Types Of Equity Funds
Equity funds are the most popular of all the different types of mutual funds. These funds invest in the stocks of different companies. They are managed by a fund manager, who decides when to buy and sell equities to maximize gains and minimize risks. There are many types of equity funds to meet different investment needs.
Equity funds are very popular with investors for several reasons. One, they can invest small amounts in mutual funds. Two, they are able to spread risks since they get exposure to many stocks when they invest in a mutual fund. Three, these funds are managed by professionals who are experts in their field. Systematic Investment Plans, or SIPs, also make it possible for investors to invest small amounts each month according to what they can afford.
While investing in equity carries market risk and no one can predict the direction of stock prices accurately, it has over the years made higher returns than most other asset classes, like gold, real estate or fixed income instruments. So if you want to get on to the equity bandwagon, you have to invest in one of the many types of equity funds.
Open ended funds
Most types of equity funds fall in the open ended category. In the case of an open ended fund, once an asset management comes out with a new fund offering (NFO), fund always remains open to the public. So investors can put in their money into this fund at any time, and redeem funds at any point. These mutual funds are bought and sold at their net asset values (NAV). NAV is the net value of each share. That is, assets minus liabilities divided by the number of outstanding shares. NAVs are declared each day by the AMC.
Close ended funds
Close ended funds are open for a certain fixed period, after which they are closed for further investment. They are then listed on the stock exchange and traded like any other share. Prices are determined on the stock exchange according to the demand and supply for the fund, and they may be higher or lower than the NAV. The problem with these funds is that since they have a fixed maturity period, they can be redeemed only at a certain point of time, and there’s no telling if the market conditions will be favourable at that time
Large cap funds
Large cap funds invest in large, well-established companies with large market capitalisation. According to the Securities and Exchange Board of India (Sebi), the top 100 companies in terms of market cap in the BSE Sensex have been classified as large cap companies. Among the different types of equity funds in India, large cap funds are the most popular. Large cap funds are suited for investors who want regular, stable returns and less risk. Information on large cap companies is readily available and it’s fairly easy for investors to make decisions on buying or selling these stocks. However, the potential for growth is fairly limited since these are mature companies and may have reached their peak.
Mid cap funds
There are some types of equity funds that are suitable for investors who are willing to bear more risk in order to make higher returns. Mid cap funds come within this category. Mid cap funds invest in those companies that are still in the growth stage, unlike large cap companies which are mature. Mid cap tend to more volatile. That is, NAVs of mid cap funds tend to fall sharply during a bear phase than large cap funds. However, when the stock market is bullish, returns from mid cap funds tend to be higher.
These types of equity funds are not suited for investors who are new to the stock market or are risk averse since they may not be able to handle such volatility with equanimity. While some of these mid cap companies could grow into giants, the ride may not be a smooth one, and any bump on the road could lead to panic among investors and lead to a huge price drop. Some could even fall by the wayside. In order to realise maximum gains, you will need to stay invested in these funds for at least 10 years. According to Sebi guidelines, companies that are ranked between 101 and 250 in terms of market capitalisation fall into the mid cap category.
Small cap funds
Small cap funds invest in shares of companies that are still in their infancy. Since most of these companies are relatively unknown, risks can be high in these types of equity funds. It needs the skills of an experienced fund manager to find shares of companies that show promise. The payoffs can be substantial from these types of mutual funds, if you are a risk taker. Like mid cap funds, these too need to be held for longer periods of time to realise true gains.
Because of the risks involved, buyers of small cap stocks tend to panic during a bear phase and rush to sell them. Since these stocks are relatively illiquid, fund managers may find it difficult to offload these shares during a bear phase and may have to sell them at a discount when there is redemption pressure. The result will be sharp drop in NAV.
According to Sebi guidelines, all listed companies except that fall in the first 250 in terms of market capitalisation fall in the small cap category.
For those unwilling to trust their finances to the mercies of a fund manager, the index fund could be right choice. Index funds invest in the shares of companies that make up an index, like for example the Sensex or the Nifty. Returns will therefore depend on the way these indices move. If the stock market moves up, index funds will go up in a similar proportion. Among the different types of equity funds, these fall in the lower risk category. But investors can miss out because there are funds that do outperform the Sensex or Nifty.
Index funds are passively managed funds, since the fund manager has a limited number of options while investing and there is no need for substantial intervention on his part. Therefore, expense ratio for these types of equity funds could be on the lower side. And lower expense ratios means more returns for investors.
