How Equity Mutual Fund Schemes Work

It is actually quite simple. You give money to a mutual fund, which invests it in equity stocks on your behalf wherein the gains or losses also accrue to you. Of course, there are technicalities involved but this is the crux of investing in equity mutual fund schemes. However, being a prudent long term investor, it helps to know more details about how an equity fund works. So let us see what they are.

Investment Objective: First and foremost, equity funds are not one size fits all. There are a variety of equity funds classified by their investment objective which needs to be mapped to your risk profile. Though the investment objective of all equity funds is capital appreciation, it is the risk taken to achieve this objective that varies. This further depends upon the type of stocks that the fund would invest in.

This could either be based on the market capitalisation of the stock like large cap, mid-cap or small cap wherein the former is relatively less risky (volatile) than mid-cap or small cap. The objective may also be to invest in a mix of stocks across market capitalisation and across sectors termed as diversified equity funds. Another objective may be to save tax – called equity linked savings scheme or it could be to invest in specific sectors or themes say banking (sector) or infrastructure (theme) or invest in international equity.

Investment Strategy or Style: You as an investor also need to know the investment strategy followed by the fund house, meaning the methodology followed for selecting stocks. The key investment strategies or styles include top down strategy, bottom up strategy, value strategy and growth strategy.

1. Top-down strategy - simply means that the sector is chosen first and then the best stocks within that sector are bought in the portfolio.
2. Bottom up strategy- means that well-researched stocks are bought irrespective of the sector.
3. Growth Strategy – means that the fund will invest in companies which have a consistent track record of profitability and growth, and are likely to continue on this path in the future.
4. Value Strategy – means that the fund will invest in companies which have a potential to grow exponentially in future and are currently available at a lower value.

Asset Allocation – While most equity funds are close to fully invested in equities, there are a few which may have a split allocation between predominantly equity (at least 65%) and the rest in debt or an allocation between domestic and international equity. It is important to look at asset allocation from a tax efficiency perspective because as per the current Income Tax Act, 1961 provisions, equity funds are those which have an annual average of 65% allocation to domestic equity. Hence international equity funds which have a predominant foreign equity allocation are classified as debt funds for income tax purposes.

Expenses: Last but not the least, it is important to know that you are also charged for investing in equity mutual funds. While this may be true for investing in any mutual fund scheme, equity mutual fund investors are charged more than those who invest in other asset class. In short, the riskier the asset class, the higher the charges. For example, equity funds will have higher charges vis-à-vis debt funds.

These charges are denoted by a term called ‘Expense Ratio’ which is nothing but the ratio of scheme expenses to its assets under management (AUM). These expenses include cost of running the mutual fund scheme like brokerage cost, administrative cost, marketing and distribution cost, commissions, investment management charges, service tax (if any), investor education charges, among others. You may also note that funds with a similar objective may have different expense ratios depending upon their AUM and actual costs incurred to run the scheme.

There could be a further variation of expense ratio even within equity funds, depending on whether they are actively or passively managed equity funds. The latter, which replicate an equity index, have a lower expense ratio than actively managed equity funds.

You also ought to know that there are two classes of expense ratios – one for direct plans and the other for regular plans. In the former, commissions and distribution costs are excluded while they are included in the latter. Returns of direct plans are higher than regular plans to the extent of the difference in the expense ratio.

Summing up

Simply put, equity mutual fund schemes pool your money and invest in equity stocks after in-depth research. However, it is important to understand the basics of how equity funds work. This includes knowing the objective of the equity fund and mapping it to your risk profile. Next is the asset allocation of the fund followed by the investment strategy. Last but not the least; you also ought to know the expense ratio of the fund as it could impact returns.

Information contained in this article is not a complete representation of every material fact and is for informational purposes only. Regulatory/ taxation details, if any are provided on a best effort basis and are as per the existing laws and subject to change from time to time. The recipient is advised to consult an advisor/ tax consultant prior to arriving at any investment decision.