What is an equity fund?

Equity funds are a category of mutual funds that primarily invest in stocks of various companies listed on the stock exchange. These funds pool money from multiple investors with the objective of seeking a relatively better return potential by participating in the stock market. Additionally, equity funds offer an opportunity for individuals to indirectly invest in a diversified portfolio of stocks, even with a modest amount of capital.

Table of contents

What is an equity fund?
Different taxes on equity mutual fund
Factors impacting tax on equity mutual funds in India
Tax planning strategies for equity mutual funds
Understanding equity and its role in long-term wealth creation
Understanding liquid funds
Transitioning from liquid funds to equity
Benefits of this strategy
Steps to transition from liquid fund gains to equity investments
Factors to consider
Why do many people choose equity mutual funds?
When is the right time to invest in equity mutual funds?
Why should you invest long term in Mutual funds?
Mistakes to avoid when investing in equity funds

Features of equity funds:

Professional management: Equity funds are managed by expert fund managers who make investment decisions on behalf of investors.

Diversification: Investing in a variety of stocks reduces risk since under performance in one stock/sector may be offset by others.

Liquidity: Investors can sell open-ended equity fund units on any business day at the prevailing NAV (Net Asset Value).

Benefits of equity funds:

Potential for growth: Equity funds offer the potential for capital appreciation over the long term.
Access to expertise: Investors benefit from the expertise of fund managers who analyse stocks and make informed investment choices.
Affordability: Even with a modest initial investment, individuals can access a diversified portfolio of stocks through equity funds.

Types of equity funds:

Equity funds come with several flavours, each with its unique characteristics and investment strategies. Here's a breakdown of some of the types of equity funds:

Large-cap equity funds:

Covers top 100 companies in terms of market capitalization.
These funds predominantly invest in stocks of well-established and large companies.
They are known for stability and relatively lower risk due to the size and reputation of the companies in the portfolio.

Mid-cap equity funds:

Covers 101-250 companies in terms of market capitalization.
These funds focus on stocks of medium-sized companies.
They offer a balance between growth potential and risk, making them suitable for investors with moderate risk tolerance.

Small-cap equity funds:

Covers companies beyond 251 in terms of market capitalization.
Small-cap funds primarily invest in stocks of smaller, emerging companies.
They have the potential for high growth but are also associated with higher volatility.
Suited for investors with a higher risk appetite and a long-term investment horizon.

Sectoral/thematic equity funds:

These funds concentrate their investments in specific sectors or themes, such as technology, healthcare, or bank, among others.
They allow investors to potentially capitalise on the growth prospects of a particular industry.
Risk varies depending on the specific sector's performance and market situation.

Dividend yield equity funds:

These funds focus on stocks of companies with a history of paying dividends.
They aim to provide a regular income stream in the form of dividends in addition to potential capital appreciation.

Multi-cap equity funds:

Multi-cap funds have the flexibility to invest across large, mid, and small-cap stocks.
In multi cap large cap, mid cap and small cap are compulsorily allocated 25%.

Investing in equity funds offer a gateway to the world of stocks for investors looking to build wealth over time. However, it's crucial to remember they also carry market-related risks. Therefore, it's advisable to consult a financial advisor before making investment decisions to align your choices with your financial goals and risk tolerance.

Different taxes on equity mutual fund

Here are the types of equity mutual funds taxation:

Income Distribution cum Capital Withdrawal or IDCW

IDCW means the distribution of income of a mutual fund scheme, which may include both dividends paid by stocks and capital gains earned by selling underlying stocks from the scheme portfolio. Income received by the investor as IDCW is added to their gross taxable income and taxed according to the income tax slab rate of the investor. In addition, there is also a standard TDS rate of 10% on dividend income more than Rs.5,000.

Capital gains tax

This tax is applicable when investors sell their mutual fund units at a profit. The rate of taxation depends on the type of mutual fund and the holding period:

For equity funds, which have more than 65% of the total fund amount invested in equity shares of companies, short-term capital gains (holding period less than 12 months) are taxed at a flat rate of 20% (plus applicable surcharge + 4% cess), irrespective of the investor's income tax bracket.

