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Understanding Equity MFs

This episode opens with the basics of mutual funds, with focus on types of equity funds, their selection criteria, things-to-consider and taxation on returns.

55439 views  16 Oct 2017

All about Equity Mutual Funds

Equity mutual funds investments are one of the most popular investment options to build a huge corpus in the long-term. There are a number of reasons why you should consider investing in mutual funds. Firstly, mutual funds are managed by professional managers, and secondly they offer liquidity and diversify the investment risk. For instance, on an average, a large cap equity fund has given 15% CAGR return in the past 5 years.

However, despite the extensive campaigns from AMFI and funds houses, many newcomers still lack adequate knowledge about equity mutual funds. So let’s try to understand the basics of mutual fund investment.

What are Mutual Funds?

In a mutual fund, money from various investors is pooled together and invested in a portfolio of instruments. A mutual fund may invest only in equities or debt instruments or a mixture of the two, also called balanced funds.

Types of Funds

Fund can be broadly categorized as open-ended funds, close-ended funds and interval funds.

  • Open-ended funds:
    It allows the mutual fund investor to enter/exit the mutual fund scheme at daily NAV, subject to exit load at the time of withdrawal. In other words, the scheme does not have a lock-in period which requires holding money in the scheme for a specified tenure.
  • Close-ended funds:
    These funds are opposite to open-ended funds. It has a lock-in period and you have to compulsorily stay invested in the scheme for the specified tenure say for 3 years or 5 years. Additionally, unlike in open-ended funds, you cannot buy the units of a close-ended fund after its NFO period is over. This means that new investors as well as the current investor cannot enter/exit till the term of the scheme ends.
  • Interval Funds
    To get liquidity in close-ended funds, there is another category called ‘interval’ funds. Essentially, these are close-ended funds that become open to transactions during preset interval periods, for instance, first 5 days of every quarter.

Types of Equity Mutual Funds

  • Diversified Equity Funds
    Mutual fund schemes that invest more than 65% of the AUM in equities and equity related instruments are treated as equity mutual fund scheme. Equity funds can be further classified as large cap equity funds, mid cap funds and small cap funds. Large cap funds invest in companies which are highly liquid, blue chip companies, possibly market leaders in their respective sectors. Mid-cap funds invest in emerging companies with market capitalization that is lower than large caps, while small/micro funds invest in small companies with market capitalization that is lower than mid caps.
  • Sector Funds
    Sector mutual funds are a type of equity mutual funds which invest in a particular sector like Pharma, IT, Infra and, Banking and Financial.
  • Balanced Funds
    If a balanced fund invests more than 65% of its AUM to equity and equity related instruments, and rest in fixed income securities, it is called ‘Equity-oriented Balanced Fund’.

Things to Consider Before Investing in Mutual Funds

  • Historical Returns
    Once the category of fund has been identified, you should look for funds that have beaten the benchmark returns with higher consistency than other funds over a large period, say 5-10 years. Secondly, you should also consider Sharpe Ratio of the fund. The Sharpe Ratio gives the amount of return generated for each unit of risk. So, higher the Sharpe ratio, more attractive the risk-adjusted return.
    Scheme Name 1 Year 3 Year 5 Years 10 Years
    Category Return - Large-cap Funds 13.6 11.4 15.0 8.9
    Category Return - Mid-cap Funds 16.0 17.6 23.2 12.8
    Category Return - Balanced Fund (Equity-oriented) 11.2 10.8 14.7 10.0
    Category Return - Balanced Fund (Equity-oriented) 10.6 5.5 10.8 6.1

    1 year returns are absolute; returns above 1 year are CAGR.
    Returns as on September 28, 2017

  • Evaluate Fund Managers
    You should compare performance of all the funds managed by the Fund Manager with their respective benchmarks and peers across market cycles. If the funds have given higher return than the benchmarks and peers, then the Fund Manager is worth relying on.
  • Beta
    Beta is a measure that is used to find out the sensitivity of equity funds to market movements. A beta of 1.25 means that fund’s return on an average is 1.25 times the benchmark returns. In bull market, this is a reason to cheer, while in falling markets, your fund will fall more than the benchmark.
  • Check the Expense Ratio
    Expenses make a difference in net returns between two identical schemes. This is because expenses are knocked down from the market value of the investments. Let’s consider two funds, X and Y, with exactly same portfolios, but the first charges 1.50% expense while the second charges 1.0% expense. The second fund will generate an extra 0.50% return over the first one.

Taxation on Mutual Funds

Equity Funds

Profits earned on equity mutual fund investments for a period of less than one year are taxed at 15%. It is known as short-term capital gains tax. However, dividends and long-term gains from equity and balanced funds (that have 65% or more of their assets invested in equity) are tax free for the investor.

Taxation on Equity Mutual Funds for Individual/HUF (2016-17)

Capital Gains Taxation

Equity Oriented Funds Tenor Individual/HUF
Long term capital gains Units held for more than 12 months NIL
Short term capital gains Units held for 12 months or less 15%*

*excluding cess and other taxes

Taxation on Dividend (Payable by Investor/HUF)

Scheme Type Individual/HUF
Equity oriented schemes Nil

Dividend Distribution Tax (payable by the MF schemes)

Scheme Type Individual/HUF
Equity oriented schemes Nil