What are equity funds: Types,Benefits,Taxation,Who Should Invest

If you are aiming for long-term wealth creation or want to build a diversified portfolio, equity funds can be a great option. Read this post to know what they are, how they work, and who should invest in them.

How do equity mutual funds create wealth over the long term? There are 5 reasons why these equity funds manage to create wealth in the long term.

• Firstly, equity funds create a diversified portfolio of quality equities. Normally quality stocks with growth potential tend to outperform the index over the longer period of time.
• Secondly, equity funds are tax efficient in terms of the investment exemptions in ELSS, the tax on dividends and the tax on capital gains. Over the longer term this contributes substantially to wealth creation.
• Thirdly, long term wealth creation is as much about enhancing returns as it is about managing risk. Since mutual funds are, by default, diversified the portfolio is better able to face the vagaries in stocks, sectors as well as the economy overall. This also enhances returns in the long run.
• Fourthly, the power of compounding works in favour of mutual funds. Compounding is the best way to create wealth in the long run. Compounding is not just about earning returns on your investments but also earning returns on your returns. This can have a magnifying impact on wealth creation.
• Lastly, equity mutual funds offer additional returns through stock selection. That is the advantage that diversified equity funds offer over an index fund. The skill of the fund manager helps you earn alpha above the index returns and when compounded over a longer period of time, it generates wealth.

While there are many classes and sub-classes of equity funds, here are the 4 most popular categories of equity mutual funds.

1. Equity Diversified Funds:

   Equity diversified funds are equity funds that create a diversified portfolio of equity assets. They are the most popular among equity funds and also equity funds that investors must prefer to create long term wealth. Being equity funds, they qualify for favourable tax treatment on dividend and on capital gains (both short term and long term). On the risk scale, equity diversified are more risky than balanced funds but are less risky than sectoral and thematic fund, which carry a much higher concentration risk.

2. Equity Linked Savings Schemes (ELSS):

   An ELSS is exactly like a diversified equity fund, the only difference being that the ELSS qualifies for an additional tax exemption under Section 80C of the Income Tax Act on investments made in the ELSS. Section 80C offers exemption up to Rs.150,000 per year for a variety of investments including ELSS. The only difference between an ELSS and an equity diversified fund is that due to the tax exemption, there is a statutory lock-in period of 3 years for ELSS funds.

3. Sectoral Funds:

   They are a variant of equity funds with a higher degree of concentration risk as they typically focus on one industry only. For example, there are sectoral funds that are focused on sectors like banking, IT, FMCG, healthcare etc. Being concentrated funds, they run a very high concentration risk. For example, if an investor is holding a Healthcare Fund and the pharma stocks start underperforming due to issues with the US FDA, then the Healthcare Fund will consistently underperform the market. Sectoral Funds have the potential for higher returns but that comes at a much higher level of risk.

4. Thematic Funds:

   Thematic funds, like sectoral funds, offer a concentrated approach to buying equities. But while sectoral funds focus on a particular industry, thematic funds focus on a theme. Examples of such themes include mid-cap funds, small-cap funds, dividend yield funds, turnaround funds etc. Even in thematic funds, the risk is elevated when the theme does not work out as per your expectations. For example mid-cap and small-cap funds can run liquidity risk and can underperform during volatile market conditions. Turnaround funds may not give the desired results. An investor needs to be conscious of the elevated risk in thematic funds before getting investing in them.

There can be no hard and fast rules because mutual funds are not about timing the market but time in the market. Here are a few basic guiding principles…

• It is always better to start early. The earlier you start investing in equity mutual funds the more time you have to enjoy the power of compounding.
• You do not need to worry about timing the market. A better way is to opt for a systematic investment plan (SIP). Here time matters more than timing.
• Do not look at your mutual fund investments in isolation. Look at them as part of your overall financial plan and ensure that your mutual fund investments sync with your long term goals.

Here is a list of some of the most important benefits that mutual funds proffer to investors.

• Mutual funds bring professional management to the table. With access to information and top-end analysis and supported by the services of fund managers, traders and analysts, mutual funds transmit the benefits of scientific investment to investors at a very nominal cost.
• Mutual funds bring the benefit of diversification to your investments. For example, as an individual investor you will have limitations on the amount you can invest and the number of stocks you can buy. Mutual funds overcome the problem. By creating a centralized portfolio of quality equities, an equity fund gives an investor the benefit of diversification. This diversification across assets gives the investor the benefit of reduced risk in the market.
• Mutual funds help you to build enormous wealth over the long term. In fact, the power of compounding works best with respect to equity mutual funds. Equity mutual funds are for the long term if you want to generate wealth and it can actually be a worry-free method of generating wealth over the long term.
• Transparency is the biggest advantage with a mutual fund. For example, when you invest in a corporate bond or in a bank FD, you exactly do not know what the company or bank is doing with your money. In case of an equity mutual fund or a debt mutual fund, you have complete details of how every penny collected by the fund is invested, what is the actual worth of your fund each day and a monthly factsheet with provides a lot of analytical risk and return metrics.
• Mutual funds are liquid. This is unlike your holdings in a company bond, company fixed deposit or even a bank deposit. You can liquidate mutual funds are short notice. While you get your equity funds money in T+2 days, your money in case of debt funds and money market funds will be credited on T+1 day itself.
• Mutual funds are regulated by SEBI and that gives an additional level of comfort for the investor. Additionally, there is a board of trustees consisting of eminent people which ensures that interests of the mutual fund investors are adequately protected. Transparency is an added advantage for mutual funds.
• From a financial planning perspective, mutual funds offer solutions for every need. Consider the following. Equity funds meet the need for growth while debt funds meet the need for stability with additional returns. Liquid funds meet the need for liquidity while ELSS funds met the need for tax planning. There are dedicated mutual funds which are focused on specific needs like retirement, children’s education etc. This makes the mutual fund product extremely flexible and amenable.

The Income Tax act only differentiates between equity funds and non-equity funds. Any fund with more than 65% holdings in equity is classified as an equity fund for tax purposes. Hence an equity fund will be classified as equity for tax purposes. Here is what it means in terms of tax implications.

• Equity funds gains will be short term if held for less than 1 year and it will be long term if held for more than 1 year.
• In the case of short term capital gains on equity funds, they will be taxed at a concessional tax rate of 15% on the STCG. However, this will be subject to any cess and surcharge applicable from time to time.
• In the case of long term gains on equity funds, the first Rs.1 lakh of gains for the entire equity category will be exempt. Any gains above that will be taxed at a flat rate of 10%, without any indexation benefits.
• Short term capital losses on equity funds can be set off against long term and short term gains. However, long term capital losses can only set off against long term gains. Such losses can be carried forwards for 8 years if not absorbed fully in current year.
• Dividends on equity funds and debt funds are now treated as other income in the hands of the investor and taxed at the peak applicable incremental rate of tax.