Equity Mutual Funds are one of the most return generating securities in the MF sector. They invest in the Equity shares of multiple companies and sectors to form one well-managed Equity fund.
Owing to the diversification in different funds, there are MF schemes for various purposes and risk levels. For instance, if a fund only invests in one sector of shares, it is termed a sectoral fund. Thereafter, there are many external and internal factors that affect how each scheme will function.
As an investor, it can get tricky to choose the right scheme in order to gain the maximum benefit out of it. In this post, we have compiled 6 key factors that you should consider before stepping into Equity funds.
Let’s get into it.
1. Your Financial Goals
The first and foremost thing to consider before putting your money in Equity MF, or any other scheme for that matter is to define your goals from that investment. To set a smart goal, answer how much wealth do you wish to create for a specific goal and in how much time do you need that money.
When you have derived an investment goal and horizon, consider your risk profile according to the stage of the investor life cycle you fall in. For instance, a person in his accumulation phase can afford more risk than a person nearing retirement.
Equity Mutual Funds usually fall under moderately high risk. Thus, only investors with a certain risk appetite should opt for this avenue.
2. Types of Equity Mutual Funds
The next is choosing the right type of Mutual Fund. A Mutual Fund is highly customizable security. There are different schemes for the unique needs of every investor. In the case of Equity Mutual Funds, there are 5 key categories of funds:
These are the kind of funds that follow a certain theme in their portfolio diversification. For instance, a fund investing in agriculture-themed companies will hold shares of companies dealing in cement, power, steel, etc.
Thus, a change in the theme of a fund will impact how it performs in the market.
Sectoral Funds are similar, but narrower in scope than thematic funds. They only invest in companies from a specific sector.
For instance, a fund investing in the BFSI domain will hold stocks of banks and other financial institutions.
Focussed Equity Funds
These equity funds have a concentrated portfolio of up to 30 stocks. These funds can invest in shares of various sectors or sizes. The only condition is the specific number of stocks it can hold.
Since a fund manager can buy only 30 stocks in a focussed Equity Fund, the holding of each stock is high. It means the fund will be highly affected by market volatility.
In favorable conditions, Focussed Equity Stocks perform better than any other diversified or multi-cap funds.
Companies are ranked in the market according to their size and market share. For instance, Fortune 500 depicts the top 500 companies of the world.
Equity Mutual Funds are categorized according to their investment in the various capital sizes of companies. They include small, mid, and large-cap stocks.
Companies with a ranking of 250 and below in the market fall under this category. In India about 95% of the companies are small-cap. Small-cap Equity Funds invest 65% of their holding into such companies and offer great returns in comparison to the mid and large-cap funds.
Mid Cap Funds
They invest in companies from the 101-250th position in the market and offer better returns than large-cap funds.
Large Cap Funds
And finally, Large-cap funds invest in the top 100 companies and are considered more stable in returns than any other.
The last category of Equity Mutual funds is the investment style. It includes Value funds that invest in undervalued stocks and contra funds that invest in stocks that are under-performing at the moment. Both these types of funds try to catch the market bottom in order to benefit from the price hike.
3. Characteristics of a Mutual Fund
Mutual Funds have various factors that affect their performance in the market. Here are three key factors to judge a good Equity Mutual Fund:
Size of the Fund
It refers to the total wealth invested in that fund and is termed as AUM(assets under management). The AUM is the market value of all investments made under a particular fund.
In Equity Mutual Funds, Large-cap funds have a high AUM in comparison to mid and small-cap funds. However, high AUM does not necessarily mean a good fund. It means many people have invested in the fund i.e the trading volume is high.
While it is an important factor in choosing a mutual fund, it should not be the sole reason. One should be beware of following the masses. Sometimes, due to high AUM, the fund manager is not able to take quick decisions.
Mutual Funds are a well-managed pool of stocks with diversified risk and high return generation potential. This management is done by a fund manager. Thus, in return for the fund manager’s efforts, an investor pays a certain amount. This is called the expense ratio.
Funds with active management have a higher expense ratio. As an investor, you should compare the expense ratios of various funds to the category average.
Every Mutual Fund follows a certain strategy in its asset allocation. Some funds invest largely in mid-cap stocks while others stick to small or large cap stocks. Change in this strategy affects the performance of the fund in the market.
When a fund manager moves away from the objective or strategy of a fund, it is termed as a “portfolio drift” which can sometimes negatively impact the fund performance.
In case of this change, the investors should clearly understand the reasoning and motive behind it before investing or continuing to invest in a certain Mutual Fund. Press releases and company statements help gather this data.
4. Taxation on Equity MFs
When you invest in Mutual funds, there is a certain amount of tax you need to pay on the capital gains and dividends. They are taxed as follows:
Short-term Capital Gain (STCG) Tax
Short Term Capital Gain refers to the profit generated from investments in one year or less. In this case, 15% tax is levied on the total amount.
Long-term Capital Gain (LTCG) Tax
LTCG is levied on investments of more than one year in the market. Since Mutual Funds promote long-term wealth creation, no tax is levied on up to 1 lakh of investment, for more than 1 year.
Above 1 lakh, 10% tax is levied on LTCG.
Equity Linked Saving Scheme
This is a special scheme designed for investors to save tax on STCG and LTCG. The Equity Linked Saving Scheme or ELSS offers tax benefits of up to 1.5 lakh on your total taxable amount.
This is as per section 80C of the Indian Income Tax Act.
5. Dividend Distribution
Earlier, dividends distributed by companies to their investors were taxed under the Dividend Distribution Tax (DDT). However, it was abolished in April 2020 and a new section 194K was introduced.
According to this section, dividends exceeding INR 5000 are applicable to 10% Tax Deductible at Source. Investors have to pay this TDS plus tax according to the tax slab they fall in.
6. Historical Performance
The most common indicator of any fund’s performance is its returns over the years against its benchmark. Before selecting any Equity Mutual Fund, investors should track the fund’s performance for the last 5-10 years to get an idea of its growth pattern and frequency.
However, it is important to note that historical performance should not be viewed as the potential performance of the fund.
Other Key Factors to Remember
Direct Plans give Higher Returns
There are two ways of investing in Mutual funds: Directly in a fund house or indirectly through a distributor or advisor. If you choose to invest with a distributor, you are availing his/her services and thus have to pay a certain commission.
Thus, investing via a direct plan is more profitable for investors. Also, the expense ratio of a direct plan is lesser than that of an indirect plan.
Consistency is Key in MF Returns
While analyzing the historical performance of a stock, one should look for consistency instead of high numbers. A company giving consistently growing returns is better than one giving very high returns.
This is a very important factor in deciding on an MF scheme.
SIPs are a Gold Mine to Minimize Risk
As the name suggests, a Systematic Investment Plan organizes and aligns your investment portfolio. With automated SIPs, you don’t only save the recurring hassle, but also leverage Rupee-cost averaging.
This means, when the market shows bullish behavior, you can avail more units for the same price.
SIPs are a great way for investors looking to enter the MF sector.
We explained the various factors an investor should consider before investing in Equity Mutual Funds. While they come with a moderately high level of risk, the return generated is worth it. Thus, with proper research and knowledge, investors can create good wealth in the market.
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