Module 2 : Equity Funds
Categories of MF Equity Schemes
What are Equity Mutual Funds?
Equity mutual fund schemes in India invest in equity or equity related securities. Equity securities are essentially shares of comp anies. In most cases, these are shares of public companies, i.e. companies which are listed on stock exchanges. There could be other types of equity related securities which derive their value from equity shares of companies e.g. futures, options etc. Different types of equity securities have different risk profiles depending on the characteristics of the underlying stocks.
Equity mutual fund schemes in India invest in equity or equity related securities. Equity securities are essentially shares of comp anies. In most cases, these are shares of public companies, i.e. companies which are listed on stock exchanges. There could be other types of equity related securities which derive their value from equity shares of companies e.g. futures, options etc. Different types of equity securities have different risk profiles depending on the characteristics of the underlying stocks.
Categories of MF Equity Schemes
What are Equity Mutual Funds?
Equity mutual fund schemes in India invest in equity or equity related securities. Equity securities are essentially shares of comp anies. In most cases, these are shares of public companies, i.e. companies which are listed on stock exchanges. There could be other types of equity related securities which derive their value from equity shares of companies e.g. futures, options etc. Different types of equity securities have different risk profiles depending on the characteristics of the underlying stocks.
Categorization of equity funds based on market cap
Market capitalization of a company is defined as the share price of the company times the number of shares outstanding. Companies with larger market cap have higher revenues and profits than companies with smaller market caps. SEBI has classified
stocks into three market cap segments:-
Large cap: Top 100 stocks by market capitalization are large cap stocks.
Midcap: 101st to 250th stocks by market capitalization are midcap stocks.
Small Cap: 251st and smaller stocks by market capitalization are small cap stocks.
Different types of equity mutual funds are classified into the following categories according to market cap composition of the underlying stocks.
Large Cap Funds: As per SEBI’s mandate large cap funds must invest at least 80% of their assets in large cap stocks. The balance can be invested in midcap, small cap and other assets. These companies are characterized by market leadership in their respective industry sectors, greater financial strength and wide public ownership. Large cap funds are usually less volatile and considered to give more stable returns than midcap and small cap funds.
Midcap Funds: As per SEBI’s mandate midcap funds must invest at least 65% of their assets in midcap stocks. Midcap stocks are perceived to be more risky than large cap stocks but have higher earnings growth potential. Midcap stocks can in future become large cap stocks and see valuation re-rating. Therefore, these funds have greater wealth creation potential in the long term, though they can be more volatile in the short term. Midcap funds are however, less volatile than small cap funds in bear markets.
Small Cap Funds: As per SEBI’s mandate, small cap funds must invest at least 65% of their assets in small cap stocks. . Small cap stocks are perceived to be more risky than large cap and midcap stocks, but they have higher return potential than midcap and large cap stocks in the long term. Small cap stocks can be extremely volatile in the short term. Percentage of free floating shares in small cap is much less than mid and large cap stocks and in extreme market conditions these stocks can have much less liquidity compared to large and midcap stocks. Investors should take these factors into consideration in portfolio construction.
Large and Midcap Funds: As per SEBI’s mandate these funds must invest at least 35% of their assets in large cap stocks and at least 35% of their assets in midcap stocks. The balance assets can be invested in stocks of any market cap segment and other assets. The risk / return characteristics of these funds combine elements of large cap and midcap funds.
Multi-cap Funds: As per SEBI’s new regulations these funds must invest at least 25% of their assets in large cap stocks, at least 25% in midcap stocks and at least 25% in small cap stocks. Multi-cap funds are meant to give investors exposures to all market cap segments. Since the new regulation came only a few months back, we need to wait and see how this category of funds evolves.
Flexi-cap Funds: In 2020, SEBI introduced a new equity mutual fund scheme category known as Flexicap funds. These funds have a flexible mandate with regards to investments in any market cap segment e.g. large cap, midcap and small cap. Though flexi-cap funds category is a new fund category in terms of nomenclature, it is essentially the same as the old multi-cap category (before it was redefined by SEBI).
Equity funds classification according to investing styles
In addition to market cap categories, the following types of equity funds can also be categorized according to the investment styles of the schemes.
Dividend Yield Funds: These schemes invest predominantly in high dividend yield stocks. Dividend yield of a stock is the ratio of the dividend paid by the stock to its current market price. High dividend yield stocks are usually mature companies with stable business models and cash-flows. Hence they are thought to be less risky.
Value Funds: Value funds practice value investing strategy. The funds invest in companies which are trading at a discount to its intrinsic value. Value stocks are usually characterised by relatively low price earnings or price to book multiples and relatively higher dividend yields.
Contra funds: Contra is an investing strategy which is opposite to the market trend. Contra fund managers invest in stocks that are currently underperforming due to short term issues but which have good growth potential in the medium to long term. Many investors get confused between value and contra funds. Contra fund managers invest in stocks which are currently out of favour because the market does not expect them to do well, but the fund manager does. Essentially, contra fund managers invest in high conviction stocks which they think the market is mispricing due to some reason.
