All you wanted to know about Equity Mutual Funds

Mutual funds have become the most sought after investment avenues today. They are affordable to invest in, promise attractive returns, diversify risks, are easy to liquidate and, in some cases, give you tax advantage too. That is why many of us choose different types of mutual funds for meeting our various financial goals.

Talking about the different types of mutual funds, equity mutual funds are one of the most popular type of mutual funds presently. However, even though a majority of investors have a considerable portfolio consisting of equity mutual funds, they are not fully conversant with them. So, here’s a complete guide to equity mutual funds.

What are equity mutual funds?

Equity mutual funds are mutual funds which invest at least 65% of their portfolio in equity and equity oriented investments. Thus, these funds are volatile as they carry similar risks as that of other equity investments e.g. stocks. The returns, however, have also been high in the long term (but can be negative in the short term). In fact, equity mutual funds have delivered the highest returns among the different types of mutual fund schemes over the long term.

Risks in equity mutual funds

There are two main types of risks which you can find associated with equity mutual funds.

1. Market risk

Market risk is the inherent risk present in all equity type investments be it stocks or Mutual Funds.

Stock markets move up and down based on economic news, corporate performance and investment sentiment. If the stock markets fall, the value of all equity investments including Equity Mutual Funds also fall (i.e. the NAV of the Mutual Fund goes down).

Market risk is also referred to as market volatility and equity mutual funds have a very high market risk as their returns depend on market movements.

Market risk is higher for mutual funds that invest in smaller companies than for mutual funds that invest in bigger companies since stocks of smaller companies are more volatile.


2. Concentration risk

Concentration risk deals with the composition of the mutual fund portfolio. If the fund manager allocates a majority of the funds to a single stock or sector, it leads to concentration (opposite of diversification). Because of this any adverse impact to that stock or sector will have a highly negative impact on the investment’s value and may take years to recover.

This risk is mainly present in sector and thematic mutual funds for eg a Pharma Sector Mutual Fund will invest only in the Pharma sector and hence if the pharma sector goes into a downturn then the fund will also have negative returns even if rest of the economy is doing well.

Types of equity mutual funds

Equity mutual funds are categorised into 11 different types of funds by SEBI. This categorisation is broadly done on the basis of three parameters.

  1. Market capitalisation of the investments in the fund portfolio
  2. Sectors and themes in which investments have been done
  3. Style of investing of the mutual fund portfolio

These are the 11 different categories of equity mutual funds –

Categories of equity mutual funds Composition of the fund Rationale for investment
Large cap fund At least 80% investment in large cap equity stocks and equity related instruments To invest in safe blue-chip stocks for less volatile returns
Suitable for equity investments of investors with low risk profile
Large and Midcap Fund At least 35% investment in large cap equity and another 35% in mid-cap stocks To invest in a mix of stocks of large and mid-sized companies
Higher risk and returns than purely large cap funds
Suitable for equity investments of investors with moderate risk profile
Midcap Fund At least 65% investment allocation to mid-cap companies’ stocks To invest primarily in stocks of mid-sized companies
Higher risk and returns than Large & Midcap funds
Suitable for equity investments of investors with high risk profile
Small cap Fund At least 65% investment allocation to small cap companies’ stocks to invest primarily in stocks of small companies
High risk & volatility i.e. in bad times can lead to huge losses and in good times huge returns
Suitable for equity investments of investors with high risk profile
Multicap Fund Mixed investment in large cap, mid cap and small cap stocks without any restriction of minimum allocations to a specific market-cap To invest in a mix of stocks irrespective of company size
Higher risk and returns than purely large cap funds
Suitable for equity investments of investors with moderate risk profile
Dividend Yield Fund Primarily invest in stocks which pay good dividends Strategy based fund so have lower flexibility in stock selection
Suitable for investors looking to specifically invest in a dividend yield strategy
Value and Contra Funds Value funds – primary investments in stocks which are undervalued as per the fund manager’s perspective
Contra funds – investment in stocks which perform contrary to market movements
Strategy based fund so have lower flexibility in stock selection
Suitable for investors looking to specifically invest in a value or contrarian strategy
Focused Funds Investment in a maximum of 30 stocks Higher concentration risk because of fewer stocks in portfolio
Can be a part of equity investment portfolio of investors with moderate or high risk profile
Sectoral or Thematic Funds At least 80% investment in the designated sector like banking, pharmaceuticals, information technology, etc. Sector specific funds so high concentration risk
Only suitable for investors looking to invest in a particular sector
Not recommended for general purposes
Index funds Primary investment is done in the stocks of a particular index like Sensex or Nifty in the same weightage as the index Passive investment to replicate the returns of an index like Nifty or Sensex
Used by investors who don’t believe in active management
Equity Linked Saving Scheme (ELSS) At least 80% of investment is done in equity and equity oriented stocks For availing tax advantages under Section 80C on the invested amount
Has a lock-in of 3 years

Equity Fund Options: Growth, Dividend Payout, Dividend Re-investment

All equity funds are available in three options. In all three options the underlying investment portfolio is the same, but they differ in treatment of profits earned.

Growth option

Under this option, the fund keeps on growing as per the market returns. The profits earned are reinvested further thus leading to compounding. In order to take money out you need to sell your Mutual Fund units (partially or fully).

