Things To Look At Before Investing In Equity Funds

Mutual Funds have become a household name in India with investors leveraging the benefits of a professionally-managed basket of securities. There are different types of funds designed to cater to the varying needs of investors like equity funds, debt funds, etc. Equity Funds are mutual funds that invest in stocks of different companies. 

The fund manager of an equity fund defines a risk level and investment approach to generate returns comparable to the benchmark of the scheme. 

As an investor, you need to go through all scheme-related documents and find a scheme that works for you.

Factors To Consider Before Investing In Equity Funds

If you are thinking of investing in equity funds, then here are some factors to consider that will help you choose the right fund:

1. Size Of The Fund

The size of the fund is the total assets under management (AuM). While there are no definitions regarding the ideal size of a mutual fund, if it is too large or too small, the fund’s performance can get affected. One way of looking at it is by comparing AuMs with the category average.

2. Expense Ratio

As a mutual fund investor, you will have to bear the fund management costs charged in the form of an expense ratio. Actively managed funds tend to have a higher expense ratio than passively managed funds. Ensure that you check the expense ratio and compare it with the category average.

3. Risk Reward Ratio

The Risk-Reward Ratio or RRR is the potential return an investor can earn for every rupee risked and invested in the market. It helps investors compare the returns they can expect from an equity fund investment and assess the maximum risk they need to take to achieve the returns. You must ensure that the RRR of the fund is in sync with your risk tolerance levels.

4. Types Of Equity Funds

There are different ways of categorizing a mutual fund as described below:

Categories based on the Investment Strategy of the fund

• Sectoral funds – These equity funds invest in a specific sector(s) of the market. So, you can have a BFSI or Pharma, or IT equity fund that invests in the said sector alone.
• Thematic funds – These equity funds follow a theme for picking stocks. Some examples are an emerging market theme where the fund invests in stocks from emerging markets (countries), exports and services theme, etc.
• Focused Equity Funds – The funds invest only in a fixed number of stocks. According to the guidelines issued by the Securities and Exchange Board of India (SEBI), Focused Equity Funds can invest in a maximum of 30 stocks across different market caps. The market capitalizations of the companies selected have to be in sync with those specified at the time of the launch.

A Focused Equity Fund is like a multi-cap fund with a limit on the number of stocks it can invest in. Hence, it is a concentrated portfolio of funds. Unless specified otherwise in the scheme documents, a focused equity fund can invest across various sectors too. Since these funds have only 30 stocks, the fund manager has to take big positions in each stock. Hence, they can be volatile in the near-term. However, in polarized markets, if the fund consists of stocks that are driving the markets, then the returns can be better than other multi-cap or diversified funds.

• Market cap: There are small-cap, mid-cap, large-cap and multi-cap funds.

• Investment style: Funds based on investment style are value funds and contra funds. While value funds invest in undervalued stocks, contra funds usually go for stocks that are presently not performing well.

5. Tax Benefits

Equity Linked Savings Schemes or ELSS funds are equity funds that offer tax benefits under Section 80C of the Income Tax Act, 1961. You can avail of a tax exemption of up to Rs.1.5 lakh per financial year from your annual taxable income.

6. Taxation Of Equity Funds

When you invest in equity funds, the capital gains and dividends are taxed as follows:

Capital Gains

• Long-Term Capital Gains (LTCG) Tax – For equity mutual funds, LTCG is applicable on mutual fund units held for more than one year. If the LTCG amount is up to Rs.1 lakh, then there is no tax liability. If more, then the amount above Rs.1 lakh attracts an LTCG Tax at 10% without indexation benefits.
• Short-Term Capital Gains (STCG) Tax – For equity mutual funds, STCG is applicable on mutual fund units held for one year or less. The STCG tax is levied at 15%.

7. Dividends

The Dividend Distribution Tax (DDT) was abolished in April 2020. However, a new Section 194K was introduced under which dividends paid in the excess of Rs.5000 are subject to a 10% TDS. This is applicable to the Dividend Option alone. Also, you will have to pay tax on the dividend received as per your tax slab. Any TDS deducted (vide Section 194K) can be subtracted from the tax liability on dividend income.

8. Think About Your Financial Goals

If you are planning to invest in equity funds, then it is important to keep your financial goals in mind before signing the dotted line. Every equity fund can be unique with a different risk level, fund composition, and track record. Also, all investors are unique and have different risk tolerance levels, financial goals, and investment horizons. Hence, it is important to look for funds that suit your requirement.

9. Performance Of The Fund

When you start looking for an equity fund, look at the fund’s performance over the past 4-5 years. Look at how the fund has performed compared to its benchmark and peer funds within the same subcategory. Look for funds that have consistently beat their benchmark over time.