Equity investing: Here’s all you need to know before investing in equity funds

By Santosh Singh

Equity as an asset class has outperformed fixed income over long periods and also is much more liquid than physical assets like real estate. However, direct equity is not every investors cup of tea given the tedious exercise of finding right stock and keep on following it on a regular basis. Equity fund is a simpler way to get exposure to the equity markets for retail investors. 

Broadly there are two type of equity funds a) Actively managed and b) Passively managed 

A) Active managed: These are the funds which invest in equities by actively selecting stocks based on thorough analysis. The basic premise being investing after research would lead to superior selection and eventually superior returns. The funds are generally benchmarked against an index, however the stock selection is not restricted to the index. Which means that the Fund manager may decide to have altogether different stocks or the weights can be different from the index itself. These are called active weights. Based on the customers and the regulatory requirements, the funds can be either in a Mutual Fund structure or Portfolio management structure or Alternative Investment Funds. Retail investors generally invest in the mutual fund structure given the flexibility and no size cap on minimum investments and hence would focus on that itself.

B) Passive funds: These funds are based on the premise that markets are efficient and hence tracking the index would lead to better outcomes for the investors as the costs are low. In these funds the aim is to minimise tracking error and hence be as close to the index as possible. The fund tries to mimic the index to the closest possible extent and hence any change in the weight or index constituent is bought and sold by the fund in the same proportion.

For today we are going to focus on actively managed funds.

As we discussed earlier active funds are trying for superior returns. Most of these funds deploy different strategies which can be based on different criteria’s.

Size of the companies: These funds decide their investment universe based on the size of the companies. Also the index is based on the same premise. SEBI has given multiple classifications for the funds based on their sizes. Some of the examples are 

1. Large cap funds: These funds would predominantly invest in large cap stocks, with some flexibility to go out of the large cap. SEBI classifies top 100 market cap companies as large caps and it provides the list of these companies on a regular basis. Benchmark’s are generally Nifty 50. These funds provide the investors with an exposure to the top listed companies in India, with the fund manager through his expertise would try to select better from these stocks. 
2. Mid cap funds: As the name suggests the investments would be predominantly in the mid sized companies. SEBI classifies companies from 101 to 250 in this category and it publishes the list of these companies on a regular basis. Expectation of these funds is to provide exposure to companies which are in mid tiered category and which are expected to grow faster than their larger counterparts. 
3. Multicap category: These funds can invest across asset classes with a much larger exposure to mid & small caps compared to the large cap funds. This category has somewhat more flexibility than the other fund categories
4. Flexi cap funds: These funds provide maximum flexibility to the fund managers as it allows them to go across the market capitalisation range and invest. This fund category provides much more freedom to the fund manager.

Sectoral/Thematic Funds: These are the funds which invest predominantly in a particular theme or sector. The funds can have much higher volatility than the funds discussed earlier. However, the expectation is that if a sector or a theme is identified well the ability to generate higher returns is much more. The likes of banking fund or consumer or infra funds are examples of these type of funds 

Equity linked Saving Schemes (ELSS): These are the funds which come with tax benefits but have a lock-in of three years. The funds have to predominantly invest in equity and equity linked securities. 

Focussed fund: These funds can define their style according to the market cap but have a limitation of investing in maximum 30 stocks. The funds have much focussed approach to investing given the stock limitations. 

For individual investors the risk profile and time span should the criteria to select funds. We have seen time and again that the retail investors try to time the market and that has been the biggest reason for the investors to not able to generate market returns. Also, inability of the investor to identify his risk-bearing capacity has been another reason where the investor has to sell when the markets fall. Hence, like any finance companies which does its Asset liability management (ALM) before investing/ giving loans, an individual investor should also look at it. 

Generally, large cap funds are said to be less volatile but the expectation is that mid and small cap may generate higher returns over a very long period of time. Sectoral funds tend to have highest volatility and risk but may also generate highest returns if the sector selection has been right.

Hence, overall equity funds are a better way for retail investors to invest in equity but the decision making of where to invest should be based on risk profile and available time.

(Santosh Singh is the Head of Research T Motilal Oswal asset Management Company. The views expressed by the author are his own. Please consult your financial advisor before investing.)