Long-term capital gains (holding period of 12 months and longer) up to Rs.1.25 lakh per financial year are tax-exempt. Any gains exceeding this limit attract a long-term capital gains (LTCG) tax at a rate of 12.5% (plus applicable surcharge + 4% cess), without the benefit of indexation.

Factors impacting tax on equity mutual funds in India

In the dynamic financial landscape of India, several factors can influence the tax on equity funds. Let’s examine them:

Holding period: The duration for which you hold equity mutual fund units directly affects the tax treatment. Therefore, long-term and short-term capital gains are taxed differently.
Type of mutual fund: Equity mutual funds are classified into different categories based on their investment objectives and underlying assets. Different tax rules apply to equity-oriented funds, and equity-linked saving schemes (ELSS) that come with a lock-in period of 3 years.
Capital gains: A profit made from selling a capital asset for a higher amount than its purchase cost is referred to as a capital gain. The capital gains you earn over time also influence the tax of equity funds.

Tax planning strategies for equity mutual funds

When it comes to managing your equity mutual fund tax, there are a few key aspects to consider:

Stay consistent: The duration for which you hold your equity mutual fund units can impact your tax liability. Avoid frequent buying and selling of equity fund units and consider them as long-term investments.
Opt for SIPs: SIPs provide a disciplined approach to investing in equity mutual funds. While each SIP instalment is considered a separate investment, the tax implications are determined basis the holding period of individual units. Thus, if you start an SIP, each instalment will have its own holding period, impacting the tax treatment accordingly.
Annual limit: Keep in mind that the annual upper limit for tax exemption on long-term capital gains is Rs.1.25 lakh. You can consider maximising the use of this limit effectively by selling units of equity funds that do not meet your expectations.

Understanding equity and its role in long-term wealth creation

An equity portfolio is a collection of stocks and shares. You can invest in equities either directly through the stock market, or through equity mutual funds. When you invest in equities, you essentially purchase shares of publicly listed companies. Investors make money if these shares increase in value over time.

Equity investments can aid wealth creation because of their superior return potential in the long term when compared to debt securities and other traditional savings avenues.

Understanding liquid funds

These are a type of debt mutual fund that invests in short-term money market instruments like treasury bills, commercial paper, and certificates of deposit with maturity up to 91 days. They offer high liquidity and are considered low-risk investments.

Transitioning from liquid funds to equity

While several investors begin their investment journey directly with equity mutual funds, another strategic approach could be to first park funds in a short-term avenue such as liquid funds and then transition to equities. This strategy could be useful for:

Investors who do not know which fund to choose but want to park their money in an avenue with modest return potential rather than leave it idle in their savings accounts.
Investors saving up for a lumpsum amount that they will then invest in equity.
Risk-averse investors who want to invest in equities as well as low-risk avenues.
Investors choosing a Systematic Transfer Plan (STP). An STP allows you to transfer a fixed amount or a fixed number of units from one mutual fund to another at regular intervals.

Benefits of this strategy

Risk mitigation: By initially investing in low-risk liquid funds, you reduce the risk associated with market volatility. By transferring only gains from liquid funds into to equity funds, investors keep their principal relatively stable.
Rupee cost averaging: Using an STP to transfer gains to equity funds allows you to benefit from rupee cost averaging. By investing a fixed amount regularly, you buy more units when prices are low and fewer units when prices are high, potentially lowering the average cost per unit over time.
Liquidity and flexibility: Liquid funds offer high liquidity, ensuring that your money is not locked in. You can easily adjust your strategy based on market conditions or personal financial needs.

Steps to transition from liquid fund gains to equity investments

Assess your liquid fund gains: Start by evaluating the gains you have made from your liquid fund investments. Check the returns and decide how much of these gains you are willing to reinvest into equities.
Understand your investment goals: Determine what you want to achieve with your equity investments. Your goals could range from desiring a steady income stream to exponential growth. The goal will help you decide the type of equity funds to invest in.
Choose the right equity funds: Select equity funds that align with your investment goals and risk tolerance.
Diversify your investments: To mitigate risk, it is advisable to diversify your investments across equity fund types and sectors.

Factors to consider

When transitioning from liquid funds to equity funds, investors should keep the following in mind:

Risk tolerance: Equities are riskier compared to liquid funds. Understand your risk tolerance before investing. If you are uncomfortable with high risk, consider allocating a smaller portion of your liquid fund gains to equities.