Focused funds: As per SEBI’s mandate focused funds can invest in maximum of 30 stocks. Since the number of stocks in these funds is limited to 30, they have higher concentration risks than more diversified equity funds. The alpha (excess returns over market returns) of a focused fund can be high depending on the fund manager’s stock selection skills.
Sectoral or Thematic Funds
So far we have discussed about equity mutual fund schemes in India which diversify across different industry sectors. Diversification reduces un-systematic, i.e. stock or sector specific risks. Sectoral and thematic funds, on the other hand, invest in a particular industry sector or in an investment theme. Sectoral funds invest in one industry sector e.g. banking, technology, pharmaceuticals, FMCG, infrastructure etc. An investment theme, on the other hand, can encompass several sectors. For example, consumption theme can cover banking & financial services, automobiles, consumer durables, consumer non-durables, media and entertainment etc. Similarly healthcare theme can cover several sectors in addition to pharmaceuticals, e.g. hospitals, diagnostic centres, wellness products, health insurance etc. Thematic funds are more diversified than sector funds.
According to SEBI’s mandate these types of equity mutual funds should invest at least 80% of their assets in a particular sector or theme. Thematic and sectoral funds have higher sector risks compared to diversified equity funds. Financial advisors suggest that diversified funds should form the core of your equity investment portfolio and you can add a small percentage of thematic or sectoral funds to boost your portfolio returns over the investment tenure. Though many financial advisors suggest that performance of thematic or sectoral funds is subject to market timing, there are several investment themes which are suitable for long term investments, including for investments through SIP. You should consult with your financial advisor to know more about such schemes.
Equity Linked Savings Schemes
One of the most popular types of equity funds is Equity linked savings schemes (ELSS). ELSS is diversified equity funds with a lock-in period of 3 years, i.e. you will not be able to redeem units of these schemes for 3 years from the date of investment. If you are investing in ELSS through Systematic Investment Plan (SIP) then each SIP instalment will be locked in for 3 years. Under Section 80C of Income Tax Act 1961, investments in ELSS up to Rs 1.50 lakhs in a FY is eligible for deduction from your taxable income and reduce your income tax obligations.
Historical data shows that ELSS have the potential to give superior returns in the long term compared to other 80C schemes like Public Provident Fund, National Savings Certificates, Tax Saver Bank FDs, Life insurance policies etc. Equity Linked Savings Schemes are more liquid (shortest lock-in period) and more tax efficient than several other Section 80C investment options. Apart from 80C tax savings, capital gains in Equity Linked Savings Schemes of up to Rs 1 lakh in any assessment year is tax exempt and taxed at 10% thereafter.
Who should invest in different types of equity mutual funds?
Your primary investment objective is capital appreciation.
You should have sufficiently long investment tenure (ideally at least 5 years)
You should have moderately high to high risk appetites
In addition to capital appreciation, you can also save taxes by investing in ELSS.
You should always invest according to your risk appetite. Different categories of equity funds have different risk / return characteristics.
You should consult with your financial advisor before investing
Equity mutual fund schemes in India invest in equity or equity related securities. Equity securities are essentially shares of comp anies. In most cases, these are shares of public companies, i.e. companies which are listed on stock exchanges. There could be other types of equity related securities which derive their value from equity shares of companies e.g. futures, options etc. Different types of equity securities have different risk profiles depending on the characteristics of the underlying stocks.
Categorization of equity funds based on market cap
Market capitalization of a company is defined as the share price of the company times the number of shares outstanding. Companies with larger market cap have higher revenues and profits than companies with smaller market caps. SEBI has classified
stocks into three market cap segments:-
Large cap: Top 100 stocks by market capitalization are large cap stocks.
Midcap: 101st to 250th stocks by market capitalization are midcap stocks.
Small Cap: 251st and smaller stocks by market capitalization are small cap stocks.
Different types of equity mutual funds are classified into the following categories according to market cap composition of the underlying stocks.
Large Cap Funds: As per SEBI’s mandate large cap funds must invest at least 80% of their assets in large cap stocks. The balance can be invested in midcap, small cap and other assets. These companies are characterized by market leadership in their respective industry sectors, greater financial strength and wide public ownership. Large cap funds are usually less volatile and considered to give more stable returns than midcap and small cap funds.
Midcap Funds: As per SEBI’s mandate midcap funds must invest at least 65% of their assets in midcap stocks. Midcap stocks are perceived to be more risky than large cap stocks but have higher earnings growth potential. Midcap stocks can in future become large cap stocks and see valuation re-rating. Therefore, these funds have greater wealth creation potential in the long term, though they can be more volatile in the short term. Midcap funds are however, less volatile than small cap funds in bear markets.
Small Cap Funds: As per SEBI’s mandate, small cap funds must invest at least 65% of their assets in small cap stocks. . Small cap stocks are perceived to be more risky than large cap and midcap stocks, but they have higher return potential than midcap and large cap stocks in the long term. Small cap stocks can be extremely volatile in the short term. Percentage of free floating shares in small cap is much less than mid and large cap stocks and in extreme market conditions these stocks can have much less liquidity compared to large and midcap stocks. Investors should take these factors into consideration in portfolio construction.