A diversified fund invests across companies regardless of market capitalisation or sector. These types of equity funds enable investors to reap the benefits of diversification and reduce the risks involved in investing. Of course, this category includes a wide variety of schemes and risk profiles. While some may lean in favour of large cap companies, others may have a lot of mid cap and small cap shares in their portfolios. The risk profile of a diversified fund may be somewhere between a large cap fund and a mid cap or small cap fund. While the risks may be low, the returns from these types of equity funds may not be all that great either. This is because fund managers have to look at diverse stocks and may not be able to have the kind of focus that those managing other funds like mid caps or large caps have.
Sectoral funds are those that invest in specific sectors of the economy, like banking and finance, fast moving consumer goods (FMCG), infrastructure etc. Of course, exposure to one particular sector involves a higher level of risk because there is no diversification. This kind of fund is for those who know a particular sector well and are willing to place their bets on it. Returns will depend on timing based on research and knowing the direction the sector is taking. A wrong move could lead to sub-optimal gains or losses. In any event, sectoral funds should not form a major part of your mutual fund portfolio.
Some types of equity funds are eligible for tax benefits. Section 80C of the Income Tax Act has something called equity linked savings scheme (ELSS) that allows a deduction in taxable income. Most asset management companies have ELSS funds that allow you to invest a maximum of Rs 1.5 lakh and get a reduction in taxable income. For example, if you have an income of Rs 10 lakh and you invest Rs 1.5 lakh in ELSS, your taxable income will be Rs 8.5 lakh, leading to a considerable saving in income tax. However, investors must remember that ELSS have a lock in period of three years. But as far as tax saving instruments go this is on the lower side. Public Provident Fund (PPF), for instance, has a lock-in period of 15 years!
In these types of equity funds, fund managers focus on holding a small, select number of stocks, not more than 20 or 30. One of the disadvantages of this fund is the lack of diversification. Fund managers can reduce risk by investing in a large number of shares, however, returns can be pulled down by the underperformers. In the case of focused funds, fund managers are able to do more careful research and find stocks that can offer good returns to investors.
Multi cap fund
As the name suggests, this is one of the types of equity funds that invests in stocks of different market capitalisation. The fund manager may invest in large cap, mid cap and small cap stocks and the proportion may vary according to the investment objectives.
Contra equity fund
This is one of the types of equity funds that follow a contrarian approach to investing. Fund managers in charge of these funds go against the prevailing sentiment while buying or selling stock. For instance, they may sell while others are buying and buy when everyone else is selling. A contrarian investor believes that in a bear market there is a surfeit of pessimism and stocks are valued below their intrinsic values and therefore present a buying opportunity. Similarly, in a bull market excess optimism drives prices up too high and it could be a right time to sell.
Hybrid fund/ balanced fund
A hybrid or balanced fund invests in multiple asset classes to meet the need for varying investment objectives and risk appetite. A balanced fund may invest in a mix of debt and equity. This is among the types of funds that is preferred by conservative investors who want to enjoy the steady returns and low risk that a debt fund involves, combined with the high-return-high-risk profile of an equity fund. Generally, balanced funds in India invest 60 per cent of their corpus in debt and 40 per cent in equity. A conservative fund may invest less in equity and more in debt.
How to choose between different types of equity funds
All these different types of equity funds means that investors may have a tough time figuring out how to choose the right one. For that, you will have to consider several factors.
Cautious investors: For cautious investors, the best choices will be large cap funds or balanced funds. These types of equity funds may not offer higher than normal returns, but they involve less risk. Index funds too are an alternative since they just follow an index, and returns will depend on the general direction of the stock market.
Risk takers: For the risk takers, mid cap and small cap funds are the right choice. These are companies in the growth stage and have the potential to grow. These offer higher returns, but also involve higher risk.
Cost conscious: It’s better to be cost conscious while investing in mutual funds, since higher expense ratios will cut into your returns. There are some types of equity funds that are passively managed, like index funds. Since they don’t require active involvement of fund managers, their expense ratios will be on the lower side.
Tax benefits: ELSS funds offer an excellent way of saving tax and generate returns at the same time. You can save a sizeable chunk of income tax by investing in these types of equity funds.
Returns: Returns do matter when you are choosing to invest in an equity fund. You should compare returns of different schemes before investing. Download the AngelBEE mutual fund investment app to find the best mutual fund in each class.