Investment horizon: Equities are suitable for long-term investments. Ensure that you do not need the money in the short term. A longer investment horizon helps you ride out market volatility.

Market conditions: While timing the market is not recommended, be aware of current market conditions. Avoid investing a large sum during a market peak. Consider averaging out your investments over time through an STP or an SIP.

Financial goals: Align your equity investments with your financial goals. If you have short-term goals, keep some funds in relatively stable investments like liquid funds.

Liquidity needs: Ensure you have enough liquidity for emergencies. Do not invest all your liquid fund gains into equities. Keep a portion in liquid funds for easy access.

Why do many people choose equity mutual funds?

Diversification made easy

As they say: "Don't put all your eggs in one basket." Equity mutual funds allow investors to achieve diversification effortlessly. Instead of concentrating their funds on a handful of stocks, investors' money is spread across various sectors and companies.

Professional expertise

Many investors lack the resources to conduct thorough analyses of companies and market trends. Equity mutual funds eliminate this barrier by entrusting fund managers with the task of making informed investment decisions.

Liquidity

Equity mutual funds provide a level of liquidity. Investors can buy and sell fund units on any business day, allowing them to access their invested capital relatively quickly. This flexibility is particularly appealing to investors who might need to access their funds in case of emergencies.

Affordability

Equity mutual funds permit investors to enter the stock market with a relatively smaller amount. This democratization of stock market participation has been a pivotal factor in attracting a broader range of investors, including those who previously found such opportunities inaccessible.

Tax efficiency

Some equity mutual funds in India offer tax benefits. For instance, Equity Linked Savings Schemes (ELSS) provide investors with tax deductions under Section 80C of the Income Tax Act. This feature has made these equity mutual funds an attractive option for individuals looking to save on taxes while potentially earning returns.

Systematic investment plans (SIPs)

SIPs allow investors to contribute a fixed amount at regular intervals, such as monthly or quarterly. This strategy not only cultivates a disciplined approach to investing but also minimizes the impact of market volatility. By buying more units when prices are low and fewer units when prices are high, investors can potentially benefit from rupee-cost averaging.

Long-term wealth creation

Equity mutual funds are particularly well-suited for those with long-term investment horizons. While the stock market can experience short-term fluctuations, historical data suggests that - over extended periods - it tends to offer relatively reasonable returns compared to other asset classes. This feature of equity funds aligns well with the goals of many investors who seek to build wealth over time.

When is the right time to invest in equity mutual funds?

Mutual funds have become increasingly popular due to their flexibility, attracting investors of varying risk profiles. While investors seek the suitable mutual fund to invest in, they are also curious about the ideal timing for their investments.

There is no definitive "best" time to invest in mutual funds. The concept of timing the market to find the perfect moment to invest in equity mutual funds can be elusive. Instead of waiting for an ideal time that may never come, it is prudent to start investing today and adhere to fundamental investment principles. Moreover, it is advisable to stay invested for a longer duration to reap optimal benefits.

Why should you invest long term in Mutual funds?

Investing in mutual funds with a long-term horizon offers numerous advantages and can be highly beneficial for investors. Here are several reasons why favouring a long-term investment approach in mutual funds is advantageous:

Compounding returns: Long-term investments allow the power of compounding to work. It allows your earnings to grow as your investments grow. The power of compounding works by growing your wealth exponentially over long term. It adds the profit earned back to the principal and then reinvests the entire sum to accelerate the profit earning process.

Smoothing market volatility: Investing in mutual funds with a long-term perspective helps pacify the impact of short-term market volatility.

Potential for higher returns: By holding equity-oriented mutual funds for the long term, investors have the potential to capture the growth of the underlying businesses and participate in the market's upward trajectory.

Diversification benefits: By investing in a well-diversified mutual fund portfolio, you can spread the risk and reduce the impact of any single investment's performance.

Aligning with financial goals: Long-term investments in mutual funds are well-suited for achieving various financial goals, such as retirement planning, funding higher education, or building wealth over an extended period.

Mistakes to avoid when investing in equity funds

Below are some mistakes to avoid while investing in equity mutual fund.