This option is generally the most popular and recommended option for long term investing.

Dividend Payout option

Under this option, the profits earned by the mutual fund are paid out to the investor either fully or partially (via NEFT or bank cheque) on a periodic basis and the principal amount stays invested.

If there are no profits or there are losses then no dividend that gets paid. Losses get reflected in the value of the principal amount going down.

As of 1st April 2018, there is also a 10% TDS on the dividend amount being paid out.

This option does not lead to compounding and hence is generally not recommended.

Dividend Reinvestment option

Under this option, the profits earned are not paid out but are re-invested as fresh units into the same fund. So final outcome is the same as that of growth option but instead of NAV increase there is an increase in number of units held.

This option mainly exists to take advantage of the fact that dividends are taxed at a lower rate than capital gains.

However now that there is a TDS of 10% on dividends since 1st April 2018, this is not a very useful option anymore.

You can choose any of the three option of the same mutual fund scheme but generally the growth option is recommended. The returns will be higher in this option since no money is being taken out.

You can read more about the difference between Growth and Dividend options here.

Equity Fund Plans: Regular and Direct

Moreover, each option of each equity mutual fund is available in two plans depending on who/where you get it from. These are as follows:

Regular plan

These plans are provided by Mutual Fund distributors like your bank or Goalwise. It’s the same Mutual Fund but with a small additional distribution fee (0.1-1% typically) in lieu of the service provided by the distributor (platform, convenience, customer service, fund recommendations, financial planning advice etc).

This distribution fee is included in the expense ratio of these funds and hence the expense ratio is slightly higher by that amount.

Direct plan

Direct plans can be purchased from Mutual Fund companies’ websites or from platforms like CAMS and KARVY directly without the involvement of any distributor by investors who do not require any customer service or advice (including fund recommendations). Since there is no distributor commission involved their expense ratios are slightly lower.

Depending on whether you want to manage your investments yourself or want help, you can choose to invest through a distributor/advisor or directly.

Modes of investment - Lumpsum and SIP

For investment into mutual funds, you can choose to invest lump sum amounts as and when you have the money or invest in regular monthly instalments.

Monthly instalments are called Systematic Investment Plans (SIPs) and they can be started with very small amounts of even Rs.500 per month. SIPs are affordable and give you the benefit of rupee-cost averaging because they invest on a fixed date of each month at the NAV prevalent as on that date.

Read more about choosing lumpsum vs SIP here.


Taxation of investments in Equity Mutual Funds

The returns and dividends earned from equity mutual funds are taxable, whether you are investing for the short term or long term.

Tax on investment in equity mutual funds

The principal amount invested in equity mutual funds generally comes from your income which has already been taxed so there is no further tax on it during redemption.

In addition to that, in case you are investing in an Equity Linked Saving Scheme (ELSS), even the principal amount is allowed for income tax deduction under Section 80C. The maximum amount eligible for deduction under this section is limited to INR 1.5 lakhs in a financial year.

Read more about ELSS funds and tax saving under section 80C.

Tax on returns earned from equity mutual funds

The returns earned from equity mutual funds are categorised as short term capital gains or long term capital gains depending on the period for which you stayed invested in the fund.

If you sell the investment or any part of it within 12 months of investment, the resulting gains from that sale are called short term capital gains. If, however, the period of investment was at least 12 months, the gains are called long term capital gains and will be taxed at a lower rate.

Let’s understand how these gains are taxed –

Short term capital gains (STCG) – short term capital gains earned from equity mutual fund investments are taxed at a flat rate of 15% of the gains (irrespective of your income slab).

Long term capital gains (LTCG) – long term capital gains are tax-free if they are limited to INR 1 lakh. If, however, the LTCG from equity mutual funds exceed INR 1 lakh in a financial year, a flat rate of tax of 10% is applied on the LTCG amount exceeding INR 1 lakh.

This means that if the total LTCG earned from equity mutual funds is Rs 1.5 lakhs, you would have to pay a tax of 10% on Rs 50, 000 i.e. Rs 5,000.

(Note: Till FY 2017-18 tax on LTCG was 0. It was increased to 10% from FY 2018-19. To give some relief from the new LTCG taxation rule, any LTCG accrued up to 31st January 2018 have been grandfathered i.e. considered as tax exempt).

Tax on dividends earned

The dividend declared under equity mutual funds is taxed at the rate of 10% under the Dividend Distribution Tax. This tax is deducted at source by the Mutual Fund company and the remaining amount is paid out as the dividend. Hence the amount you receive is tax-free in your hands (since the tax has already been paid).

For more infomration, read our detailed guide to Mutual Fund taxation.

Exit Load

Exit load is a percentage-based fee deducted by the Mutual Fund if you withdraw the money within a short period of time after investing.

The exit load varies from fund to fund but generally most Equity Mutual Funds have an exit load period of 1 year before which they charge an exit load fee of 1% on the amount being redeemed.

Hence it is generally not advisable to redeem your Equity Mutual Funds before 1 year unless there is some emergency (another reason why we recommend setting up an emergency fund before investing for your long term goals).

So, this is what equity mutual funds are and how they work. Understand these details of equity mutual funds before you invest in them so that you know how they work and what to expect from them.