The purpose of mutual funds is to allow small investors to have a diversified portfolio. In simple words, mutual fund is a pool of money collected from many investors, individual or institutional, to invest in stocks. It is a professionally managed entity that caters to needs of small investors for a fee. Minimizing risk is the goal of a mutual fund. An individual investor may purchase a number of stocks and put together his portfolio. But the influence of a single stock over the entire portfolio will be high as he cannot diversify beyond a limit with his available capital.
In India, an equity mutual fund should invest more than 65% of the assets in equity and equity related instruments, as per SEBI Mutual Fund Regulations. The size of an equity fund is determined by various aspects like market capitalization, investment style, geography, industry or sector wise, etc. These funds can be actively or passively managed. Actively managed fund means the mutual fund company and the fund manager analyse market and decide the best way in which the fund can be invested. Passive management is where the fund follows an index. It is build to replicate a stock market index like BSE SENSEX or Nifty. The fund just follows the index, though not to the fullest extent, and its performance goes in parlance with the chosen index. These are called index funds. Exchange traded funds (ETFs) are another type of mutual funds which are passively managed. ETFs are index funds listed on stock exchanges like individual stocks. The trade value of an ETF is determined by the net asset value of the stocks comprising the fund. Like shares, the prices of ETFs change and investors can buy and sell the funds as a whole.
The value of a mutual fund is calculated in terms of its ‘net asset value (NAV)’. At the basic level, NAV is the difference between the assets and liabilities of any financial entity like a company, asset or a fund. In mutual funds it represents per share or per unit value of a fund.
Categories of equity mutual funds:
Equity mutual fund comprises of several equity stocks picked from different companies in different industries. These funds are categorised into following:
- Large-cap equity funds invest in companies with large market capitalization. These companies are usually in the industry for a long run, have faced all hurdles and stabilized in at least few of the key business attributes.
Market capitalization is share price of a company multiplied by total number of shares being traded in the market. This is a measure of both the value of the company and its risk profile. A company with higher share price may not be a large company just for that reason. It can be a successful company yet with limited number of stocks being traded in market. Similarly a company with less share price does not convey any idea of its size. It can be having millions of shares traded in the market.
- Small-cap equity funds which invest in small companies i.e., those with market capitalization less than 100 Crores. This definition can differ among the market players. Small companies which are relatively new to the market have high potential for growth and also high risk factor. As they are less experienced than large cap companies and their poor business decisions do affect the stocks adversely.
- Mid-cap equity funds invest in companies which fall between large cap and small cap companies. Their growth potential is moderate; risk is not as high as small cap or as diverse as large caps. These are companies in their growth phase and most often they are found to be more profitable than the big heads.
- Thematic equity funds invest in a particular sector like commodities, pharmaceutical, real estate, telecommunications, banking etc. These funds perform usually well unless there is a single regulation or a government rule that comes into effect which influences the industry as a whole. This influence can either be positive or negative. Risk is always there irrespective of our patterns and styles of investment.
Now that we have understood equity mutual funds and their types let us delve into finding why they are a better option than buying stocks:
Advantages of equity mutual funds over stocks:
An equity fund gathers capital from lakhs of investors willing to invest in equity. This enables the distribution of losses if any. In case of individual stocks the investor has to bear the entire loss from fall in stock prices.
Accommodates small investors:
The greatest advantage of an equity mutual fund is making small investment in a highly diversified portfolio which is otherwise not possible for a petty investor. He cannot put in all the research that takes to identify a well diversified, risk free portfolio. He can rather choose a well performing equity mutual fund and put his money in it.
At any given point of time, the value of an equity fund doesn’t become zero. For this to happen all the companies where fund is induced should incur losses at the same time which never happens in reality. While individual shares may experience severe fall in their prices as a result of company’s poor financials, decrease in sales, losses or even bankruptcy.
Many times individual investors get lured by consistent fall in price of a stock. These are serious warnings that it might never recover in the due course. Keeping this fall in mind they get influenced to procure more of that stock and end up losing money. There is no scope for such emotional buying in case of a mutual fund. The fund manager well analyzes the reason behind that consistent fall. They look beyond the visible lines with their research and understanding of the market.
It is always a compulsion that individual stock investor establishes his high and lows for profit and loss respectively. This saves him from losing the entire money and he could minimize his loss. Equity mutual funds come with preset limits. And they operate under strict guidelines in order to eliminate the risk of poor decision making.
