Investing in equity mutual funds can potentially be an effective way to grow your wealth over time. Professional management and affordability can make long-term wealth-building potential accessible to many. However, there are numerous equity funds in the market, and selecting the right one can seem challenging.

This article seeks to help you understand the different types of equity funds, the securities they invest in, and how to choose a suitable one based on your financial goals.

What are equity funds?

Equity funds are mutual funds that invest chiefly in inequities such as company stocks. Professional fund managers, based on regulatory guidelines and their own analysis and market knowledge, design the portfolio. They also manage it, making buy and sell decisions based on market conditions, stock performance, and future outlook, among other factors. Equity funds offer higher long-term growth potential than fixed-income investments or traditional savings options. Moreover, mutual funds give investors a way to tap into the potential growth of the stock market without needing in-depth market knowledge. Additionally, the option to invest through a Systematic Investment Plan (SIP) makes these funds accessible and affordable. This makes equity mutual funds suitable for investors with a high-risk appetite who are seeking long-term growth and are willing to accept some market risk and volatility.

Types of equity funds

Here’s a breakdown of the main types of equity mutual funds as classified by the Securities and Exchange Board of India (SEBI):

1. Large cap funds

Large cap funds invest predominantly in the country’s largest companies by market capitalisation, which is ranked between 1 and 100 on the stock exchange. They are typically well-established corporations, with strong financials and a track record of relatively consistent growth. Thus, large cap stocks tend to be less volatile than those of smaller companies. This makes such funds suitable for investors who want the long-term growth potential of equities but prefer to minimise market volatility.

2. Mid cap funds

Mid cap funds invest in mid-sized companies listed between 101 and 250 on the stock exchange. These companies are usually in their expansion phase, resulting in higher potential returns than large cap stocks but with greater risk. Mid cap funds are ideal for investors with a very high risk appetite and a long investment horizon to potentially tide over short-term market fluctuations.

3. Small cap funds

Small cap funds invest in companies listed 251 and beyond on the stock exchange. These hold the highest long-term growth potential, as they have significant room for growth. However, small cap stocks are also highly vulnerable to risk and volatility. Thus, such funds are best suited to aggressive investors willing to take on very high risk for the possibility of higher returns in long term.

4. Large and mid cap funds

Large and mid cap funds seek to combine growth potential with risk mitigation by investing in both large cap and mid cap stocks. They allocate at least 35% of their portfolio to each segment. They seek leverage the growth potential of mid cap stocks and the relative stability of large cap stocks, making them suitable for investors seeking a balanced approach.

5. Multi cap funds

Multi cap funds invest across the market capitalisations, including large, mid, and small cap stocks. Typically, these funds allocate 25% of their portfolio to each category, enhancing diversification and seeking to create a balanced risk-reward profile. Investors looking to leverage the advantages of each market cap – aggressive growth potential with small caps, high growth potential with mid caps, and relative stability with large caps – can consider this category.

6. Flexi cap funds

Similar to multi cap funds, flexi cap funds invest in large, mid, and small cap stocks. However, the key difference is that the fund manager has the flexibility to adjust the allocation ratio based on market conditions. There is no minimum allocation requirement to any market capitalisation, provided that at least 65% of the portfolio remains in equities. This flexibility allows the fund manager to optimise return potential by increasing exposure to high-performing segments while reducing exposure to volatile ones, depending on market conditions. For instance, a greater allocation to large cap funds might help reduce the impact of volatility during a bear market, while a larger allocation to mid or small caps could potentially help capture gains during a bull market.

7. Dividend yield funds

Dividend yield funds focus on companies with a high dividend yield, which measures how much a company pays out in dividends annually compared to its stock price. These funds can potentially generate a regular income stream for investors or optimise growth potential by reinvesting these dividends to enhance the effect of compounding.

8. Value funds

Value funds invest in stocks that are perceived to be presently undervalued by the market when compared to their intrinsic value. The fund manager identifies companies whose stock prices seem to be lower than their fair value, due to temporary market inefficiencies. These stocks typically belong to companies with strong fundamentals. If the market corrects and the stocks reach their fair value, investors can potentially benefit from price appreciation. However, patience and a long-term investment horizon are recommended for these funds.

9. Contra funds

Contra funds take a contrarian approach by investing in stocks that are currently out of favour or underperforming but have the potential for a turnaround. These funds are suitable for investors with a high-risk tolerance who are attracted to a contrarian investment style.

10. Focused funds

Focused funds invest in a limited number of stocks (30 at maximum). These are stocks in which the fund manager has a high conviction. This concentrated approach can lead to high returns in the long term if the selected stocks perform well. However, the fund concentration also increases the risk, making these funds suitable for investors with a high-risk appetite and a long-term horizon.

11. Sectoral/thematic funds

Sectoral or thematic funds invest in specific sectors or themes, such as technology, healthcare, or infrastructure. While these funds can offer high returns in the long term if the sector performs well, they also come with greater risk due to their concentrated nature. Investors with strong conviction in a particular sector’s growth potential and some market knowledge can consider these funds.

12. ELSS (Equity Linked Savings Scheme)

ELSS funds primarily invest in equities and offer tax benefits under Section 80C of the Income Tax Act, of 1961. Investments of up to Rs. 1.5 lakh in ELSS are tax-deductible. However, these funds have a mandatory three-year lock-in period. ELSS funds are suitable for investors looking for long-term growth potential along with tax savings and do not need liquidity in the near term.

How to choose equity funds

To select a suitable equity fund, you need to factor in several things, including your financial goals, risk appetite, and investment horizon. Important considerations include:

1. Financial goals: Determine your investment objectives, such as retirement planning, buying a home, or funding your child’s education. Clear goals will help you select a suitable investment horizon and thereby, the appropriate equity fund.

2. Assess your risk tolerance: All equity funds are categorised as high risk, but some, like mid cap, small cap, and contra funds, are riskier than others, such as a large cap.

3. Consider the mode of investment: Choose between a lumpsum and asystematic investment plan (SIP). An SIP allows you to invest regularly in small amounts, which can help mitigate the impact of market volatility. Over time, this can lower the average cost of investment. This can mitigate risk and make investing affordable. You can also use an SIP calculator online to plan your investments.

4. Diversify your portfolio: Diversification helps mitigate risk by spreading your investments across multiple securities/asset classes. Consider investing in a mix of large, mid, and small cap funds. Also include some traditional investment options or debt funds in your portfolio for relative stability.

5. Fund manager’s expertise: The experience and track record of the fund manager are crucial to the performance of the fund.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.

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