Equity Mutual Funds invest in the shares of different companies. Equity mutual funds often experience frequent fluctuations. As we saw in this year, the Sensex from a low of 25,638.9 on March 24 at the start of the pandemic, the Sensex gained record highs of over 78% towards the year end. Through this article, we help investors understand the types of equity mutual funds and how to select the best equity mutual fund to invest in.
Equity mutual funds can be actively or passively (index fund) managed. Equity mutual funds are principally categorized according to market capitalization, the investment style of the holdings in the portfolio and geography. Equity funds are also categorized by whether they are domestic (investing in stocks of only Indian companies) or international (investing in stocks of overseas companies). Some specialty equity funds target business sectors, such as health care, commodities and real estate and are known as Sectoral Funds.
As per the SEBI categorization of mutual fund schemes, equity mutual funds can be classified into 10 different sub-categories.
- Large-cap Fund – Invests minimum 80% in large-cap stocks.
- Large & Midcap Fund – Invests minimum 35% in large-cap companies and simultaneously maintain a minimum 35% allocation to mid-cap stocks.
- Midcap Fund – Invests minimum 65% in mid-cap stocks.
- Small-cap Fund - Invests minimum 65% in small-cap stocks.
- Multi-cap Fund - Invests minimum 65% across large cap, mid cap, small cap stocks.
- Dividend Yield Fund - Invests minimum 65% in dividend yielding stocks.
- Value/Contra Fund - Invests minimum 65% in equity by following the value/contrarian investment strategy.
- Focused Fund – This scheme focuses on the number of stocks (maximum 30), and invest a minimum of 65% of its assets in equity & equity related instruments.
- Sectoral/Thematic Fund - The investment in equity & equity related instruments of a particular sector/particular theme (like banking, FMCG, etc.) should be a minimum of 80% of total assets.
- ELSS (Equity Linked Savings Scheme) - Invests minimum 80% of total assets in equity & equity related instruments (as per the Equity Linked Saving Scheme, 2005 notified by Ministry of Finance) with a statutory lock-in of 3 years and offer tax benefit under section 80C
As per the new categorization norms, only one scheme per category is permitted, except:
• Index Funds/ ETFs replicating/ tracking different indices;
• Fund of Funds having different underlying schemes; and
• Sectoral/ thematic funds investing in different sectors/ themes
How are Equity mutual funds classified as per market capitalization?
Market capitalization refers to the total number of outstanding shares of a company in the market multiplied by the current price of each share. It is a measure of the estimated valuation of a company.
Here’s how the market capitalization categories are defined by SEBI to ensure uniformity in respect of the investment universe for equity mutual fund schemes:
• Large caps: First 100 companies on full market capitalization basis
• Mid-caps: All companies from 101st to 250th on full market capitalization basis
• Small caps: 251st company onwards on full market capitalization basis
How to select Best Equity Mutual Funds?
You can pick potentially the best equity mutual funds by doing your own research. Here is what you need to consider:
Quantitative Parameters
Fund performance, in terms of return on investment: Investors need to look at returns over a period say five years. They should also fare reasonably well when compared with their peer set over the more extended time frames.
Financial ratios: Evaluate equity mutual funds on the basis of risk-reward ratios like Sharpe Ratio. It represents the excess return provided by the fund for a given level of risk. In short, the higher the Sharpe ratio, the better is the risk-adjusted return for that fund.
Fund history across performance cycles: Ensure that the equity mutual fund has seen the market cycles of slump and rally numerous times.
Qualitative Parameters
- Portfolio Quality
Adequate Diversification - The scheme should not hold a highly concentrated portfolio. The portfolio should be well diversified. Many investors prefer diversified funds. A diversified equity mutual fund invests over a variety of stocks and is not focused on a single sector or theme for investment. Due to this diversification, diversified equity funds tend to be less prone to market movements than sector specific funds.
Low Churn - Engaging in high churning can result in trading and high turnover cost**.** Therefore, you also need to consider the portfolio turnover ratio and expenses, i.e. those funds with a turnover ratio of above 100%.
- Quality of Fund Management
You also need to consider the fund manager’s experience, his workload and consistency of the fund house. Therefore, you could check -
The fund manager’s work experience – Experience in investment research and fund management, ideally over a decade.
The number of schemes managed – Check if the fund manager is not loaded with a large number of schemes. If he is managing more than five open-ended funds, it should raise a red flag.
The efficiency of the fund house in managing your money - You need to check if the fund house is consistent in performance across schemes or if only a few selected schemes are doing well. A fund house that performs well across the board is an indication of sound investment processes and risk management techniques in place.
You should consider your risk appetite and investment horizon while investing in equity funds. These funds are suitable for an investor having an investment horizon of say five years or more. Usually, equity mutual funds experience a lot of fluctuations during the short-run. This fluctuation averages out in the long-run. Hence, short-term investors should refrain from investing in equity mutual funds unless saving tax is their key objective, then you can invest in ELSS, it is regarded as the best option under Section 80C of the Income Tax Act, 1961 due to its shortest lock-in period of three years.
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Mutual Fund investments are subject to market risks, read all scheme related documents carefully.