Module 2 : Equity Funds
How to select equity funds?
In the previous chapter we discussed the two important factors you should consider when investing in equity funds – investment tenure and risk appetite. In this chapter we will discuss how to select equity funds basis the investment tenures, risk appetite and other factors. Different types of equity funds have different risk profiles – you should check their Riskometer profile and understand the risk profile of the fund before investing.
How to select equity funds?
In the previous chapter we discussed the two important factors you should consider when investing in equity funds – investment tenure and risk appetite. In this chapter we will discuss how to select equity funds basis the investment tenures, risk appetite and other factors. Different types of equity funds have different risk profiles – you should check their Riskometer profile and understand the risk profile of the fund before investing.
Investment Tenure
This is the most fundamental consideration for how to choose equity funds. You should invest in equity funds only if you have long investment tenures. Usually, at least 5 year investment tenure is recommended for equity funds. If your investment tenure is less than 3 years, then you should invest only in fixed income funds or arbitrage funds. For investment tenures of 3 to 5 years, you may invest in longer duration debt funds, conservative (debt oriented) hybrid funds etc.
There is no upper limit for investment tenures as far as equity funds are concerned. The longer you remain invested, higher is the potential of getting superior returns. While 5 year is the minimum recommended tenure for equity funds, a longer investment horizon is more suitable for some types of equity funds e.g. midcap funds, small cap funds.
Risk appetite
Risk appetite is a very important consideration for investing in equity funds. In the previous chapter, we discussed that risk appetite depends on both objective (investment tenure, age etc.) and subjective (risk attitude, investment experience etc.) factors. Different types of equity funds have different risk profiles, e.g. large cap funds have lower risk profiles compared to midcap and small cap funds, small cap funds are more volatile than midcap funds etc. You should invest in a fund whose risk profile matches with your risk appetite.
Investors usually invest in multiple funds across different fund categories and risk profiles, to balance risk and return. Risk appetite should be one of the most important considerations in the construction of your equity fund portfolio mix. There are certain types of equity funds which invest predominantly in a specific market capitalization segment, i.e. large cap funds, midcap funds and small cap funds (for more details, refer to Chapter 1 of this module). There are funds which invest across market cap segments e.g. large and midcap funds, multi-cap funds, flexi-cap fund etc. Irrespective of which type of funds you invest in, you should ensure that the overall risk profile of your portfolio matches with your risk appetite. For example, if you do not have high risk appetite, then large caps should form a substantial part of your portfolio. If you have more appetite for risk, you can increase your allocations to midcaps and small caps accordingly. You should consult with your financial advisor if you need help in building and managing your fund portfolio.
Core and tactical
Mutual funds which are linked to your long term goals e.g. children’s higher education, children’s marriage, retirement planning, wealth creation etc. form the core of your equity portfolio. Systematic Investment Plans (SIPs) is a disciplined and convenient way of investing in your core portfolio. However, you can also invest in lump sum, if you think you need to invest more for your goals, want to take advantage of deep corrections, have funds available and can remain invested for long tenures. You should always ensure that the overall risk profile of your core portfolio is aligned with your risk appetite. Diversified equity funds which invest in a sufficiently large number of stocks across different industry sectors, across different market cap segments (e.g. large cap, large and midcap, midcap, flexi-cap etc.) should form your core portfolio.
Experienced investors can also have a portion of their portfolio allocated to tactical investments to take advantage of market opportunities as they arise from time to time. For example, if you think that a particular sector or theme e.g. pharmaceuticals, banking, consumption etc. is attractive and can outperform the broader market over your investment horizon, then you can tactically invest in sector or thematic funds to boost your portfolio returns and wealth thereof. Tactical investments in thematic or sector funds are usually made in lump sum and involve market timing. Therefore, these funds are suitable for experienced investors who have some knowledge about the theme / sector they are investing. However, there is a misconception that thematic / sector funds are not for long term investments. In India, some investment themes e.g. consumption, can also be good long term investment options and one can also invest in themes through SIP.
Tax Planning
Section 80C of Income Tax Act 1961 allows investors in the old tax regime to claim deduction of up to Rs 1.5 lakhs by investing in certain eligible schemes. Mutual fund equity linked savings schemes (ELSS) are eligible for tax savings under Section 80C. Historical data shows that ELSS has the potential to give superior returns over sufficiently long investment horizons compared to traditional tax saving investment options like PPF, NSC, Tax Saver FDs, life insurance plans etc. ELSS, with lock-in period of just 3 years, is also more liquid than most 80C investment options. If you have sufficiently high risk appetite, you may consider investing in ELSS.
