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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.

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Factors To Consider Before Investing In An Equity Fund

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 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 for 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 horizon. 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.

Key Takeaways

  • The size and performance of the fund needs careful evaluation before selecting an equity fund
  • The expense ratio can impact your returns. Check if the fund’s expense ratio is close to the category average.
  • The risk-reward ratio can help you find a fund with a risk level within your tolerance range.
  • There are different types of equity funds that can be chosen based on your investment plan.
  • ELSS funds are equity funds that offer tax benefits under Section 80C of the Income Tax Act, 1961.
  • The tax rules for equity funds for the financial year must be checked before making the investment.

FAQs about Equity Funds

Q1. What is an Equity Fund?

Answer: An equity fund is a type of mutual fund that primarily invests in stocks.

Q2. What are the benefits of an equity fund?

Answer

An equity fund offers a range of benefits like:

  • Diversification – Since an equity fund invests in a basket of stocks, it allows you to benefit from a diversified portfolio. In comparison, if you were to invest in stocks directly and purchased a few, then the risks would be higher since you would own fewer stocks than an equity fund.
  • Professional Management – The fund management team of an equity fund is trained and spends a lot of time tracking companies and the investment potential of stocks. This allows the fund manager to select the best stocks for the portfolio.
  • Start with a small amount – If you are looking at buying quality stocks, then the amount you will have to spend to get a handful would be large. On the other hand, you can gain exposure to the same selection of stocks by buying an equity mutual fund for as low as Rs.500/1000.

Q3. What are the different types of mutual fund schemes>

Answer

The different types of mutual fund schemes are as follows:

  • Large-Cap Fund
  • Mid-Cap Fund
  • Small-Cap Fund
  • Multi-Cap Fund
  • Focused Fund
  • Dividend Yield Fund
  • Contra Fund
  • Sectoral Fund
  • Thematic Fund
  • ELSS fund

Q4. What are the risks associated with equity funds?

Answer:

The risks associated with equity fund are as follows:

  1. Liquidity Risk – The fund manager might not be able to sell holdings at the desired price at all times leading to the liquidity risk.
  2. Price Risk – The stock market is inherently volatile. Hence, the stock prices can go up or down causing the NAV of an equity fund to fluctuate too.
  3. Macroeconomic Risk – Macroeconomic factors that impact the stock markets have an impact on equity funds too.

Disclaimer: This blog has been contributed by the content desk of IIFL Asset Management Ltd. The views expressed here are of the author and do not reflect those of Groww.

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Investment in securities market are subject to market risks, read all the related documents carefully before investing. Please read the Risk Disclosure documents carefully before investing in Equity Shares, Derivatives, Mutual fund, and/or other instruments traded on the Stock Exchanges. As investments are subject to market risks and price fluctuation risk, there is no assurance or guarantee that the investment objectives shall be achieved. NBT do not guarantee any assured returns on any investments. Past performance of securities/instruments is not indicative of their future performance.