Equity Mutual Funds invest in equity instruments such as shares. Most equity mutual funds are created with the objective of generating long term growth and capital appreciation. The investing horizon for equity products is also longer, given that equity as an asset class may be volatile, in the short term. Stocks are classified on the basis of market cap and industry.
Classification of equity funds is based on the type of stocks they invest in. Hence, equity funds may be diversified funds, large cap funds; mid and small cap funds, sector funds, and thematic funds, depending upon the sectors and the market segment that they invest in.
Large-Cap Mutual Funds: Large-cap funds are, typically, the least risky funds. These companies are among the least volatile companies as they are mostly in mature businesses. You must allocate highest to this category of investment.
Mid- and Small-cap Mutual Funds: These funds are riskier than large-cap funds. They invest in small-sized companies that are in their growing stages. Since these companies are in their growing stages, they can get volatile in an uncertain market. These are high-risk companies; they typically rise more than large-cap funds in rising markets, but fall more than large-cap companies in falling markets.
Diversified Equity Mutual Funds invest across various sectors, sizes and industries, with the objective of beating a broad equity market index. These funds feature lower risk as the benefit of diversification kicks in and are suitable for investors with long investment horizons. Underperformance of one sector or stock may be made up for by the out-performance of any one or more of the other sectors or stocks.
Thematic Equity Mutual Funds invest in multiple sectors and stocks pertaining to a specific theme. Themes are chosen by the fund managers who believe these will do well over a given period of time based on their understanding of macro trends and developments. Funds may be based on the themes of infrastructure growth, commodity cycles, public sector companies, multi-national companies, rural sector growth, businesses driven by consumption patterns and service-oriented sectors. These funds run a higher concentration risk, as compared to a diversified equity fund but are diversified within a particular theme. Such fund offer a higher return if the specific theme they focus on does better than the overall market.
Sector Mutual Funds are available for sectors such as information technology, banking, pharma and FMCG. We know that sector performances tend to be cyclical. The return from investing in a sector is never the same across time. For example, Auto sector, does well, when the economy is doing well and more cars, trucks and bikes are bought. Such funds typically feature, high risk, and are unsuitable for a longer horizon. Investments in sector funds have to be timed well.
Index Mutual Funds are passively managed, where the fund manager does not take a call on stocks or the weights of the stocks in the portfolio, but simply replicates a chosen index. Replicating an index means, holding all the same stocks, in exactly the same weightage as in the index. Index funds could track the broader indices, such as Nifty and Sensex, or could track the sector-specific indices such as BSE IT (Technology) or Bankex (Banking). First time equity investors, who do not like to take a risk on the fund with respect to the benchmark, are typically recommended index funds. Index funds will always deliver a return equal to the return on the benchmark. A slight difference in return could be attributed to the expense ratio which is charged by the mutual fund. However, expense ratio on index funds is considerably lower that is 0.75% as maximum, as compared to, 2.50% for actively managed equity funds.
Equity Linked Savings Schemes or ELSS Mutual Funds is a special category of diversified equity funds designated as ELSS, at the time of launch. Investment in ELSS to the extent of Rs. 1 lakh in a year enjoys a tax deduction under Section 80C of the Income Tax Act. Investors can buy the units to claim tax deduction at any time of the financial year. An ELSS can be offered as an open-ended scheme, in which case, a fund house can have only one such scheme. Funds can also offer ELSS as a closed-end scheme. Investment in both the open and closed end ELSS is subject to a 3-year lock-in. The lock-in period will apply from the date of purchase of units. During the lock-in period investors cannot sell, redeem, pledge, transfer, or in any manner alter their holding in the fund. An ELSS scheme’s investment portfolio is quite similar to a diversified equity fund.