1. Ignoring your investment goals

Clearly defining your investment goals and time horizon is key before selecting equity funds. Your goals could be retirement, children's education, down payment for a house, etc. Investing without aligning to goals leads to selecting unsuitable funds that may not meet your needs.

2. Not understanding your risk tolerance

Know your appetite for risk and market volatility before investing in equity funds. Are you a conservative investor seeking reasonable returns, or do you have a high tolerance for market fluctuations? Choose mutual fund schemes that match your risk profile.

3. Chasing past performance

Don't invest in funds purely based on their past returns. Past performance does not guarantee future results. Evaluate the fund's investment strategy and portfolio attributes before investing for potentially long-term gains.

4. Neglecting to diversify

Don't just invest in one or two funds. Diversify across fund houses, market cap categories, sectors, and investment styles to manage risks effectively. Avoid overexposure to a single fund.

5. Investing based on short-term market fluctuations

Don't time the market or make impulsive decisions based on volatility or news events. Equity investments require a long-term time frame to ride out short-term fluctuations.

6. Overlooking the importance of regular investing

Invest regularly, like through SIPs, to benefit from rupee cost averaging and compounding over long periods. Sporadic lumpsum investments may often lead to poor timing and impulsive decisions.

7. Failing to review and rebalance your portfolio

Review your funds periodically to check if your asset allocation matches goals. Rebalance to bring your portfolio in line with original targets.

8. Making emotional investment decisions

Don't be driven by greed or fear. Have patience and discipline when investing in equity funds. Work with a long-term perspective and ignore daily noise.

9. Skipping the fine print:

Make sure you understand the fund Scheme Information Document (SID) and Statement of Additional Information (SAI).

Read the fund related documents like SID and SAI to evaluate investment strategy, risks, costs, etc. in detail before investing to ensure it is a suitable choice for your goals.

10. Not seeking professional advice when needed

Consult an investment advisor if you lack time or expertise for research before investing in equity funds. Experts can help avoid pitfalls.

FAQs:

Are equity oriented mutual funds taxable?

Yes, equity oriented mutual funds are taxable in most cases. Long term capital gains on equity funds held for more than one year are taxed at 10% plus applicable cess and surcharges. Short-term capital gains on equity funds held for less than one year are taxed at the individual’s applicable income tax slab rate.

What is the tax exemption on equity mutual funds?

Equity funds held for more than one year are eligible for long-term capital gains tax exemptions. Gains up to Rs.1.25 lakh are exempted from tax.

What are the advantages of building an equity portfolio with gains from liquid funds?

The main advantage is the potential for higher returns compared to keeping all your money in liquid funds. Moreover, combining liquid funds with equities can help create a balance between risk mitigation and return potential.

How to decide the proportion of liquid fund gains to allocate to equities?

This depends on your risk tolerance, investment goals, and financial needs. A balanced approach could be to start with a small investment and increase it as you become more comfortable with equity investments.

What are the typical returns I can expect from an equity portfolio built with liquid fund gains?

While past performance is not a guarantee of future returns, historically, equity portfolios have provided higher returns compared to liquid funds over the long term. Expect variability in the short term but potential for significant growth in the long run.

What is an equity investment in mutual funds, and how does it differ from other investment options?

Equity investment in mutual funds involves investing in stocks or company shares through pooled funds structure, offering the potential for higher returns compared to other investment options over long term.

Why is equity investment often recommended for young professionals?

Equity investment is often recommended for young professionals due to their longer investment horizon, higher risk tolerance, and potential for substantial long-term growth.

What is the difference between actively managed and passively managed equity mutual funds?

Actively managed equity funds are the equity funds in which the fund manager picks the stocks for the scheme. The competence and experience of the fund manager play an important role here to determine the returns from the mutual fund. On the other hand, passively managed equity funds track a market index or segment to invest. The fund manager does not play an active role here. The performance is usually dependent on the market conditions.

What is the risk associated with investing in equity mutual funds?

Investing in equity mutual funds comes with certain risks. The primary risk is market volatility, which causes fluctuations in the fund's value. It's essential to understand and evaluate the risks associated with equity mutual funds before investing and consider diversification and a long-term investment horizon to mitigate some of these risks.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.