Every equity fund has large number of stocks in any given industry like technology, manufacturing, service, consumer durables etc. Stocks of different companies are brought together to distribute the risk quotient and limiting the fund exposure to market fluctuations. This is not possible when you carry individual stocks. It takes a lot of time and work to analyse each company be it on a fundamental level or technical level and to select exactly those stocks which do wonders. Investors often get restricted to few companies in portfolio for easy management.
Availability of choice:
The number of mutual fund companies in India, and equity funds offered by them are so large. There are literally thousands of funds out there in market to cater to needs of every single investor. Investors averse to risk, those who are willing to invest only in a particular market segment, or only growth funds or in international markets, investors with limited resources, etc all have funds that meet their individual requirements.
We can try selecting ideal equity stocks for investment and plan the portfolio. But there can be loopholes which we might not identify. As an investor your research should include understanding financial statements, financial ratios, historical analysis, etc which are time taking and tedious. Mutual fund managers have such problems well sorted out. They follow a pre programmed strategy for scanning the stocks and pick those where risk is minimal. Even the tools available to the mutual fund companies are highly sophisticated and critical when compared to an individual investor’s analyses. The losses arising in case of one stock failing to grow will be compensated by the other well performing stocks in the fund.
All mutual funds in India are regulated by Securities Exchange Board of India (Mutual Fund) Regulations, 1996. Investor can be assured of security for his money when he chooses equity or any other form of mutual fund. SEBI acts as a guide and governs the investment activities to ensure that mutual funds are free of issues like embezzlement or misappropriation of funds. It works for the protection of interests of the investor. Apart from SEBI mutual funds also have a three tier structure namely sponsor (the company itself), public trust with trustees having capacity to enter into contracts and the asset management company which designs the investment strategy. The trustees here constantly work to ensure the fund is managed according to the objectives of the mutual fund. An individual investor’s role doesn’t end with stock selection and extends to their management, which might obviously be less efficient when compared to the work of a proficient fund manager.
Purpose of investment:
Equity mutual funds offer best solution for investors aiming at long term savings in a profitable way than fixed income alternatives like bank deposits. Their research ends with finding a good mutual fund company. Beyond that they can be assured about the core aspects like fund performance, unit price etc and check the vitals through the fund manager. In case of stocks, the investor has to play all the roles by himself. He should do his own research, pick good stocks, invest at the right time and sell for the right price. For an active investor these may not be a burden but for those who are busy otherwise find equity mutual funds as a great option.
Tax on capital gains:
Income earned on capital assets is referred as capital gains. Any short term capital gain, that is income earned on securities within one year either in the form of stocks or equity mutual funds are taxable @ 15%, if securities transaction tax (STT) is not applicable. If in case STT is applicable the short term capital gains are included in the regular income of the investor that year and taxed under applicable slab rate. Any income that extends beyond the period of one year attracts long term capital gains tax @ 10% on amount exceeding 1 Lakh.
Though the taxation of equity mutual funds and stocks is the same, EMFs offer tax saving schemes like ELSS (Equity Linked Savings Scheme). ELSS is an instrument exempted from tax under Sec 80C. They come with a minimum lock in period of three years within which you cannot sell the units. After this lock in the gains on units sold will be treated same as long term capital gains discussed above.
Cost of investment:
Mutual fund companies charge a fund management charge once in a year from the investor. Whereas in stocks you need to pay a brokerage fee depending upon your trading volume and the type of trade you choose. If you need guidance in addition to the trading facility you need a full service brokerage which costs you more. If you are a buy and hold investor the brokerage incurred may be relatively less. Both equity mutual funds and stocks have their own costs. Investor should make a choice after finding out the option where returns earned will compensate the costs.
Hence we can understand that equity mutual funds give a better return for the risk involved in the investment. They are not free from setbacks such as cost of investment (fees paid to the mutual fund company), lack of investor control over the fund, longer return period, etc. But we should always think from the risk perspective. The investors should question themselves whether their individual stocks matchup over and above the risk taken. Though mutual funds come at a cost, if you are willing to give a minimum of three to five years, you can surely reap good and consistent profits. Nevertheless the losses are always kept at the bay if you opt for equity mutual funds rather than stocks. An enthusiastic investor has no limits and can choose either of them. But they should always do the risk return analysis before choosing the right place for their money. Stocks might give early and high returns whereas equity mutual funds offer consistent and long term returns.