Conclusion
In this article, we discussed how to choose equity mutual funds for your investment needs and constructing your equity portfolio. You should have long investment tenures (at least 5 years) and select funds of the appropriate risk profile according to your risk appetite. It is important that you understand the risk / return characteristics of a fund before investing. You should always consult with a financial advisor if you need any help.
Investment Tenure
This is the most fundamental consideration for how to choose equity funds. You should invest in equity funds only if you have long investment tenures. Usually, at least 5 year investment tenure is recommended for equity funds. If your investment tenure is less than 3 years, then you should invest only in fixed income funds or arbitrage funds. For investment tenures of 3 to 5 years, you may invest in longer duration debt funds, conservative (debt oriented) hybrid funds etc.
There is no upper limit for investment tenures as far as equity funds are concerned. The longer you remain invested, higher is the potential of getting superior returns. While 5 year is the minimum recommended tenure for equity funds, a longer investment horizon is more suitable for some types of equity funds e.g. midcap funds, small cap funds.
Risk appetite
Risk appetite is a very important consideration for investing in equity funds. In the previous chapter, we discussed that risk appetite depends on both objective (investment tenure, age etc.) and subjective (risk attitude, investment experience etc.) factors. Different types of equity funds have different risk profiles, e.g. large cap funds have lower risk profiles compared to midcap and small cap funds, small cap funds are more volatile than midcap funds etc. You should invest in a fund whose risk profile matches with your risk appetite.
Investors usually invest in multiple funds across different fund categories and risk profiles, to balance risk and return. Risk appetite should be one of the most important considerations in the construction of your equity fund portfolio mix. There are certain types of equity funds which invest predominantly in a specific market capitalization segment, i.e. large cap funds, midcap funds and small cap funds (for more details, refer to Chapter 1 of this module). There are funds which invest across market cap segments e.g. large and midcap funds, multi-cap funds, flexi-cap fund etc. Irrespective of which type of funds you invest in, you should ensure that the overall risk profile of your portfolio matches with your risk appetite. For example, if you do not have high risk appetite, then large caps should form a substantial part of your portfolio. If you have more appetite for risk, you can increase your allocations to midcaps and small caps accordingly. You should consult with your financial advisor if you need help in building and managing your fund portfolio.
Core and tactical
Mutual funds which are linked to your long term goals e.g. children’s higher education, children’s marriage, retirement planning, wealth creation etc. form the core of your equity portfolio. Systematic Investment Plans (SIPs) is a disciplined and convenient way of investing in your core portfolio. However, you can also invest in lump sum, if you think you need to invest more for your goals, want to take advantage of deep corrections, have funds available and can remain invested for long tenures. You should always ensure that the overall risk profile of your core portfolio is aligned with your risk appetite. Diversified equity funds which invest in a sufficiently large number of stocks across different industry sectors, across different market cap segments (e.g. large cap, large and midcap, midcap, flexi-cap etc.) should form your core portfolio.
Experienced investors can also have a portion of their portfolio allocated to tactical investments to take advantage of market opportunities as they arise from time to time. For example, if you think that a particular sector or theme e.g. pharmaceuticals, banking, consumption etc. is attractive and can outperform the broader market over your investment horizon, then you can tactically invest in sector or thematic funds to boost your portfolio returns and wealth thereof. Tactical investments in thematic or sector funds are usually made in lump sum and involve market timing. Therefore, these funds are suitable for experienced investors who have some knowledge about the theme / sector they are investing. However, there is a misconception that thematic / sector funds are not for long term investments. In India, some investment themes e.g. consumption, can also be good long term investment options and one can also invest in themes through SIP.
Tax Planning
Section 80C of Income Tax Act 1961 allows investors in the old tax regime to claim deduction of up to Rs 1.5 lakhs by investing in certain eligible schemes. Mutual fund equity linked savings schemes (ELSS) are eligible for tax savings under Section 80C. Historical data shows that ELSS has the potential to give superior returns over sufficiently long investment horizons compared to traditional tax saving investment options like PPF, NSC, Tax Saver FDs, life insurance plans etc. ELSS, with lock-in period of just 3 years, is also more liquid than most 80C investment options. If you have sufficiently high risk appetite, you may consider investing in ELSS.
Conclusion
In this article, we discussed how to choose equity mutual funds for your investment needs and constructing your equity portfolio. You should have long investment tenures (at least 5 years) and select funds of the appropriate risk profile according to your risk appetite. It is important that you understand the risk / return characteristics of a fund before investing. You should always consult with a financial advisor if you need any help.