What are Equity Mutual Funds? Types, Benefits & How They Work

Have you ever wondered how some people use the stock market to make more money without investing hours in researching market trends or company reports? 

The answer often lies in equity mutual funds, a smart investment vehicle that has helped millions of Indians build their financial futures.

Let me take you through everything you need to know about equity mutual funds in a manner that will actually make sense, devoid of confusing jargon.

Picture this: You want to invest in the stock market, but you either don’t have the time, the expertise, or maybe even the confidence to pick individual stocks. This is where equity mutual funds come into play.

Data from the Association of Mutual Funds in India shows that the industry manages assets worth more than ₹50 lakh crore as of 2024, of which a substantial proportion consists of equity funds. That’s a lot of trust placed in these investment vehicles! But before you jump in, let’s understand what these funds really are and whether they’re right for you.

What are Equity Mutual Funds?

An equity mutual fund is basically a pooled investment scheme wherein money is collected from a large number of investors and invested mainly in stocks or equities of various companies.

Think of it this way: instead of you purchasing stocks on your own, you are pooling your money with thousands of investors, and that cumulative corpus is used to purchase shares from various companies.

Here’s what makes them special: Professional Management, Diversification, and Accessibility.

How Equity Mutual Funds Work

When you invest in an equity mutual fund, you buy units at the prevailing NAV. NAV is per unit price, dividing the total value of all assets by the  outstanding number of units.

Here is how it works: Your money becomes a part of the pool of investors’ money to form a large corpus. The fund manager researches extensively and decides, depending on the investment objective of the fund, which stocks to buy, hold, or sell.

They consider company fundamentals, valuation metrics, sector outlook, and economic indicators while building the portfolio. The NAV changes each day, depending on the performance of the underlying stocks. You can redeem your units whenever you want, at which time you will realize gains or losses.

Fund houses charge an expense ratio (capped at 2.25% by SEBI for equity funds) to manage your money. It includes the cost of fund management, administration, and distribution.

Types of Equity Mutual Funds

SEBI has laid down explicit categorization norms. Let’s delve into the major types:

Large Cap Funds invest at least 80% in the top 100 companies by market capitalization in India. They are less volatile but offer moderate growth, which is very suitable for conservative investors.

Mid Cap Funds invest 65% or more in companies ranking from 101st to 250th. They look for firms during their growth stages and are quite volatile but may give higher returns.

Small Cap Funds invest at least 65% in companies ranked 251st and below. These are high-risk, high-reward investments suitable only for investors who have long time horizons.

Sectoral/Thematic Funds invest in sectors such as banking, defence or IT. While they can give star returns when that particular sector booms, they are highly risky on account of concentrated exposure.

Thus, ELSS carries a three-year lock-in period and gives a tax deduction up to ₹1.5 lakh under Sec 80C. Although it has a lock-in period, it still carries the shortest time period of commitment for tax-saving instruments.

Value Funds seek to find undervalued companies traded below their intrinsic value, while Focused Funds invest in no more than 30 stocks, which represent the fund manager’s best convictions.

Benefits of Equity Mutual Funds

Professional Expertise: You are investing in a fund managed by experienced professionals who are NISM-certified and regulated by SEBI. The fund managers have access to research and tools that individual investors do not have.

Diversification: Your money will be invested in 40-50 or even 100 plus companies instead of taking positions in just a few stocks. When one company goes down, it is just a dent in your portfolio.

Liquidity: Most equity mutual funds other than ELSS allow redemption on any business day. Money reaches the account within 1-3 days of such redemption.

Low Entry Barrier: Equity mutual funds democratize wealth creation by allowing SIPs to start from ₹ 500 onwards. You need not start investing with lakhs.

Tax Efficiency: Long-term capital gains up to ₹1.25 lakh per year are tax-free, with amounts above taxed at just 12.5%. This is more favorable than many other investment options.

Risks & Limitations

Market Risk: Equity funds fall when markets go down. The COVID crash in 2020 saw funds fall 30-40%. This is the fundamental risk of equity investing.

No Guaranteed Returns: Unlike fixed deposits, there’s no assured return. You could make 30% one year and lose 15% the next.

Fund Manager Risk: You’re putting faith on someone else with your money. If your fund manager leaves or makes wrong decisions, your returns will suffer.

Exit Load: Most equity funds charge 1% if you redeem within a year. This reduces your flexibility.

Expense Ratio: Think of the 1-2% annual charge compounding over 20-30 years-that’s a potential cost of lakhs.

Taxation of Short-Term Gains: If held for less than a year, the after-tax return is 20% lower, which eats into the returns quite significantly.

The key? Invest only money you won’t need for at least 5-7 years. The markets reward patience, not panic.

Overview: How to Choose an Equity Mutual Fund

Retirement 25 years away? Go aggressive. Child’s education in 7-10 years? Opt for large and mid-cap funds.

Match Your Risk Appetite: Be honest. If a 20% fall would make you panic-sell, then stick to large-cap funds.

Check Long-Term Performance: Consider 5, 7, and 10-year returns, not just last year. Consistency is more important than a spectacular one-year gain.

Compare against benchmarks: Has the fund beaten the benchmark Nifty 50 for large caps, etc. consistently?

Consider Expense Ratios: Smaller expenses mean your money stays invested for you.

Don’t chase last year’s best performer or continually switch between different funds based on short-term performance.

Taxation & Exit Considerations

Long-term capital gains: If you hold the stock for over 12 months, gains up to ₹1.25 lakh annually are tax-free; above, 12.5% tax applies.

Short-term capital gains: sell within 12 months? Your gains attract 20% tax.

Dividend Taxation: Dividends are taxed at your income tax slab rate.

Exit Load: Most funds charge 1% for exits made within one year.

But exit when the objective is met or the fund continuously underperforms, or the risk profile changes. One should not exit owing to market crashes or one particular bad year.

Conclusion

Equity mutual funds provide professional management, diversification, and the potential for long-term wealth creation, keeping ahead of inflation. They are accessible, their working is regulated by SEBI, and they are tax-efficient. However, they do come with market risks and demand some patience.

Clearly define your goals, select funds that correspond with your appetite for risk, and remain invested for at least a period of 5-7 years. Be it retirement planning, saving for your child’s education, or wealth creation, equity mutual funds can be your strong ally in this financial journey. The key is informed decision-making and disciplined investing.

Also read: Debt Mutual Funds

Frequently Asked Questions (FAQs)