Large and Midcap Funds: As per SEBI’s mandate these funds must invest at least 35% of their assets in large cap stocks and at least 35% of their assets in midcap stocks. The balance assets can be invested in stocks of any market cap segment and other assets. The risk / return characteristics of these funds combine elements of large cap and midcap funds.
Multi-cap Funds: As per SEBI’s new regulations these funds must invest at least 25% of their assets in large cap stocks, at least 25% in midcap stocks and at least 25% in small cap stocks. Multi-cap funds are meant to give investors exposures to all market cap segments. Since the new regulation came only a few months back, we need to wait and see how this category of funds evolves.
Flexi-cap Funds: In 2020, SEBI introduced a new equity mutual fund scheme category known as Flexicap funds. These funds have a flexible mandate with regards to investments in any market cap segment e.g. large cap, midcap and small cap. Though flexi-cap funds category is a new fund category in terms of nomenclature, it is essentially the same as the old multi-cap category (before it was redefined by SEBI).
Equity funds classification according to investing styles
In addition to market cap categories, the following types of equity funds can also be categorized according to the investment styles of the schemes.
Dividend Yield Funds: These schemes invest predominantly in high dividend yield stocks. Dividend yield of a stock is the ratio of the dividend paid by the stock to its current market price. High dividend yield stocks are usually mature companies with stable business models and cash-flows. Hence they are thought to be less risky.
Value Funds: Value funds practice value investing strategy. The funds invest in companies which are trading at a discount to its intrinsic value. Value stocks are usually characterised by relatively low price earnings or price to book multiples and relatively higher dividend yields.
Contra funds: Contra is an investing strategy which is opposite to the market trend. Contra fund managers invest in stocks that are currently underperforming due to short term issues but which have good growth potential in the medium to long term. Many investors get confused between value and contra funds. Contra fund managers invest in stocks which are currently out of favour because the market does not expect them to do well, but the fund manager does. Essentially, contra fund managers invest in high conviction stocks which they think the market is mispricing due to some reason.
Focused funds: As per SEBI’s mandate focused funds can invest in maximum of 30 stocks. Since the number of stocks in these funds is limited to 30, they have higher concentration risks than more diversified equity funds. The alpha (excess returns over market returns) of a focused fund can be high depending on the fund manager’s stock selection skills.
Sectoral or Thematic Funds
So far we have discussed about equity mutual fund schemes in India which diversify across different industry sectors. Diversification reduces un-systematic, i.e. stock or sector specific risks. Sectoral and thematic funds, on the other hand, invest in a particular industry sector or in an investment theme. Sectoral funds invest in one industry sector e.g. banking, technology, pharmaceuticals, FMCG, infrastructure etc. An investment theme, on the other hand, can encompass several sectors. For example, consumption theme can cover banking & financial services, automobiles, consumer durables, consumer non-durables, media and entertainment etc. Similarly healthcare theme can cover several sectors in addition to pharmaceuticals, e.g. hospitals, diagnostic centres, wellness products, health insurance etc. Thematic funds are more diversified than sector funds.
According to SEBI’s mandate these types of equity mutual funds should invest at least 80% of their assets in a particular sector or theme. Thematic and sectoral funds have higher sector risks compared to diversified equity funds. Financial advisors suggest that diversified funds should form the core of your equity investment portfolio and you can add a small percentage of thematic or sectoral funds to boost your portfolio returns over the investment tenure. Though many financial advisors suggest that performance of thematic or sectoral funds is subject to market timing, there are several investment themes which are suitable for long term investments, including for investments through SIP. You should consult with your financial advisor to know more about such schemes.
Equity Linked Savings Schemes
One of the most popular types of equity funds is Equity linked savings schemes (ELSS). ELSS is diversified equity funds with a lock-in period of 3 years, i.e. you will not be able to redeem units of these schemes for 3 years from the date of investment. If you are investing in ELSS through Systematic Investment Plan (SIP) then each SIP instalment will be locked in for 3 years. Under Section 80C of Income Tax Act 1961, investments in ELSS up to Rs 1.50 lakhs in a FY is eligible for deduction from your taxable income and reduce your income tax obligations.
Historical data shows that ELSS have the potential to give superior returns in the long term compared to other 80C schemes like Public Provident Fund, National Savings Certificates, Tax Saver Bank FDs, Life insurance policies etc. Equity Linked Savings Schemes are more liquid (shortest lock-in period) and more tax efficient than several other Section 80C investment options. Apart from 80C tax savings, capital gains in Equity Linked Savings Schemes of up to Rs 1 lakh in any assessment year is tax exempt and taxed at 10% thereafter.
Who should invest in different types of equity mutual funds?
Your primary investment objective is capital appreciation.
You should have sufficiently long investment tenure (ideally at least 5 years)
You should have moderately high to high risk appetites
In addition to capital appreciation, you can also save taxes by investing in ELSS.
You should always invest according to your risk appetite. Different categories of equity funds have different risk / return characteristics.
You should consult with your financial advisor before investing