investments from any manufacturer (AMC), he will usually suggest you buy direct mutual funds as you will save significant money in that and hence higher return.
These are SEBI Registered Investment Adviser (RIA) and are dependent only on the fees from investors hence are not biased towards any product or shop (distributor).
2. He will say “we do not charge anything to you” but you have to buy from us or we will assist you in buying. You got it right, there are no free lunches. These kinds of “advisors” are distributors.
The only reason they are not charging you anything upfront is that they get a commission in the form of distributor fees from the AMC (Asset Management Company).
By this time you must be thinking who pays for these commissions?
And you guessed it right; these are borne by the investors which can be clearly understood by looking at the difference in the Expense Ratio (cost of the fund managed by AMC) for Regular (With commission) and direct (without commission) Funds.
3. He will charge you upfront fees as well as guide you to some distributor. Many such people work as financial planners and charge some small upfront fees to attract an investor but either they are a distributor (with ARN code) through some of their family members or are attached with some distributor.
Now you must be able to choose which “financial doctor” is better suited for your needs.
ELSS Fund (Tax Saving MF)-
Equity Linked Savings Scheme (ELSS) is an open-ended lock-in fund meaning thereby that one can enter any time that one wants but since it’s a lock-in fund hence the money invested is locked for a certain period. In the case of the ELSS scheme, the lock-in of 3years and the money can only be withdrawn after the term has passed.
ELSS also offers a tax deduction under section 80c of income tax to an extent of 1,50,000.00 and is quite popular amongst investors as a tax-saving option as well.
STP stands for Systematic Transfer Plan wherein investors instead of investing in one single fund at one go (as a lump sum investment) do it in a staggered way.
The investor invests the amount in a liquid fund of the same fund house also called source fund and periodically transfers some amount over some time to the target fund (hence systematic transfer).
For example, let’s say an investor wants to invest in Axis Bluechip Fund (an equity fund) but does not want to put the entire amount of 10lakh at one go as he is not sure about how markets will pan out in near future and fears that in short term might suffer some loss due to volatility.
So in this case, he can put the amount of 10lakh in an Axis Liquid fund and opt for an STP mode wherein he transfers 1lakh per month throughout 10months from the source (liquid fund) to target (bluechip equity fund).
STP should not be viewed as a return maximization tool rather it’s a risk mitigation tool.
STP helps in averaging out the buying prices and lower the risk by countering the volatility of the market.
Dividend in Equity MF (Taxation)-
For a fund to be qualified as an equity fund category, at least 65% of the corpus has to be invested in equity.
Any capital gain within 1 year is treated as STCG (Short term capital gain ) and taxed at 15% and for more than 1 year is LTCG (Long term capital gain) and is taxed at 10% with an exempt of 1lakh per financial year.
Dividends from equity mutual funds are nontaxable at the hands of investors but are paid after deducting a tax of 10% (11.64 including cess and surcharge).