Benefits of Investing in Equity Funds

Benefits of Investing in Equity Funds

As an investor, you have two choices to invest in equities. You can directly buy stocks from the equity market by opening a trading equity account with a SEBI registered broker. The other option is to opt for equity mutual funds. Both approaches have their distinct and respective merits and demerits. However, direct equity investment may not be your cup of tea if you are short on time and expertise to identify and buy stocks directly. In that case, a better choice would be opting for equity mutual funds

We all know that mutual funds are trusts that collect small parcels of funds from investors, invest these funds in a portfolio of companies and distribute the benefit to these small parcel holders (unit holders) in proportionate units allocated. This is a better option than equity in trading since there is a professional manager looking after your hard-earned funds. There are two arguments to understand here. Firstly, why invest in equities, and why opt for equity funds to invest in equities? 

Investing in equities via equity mutual funds proffers some distinct advantages. Here let us look at some of the essential merits of investing in equities via the equity mutual funds route.

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Fund management is complex and best left to professionals.

If you are not into handling and investing funds, you must be cautious about entering direct equities. In such cases, a better choice would be to invest in equity mutual funds. How do you get the advantage of professional management via equity mutual funds? Typically, an AMC works in a very formal and professional set-up with focussed experts in research, analysis and trading executed by experts. There is also the CIO and the fund manager who take a macro view and then invest the corpus of the equity fund.

There are some crucial advantages that mutual funds as an institution bring to the table. They have over a hundred man years of combined expertise, vast networks, access to dealers and companies, and the list can go. They also bring a more comprehensive industry perspective and outlook than an individual can ever do. Besides, mutual funds continuously monitor stock performance, portfolio risk, and other macro risk factors.

Diversification and risk management are built into mutual funds.

How do mutual funds manage risk? One is the expertise we discussed in the previous point. The second is through diversification. Holding a portfolio of diverse assets is better than putting all your eggs in one basket. Most of these rules, investing outlines and processes are documented and defined by the fund, so things become much more systematic. One of the significant risks in investing in mutual funds is the concentration risk. That is primarily mitigated by restricting the stock or sector level exposure.  Other risk parameters like stock liquidity and volatility are continuously evaluated by the AMC. When these factors combine, the fund's overall risk decreases sharply. Diversification is not only about reducing your risk but also about diversifying your sources of return. You have some outperformers in every cycle of the market. It is a sharp trade-off, and only professional fund managers with massive networks to support can handle such complexity.

You can hold many stocks with a small investment in equity funds.

This is perhaps one of the most important, yet most underrated, features of an equity fund. Imagine that you want to buy 1000 shares of Reliance Industries. It would cost you Rs.25 lakhs, a large sum for retail investors to be able to afford. Even with this investment, you would still be running concentration risk if the stock of Reliance goes into a downturn. That can be addressed by mutual funds, where a small investment spreads across a broad portfolio of stocks. But how small can the investment in equity funds be?

It can be very small. For instance, investing in mutual fund scheme NFOs or in ongoing funds can be as low as Rs. 5,000. Investing in systematic investment plans or SIPs can be done with as low as Rs. 500 per month. With this kind of low entry barrier, buying equity funds is just anybody’s cup of tea. In mutual funds, you can start by owning a very well-diversified portfolio by investing a very small amount. 

Rupee cost averaging through SIPs

This is another very important aspect of equity funds. We will understand this aspect at two levels. At the first level, let us look at a systematic investing plan (SIP) and how it helps. The best way to invest in equity funds is to start early and do it gradually. A small monthly investment can grow to a massive sum over 20-25 years if the SIP is sustained. SIPs also give the advantage of rupee cost averaging or RCA. You just need to persist with SIPs over an extended period, and the fluctuations will work in your favour. Since your amount of investment is fixed, the investor gets more value when the NAV goes up and more units when the NAV goes down. It is like heads you win, and tails you don’t lose.

The other important aspect is the applicability of the SIP concept to financial planning. In financial planning, the focus is on long-term goals. Such goals have to be planned once you estimate the financial requirement. This planning is best done with systematic investment plans and pegging each SIP to a specific long-term goal like retirement, child education, child marriage, second home etc. Financial planning is one of the most important applications of equity funds for the long term via the SIP route.

Equity funds also offer tax efficiency.

When an investor buys and sells stocks, he would be subjected to long or short-term capital gains tax, as the case may be. How is this decided? It is based on the holding tenure. The cut-off is 12 months. If the investor sells the equity fund after 12 months, it is a long-term capital gain, and if it is sold before 12 months, it is a short-term capital gain. So, if he holds one stock for 6 months and another for 18 months, he would be taxed for short-term capital gains tax for the former stock and long-term capital gains tax for the latter stock.

Capital gains tax on equity funds is at a concessional tax rate. Short-term capital gains on equity funds are taxed at a concessional rate of 15%, while long-term capital gains are taxed at 10% of gains above Rs1 lakhs in a financial year. There is the aspect of dividend on equity funds if you opt for the dividend plan (ICDW) plan. In such cases, the dividend will be treated as other income and taxed at the peak rate applicable to the investor. In all cases, the treatment of equity and equity funds are the same for tax purposes. The only advantage of equity funds is that one can get Section 80C benefits by investing in ELSS funds with a mandatory lock-in period of 3 years.

To summarise, mutual funds are simple, convenient, diversified and tax efficient. Above all, they are also well regulated.