What are Equity Mutual Funds?

Author
Anmol Gupta

Equity! Does that ring a bell? No!? Then read this article and also this one before you proceed with this one. And, you also need to understand what mutual funds are before going ahead with this one.

Well, if you understand what equity is and what mutual funds are, then you can probably guess what equity mutual funds are. Equity mutual funds are the mutual funds which invest mainly in shares. So you see, the risk associated with equity mutual funds is no different than investing in shares. After all, the money gets invested into shares.

The equity mutual funds are meant to provide you return in long term. You should not expect equity mutual funds to grow your money in short term, as you understand the very nature of equity by now :) Also, the short term fluctuations in equity markets which affects your equity mutual fund should also not bother you much. After all, if you are invested in equity mutual fund, you are in it for the long term! Keep calm, have faith and let your fund managers do their work. We say this because a lot of people complain that their mutual fund is not performing well. They start complaining after 3-4 years of investment in an equity mutual fund. That’s not fair guys! No equity fund will promise you a return in short term, neither they can as you know how equity behaves! Right?

Now we dive into the different kinds of equity mutual funds which you may encounter while you search for a suitable fund for you.

Passive vs Active Funds

Passive funds don’t do any path breaking thing ;) Passive funds simply invest in the companies which constitute the market indices like Sensex and Nifty, and in the same proportion as they exist in those indices. The fund managers enjoy a big amount of gala time as they do not have to take many investment decisions regarding where to invest and when to invest. They simply have to follow the proportion of a chosen index. So, if you invest in funds with strategy as passive, then your return will be that of the overall market as indicated by the market index. In case of passive funds, you will be able to assess the risk and returns of your fund in a more informed way as there are plenty of reports which focus on overall market! So, whatever affects market, affects your fund and hence your investment. But, you have no chance of beating the average market return because you are investing in the stocks which represent the average market itself! Now, if you want your returns to be greater than the average market, then you have to go for funds which have an ‘Active’ investment strategy. Active funds adopt strategies which are expected to generate higher return than the market index. Following are some of the common strategies adopted by Active funds to achieve their investment objectives.

Making a diversified portfolio-Diversified Equity Mutual Funds

The diversified equity mutual funds whole heartedly follow the principle of "Never put all your eggs in one basket”. They invest in a range of stocks. They invest in a range of segments, sectors and size of the companies. Due to this diversification, these funds tends to get less affected by a slowdown in any one particular segment, sector or company. So, you can expect these funds to be less risky than not so diversified funds.

Investing on basis of size of companies - Large Cap vs Mid Cap vs Small Cap funds

Large Cap funds choose to invest in companies which are well established and whose performance is predictable and stable. Hence, investment in Large Cap funds is relatively less risky as the companies in which fund is invested are quite stable. Btw, ‘large cap’ refers to Large Market Capitalization, which means companies whose total value of shares in Market is larger than most other companies in the stock market. The companies are so large that they have a way too many shareholders. These companies are also called as Blue Chip companies. It should also be noted that these Blue Chip companies are matured companies and do not grow at very high growth rates as compared to smaller companies or startups! They have less risk but potential to grow is also low, as they are already established in their markets or have already captured their market. So, you can expect stability in returns but not high growth.

Mid cap funds target companies which are not as big as large cap companies, but not very small too. These companies generally are in fast growth stage as they are still trying to capture their market. As these companies are not as established as large cap companies in their markets, these companies are more risky. Their stock prices fall more when their performances takes a hit. But, when you take the risk of investing in these type of companies, you also have a chance of making a higher return then you would make in large cap companies, since these companies are still in high growth phase.

Then comes the Small cap companies. Small cap companies have got even lower total valuation of their stocks in the market. These companies are smaller and less established than the Mid cap companies. As natural it seems, the risks of investing in these type of companies is quite high but investors invest in small companies with the expectation of very high gains. High gains are expected because these types of companies are still left with almost full potential to grow. These are nowhere near stability. They have got the complete market in front of them. So, if they perform well, they can make huge profits leading to high stock prices and higher returns for investors.

Investing on basis of sectors and industries

Sector funds target companies belonging only to a particular sector. Like some funds may expect technology sector to perform well and invest in technology companies. Some other fund may expect automobile sector to perform well and invest in stocks of automobile companies. Do you smell something like ‘anti-diversification’ here? Well, since these funds concentrate only on particular sectors, what if that sector goes down as a whole? We all have witnessed industries or sectors going down or even extinction in some cases. So yes, these funds are not diversified. Then, why should someone follow this strategy? Well, in case of these funds, fund manager being expert in analysing sectors expect some sectors to outperform the overall market during some point in time. And hence, they take decision to focus entirely on a particular sector. The timing of investment in this strategy is very crucial. It can make or break things. For example, there is no point in investing in companies which produce normal phones these days as smart phones are THE phones now. On the other hand, some visionary fund manager may have knowledge what will work in future and decide to invest in that. High risk but potential to achieve higher return if expectations come true, and potential to make heavy losses too if expectations do not come true.

Growth vs Value vs Dividend 

Growth strategy targets companies which have got a high potential for growth. The growth funds aim at earning their return from increase in the stock prices of the companies. This is also called as ‘Capital Appreciation’. Mug up the word ‘Capital Appreciation’, as it is quoted more than often in scheme documents. Whenever the scheme tells that their objective is capital appreciation, they mean to say that they intend to make money by purchasing at a lower price and sell at higher price. How about identifying a commodity which is selling below its actual worth? You might want to purchase such things in expectation that their price will rise to their true potential in future and then you can make profits. This is what value funds do. They identify companies whose shares are trading below their true potential and invest in them, expecting the prices to go up to their real potential.

What if you are not interested in ‘Capital Appreciation’, you need some sort of regular income to meet your goals. Then you need to invest in equity funds which strive to provide you regular income in form of dividends. Dividend funds select such companies which pays dividend so that it can be distributed to the investors or unitholders. Dividend is generally paid out by companies which are stable and do not have much scope for growth. So, rather than reinvesting their profits in growth of the company, the profits are distributed as dividends to the shareholders. You ought to seek these kind of funds if your goal is to have a regular income.

Investing on basis of a ‘Theme’

This strategy targets related sectors. For example, if the theme is smart devices, then these funds will seek to invest in all the companies which contribute to the smart devices industry. The sectors in this theme can include Software, Hardware or Electronics and Banking sector as it can provide loans to device producing companies. The theme funds are more diversified than the sector funds as they invest in multiple sectors. Still, they do have risks. What if the selected theme goes out of the market?!

Hope this helps you in assessing the schemes as per your goals! Post your questions in comments. We would be happy to hear from you.

About the Author
Anmol Gupta
Anmol is CEO at 7Prosper. He is SEBI Registered Investment Adviser, with expertise in Finance and Technology domains. Anmol is committed to help people achieve their financial freedom.

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