Types of Equity Mutual Funds

Equity funds invest in shares of companies and other related securities. While all equity and equity related securities are subject to market risks, different types of equity securities have different risk profiles. One major risk characteristic of equity is based on the size of the company or market capitalization. Market capitalization of a company is the market price of the shares multiplied by number of shares outstanding. SEBI has classified stocks into three market cap segments:-

  • Large cap:Top 100 stocks by market capitalization are large cap stocks. These companies are characterized by large size, market leadership in their respective industry sectors, greater financial strength and wide public ownership. Large cap stocks are perceived by investors to be less risky and therefore, command higher valuations.
  • Midcap: 101st to 250th stocks by market capitalization are midcap stocks. These companies are generally younger and smaller in the size compared to large cap companies. Percentage of free float shares (shares held by public) in midcap is much less than large cap stocks. Midcap stocks are perceived to be more risky than large cap stocks and therefore, trade at lower valuations compared to large cap stocks. However, midcap stocks have higher earnings growth potential than large cap stocks. Midcap stocks, in future can become large cap stocks and therefore, see valuation re-rating. While midcap stocks have the potential of giving higher returns than large cap stocks in the long term, they tend to be more volatile than large cap stocks in the short term.
  • Small Cap: 251st and smaller stocks by market capitalization are small cap stocks. Small cap stocks are perceived to be more risky than large cap and midcap stocks, but they have higher returns potential than midcap and large cap stocks in the long term. Small cap stocks can be extremely volatile in the short term. Small cap companies in India are mostly owned by promoter or promoter families and the percentage of free floating shares in small cap is much less than midcap and large cap stocks. In extreme market conditions small cap stocks can have much less liquidity compared to midcap and small cap stocks.

Equity funds classification according to market cap mix

  • 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 funds invest across industry sectors to diversify risks.
  • Midcap Funds: As per SEBI’s mandate midcap funds must invest at least 65% of their assets in midcap stocks. The balance can be invested in large cap, small cap and other assets. These funds invest across industry sectors to diversify risks.
  • Small Cap Funds: As per SEBI’s mandate, small cap funds must invest at least 65% of their assets in small cap stocks. The balance can be invested in large cap, midcap and other assets. These funds invest across industry sectors to diversify risks.
  • Large and Midcap Funds: As per SEBI’s mandate these funds must invest at least 35% of their assets in large cap funds and at least 35% of their assets in midcap funds. The balance assets can be invested in stocks of any market cap segment and other assets. These funds invest across industry sectors to diversify risks
  • Multi-cap Funds: These funds can invest across market cap segments and industry sectors. There no minimum or maximum limits with regards to any market cap segment.

Equity funds classification according to investing styles

In addition to market cap categories, 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 practise value investing strategy. The funds invest in companies which are trading at a discount to its intrinsic value. This discount in value investment parlance is known as the factor of safety. Fund managers estimate the intrinsic value of a stock after in-depth analysis of the company.. Value stocks are usually characterised by relatively low price earnings or price to book multiples and relatively higher dividend yields. Sometimes value investing is also known as contra investing.
  • 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. If the fund manager gets his / her stock selection right, then these funds have the potential of delivering superior alphas.
  • Sectoral or Thematic Funds: According to SEBI’s mandate these funds should invest at least 80% of their assets in a particular sector or theme. Investors should understand the difference between sector and 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 and 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. However, both 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 thematic or sectoral funds with an aim to augment your returns.

Investors should note that dividend yield funds, value funds, contra funds and focused funds usually follow a multi-cap strategy i.e. they invest across industry sectors and market cap segments. Each of these fund categories have their unique risk / return characteristics. You should understand how the fund manager selects stocks before investing in these funds. These funds can be good additions to your mutual fund portfolio.

Equity Linked Savings Schemes

Equity linked savings schemes (ELSS) are 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 three 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. Investments in ELSS of up to Rs 1.5 lakhs are eligible for deduction from your taxable income under Section 80C of Income Tax Act. You can save up to Rs 46,800 (not including surcharge) in taxes by investing in ELSS. 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, however since ELSS are market linked, they carry higher risk than traditional instruments.

Equity linked savings schemes usually follow multi-cap strategy. The lock-in period works to the advantage of investors because the fund managers have less redemption pressures due to the lock-in, and therefore, can stick longer to their high conviction stocks which have the potential to generate superior returns for investors in the long term. Though ELSS have lock-in period of 3 years, financial advisors recommend longer investment tenures for these funds since they have the potential to give better results over longer investment horizons.

Summary

The primary investment objective of equity funds is capital appreciation. In addition to capital appreciation, you can also save taxes by investing in ELSS funds. You should have sufficiently long investment tenure (ideally at least 5 years) and moderately high to high risk appetites for investing in any equity fund. In this article, we have given an overview of different types of equity funds. Different categories of funds have different risk / return characteristics. You should invest according to your risk appetite. You should consult with your financial advisor to understand which equity fund is best suited to your investment needs.

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Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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