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Wednesday, December 16, 2009

Equity Mutual Funds Investment - A Guide

The options for investments are many with mutual funds, though the first thing anyone new to investments thinks is equity mutual funds.

In India, mutual funds companies have the second largest corpus of investments after life insurance companies.

Mutual fund type based on asset class
Mutual funds can be of different types based on what they are composed of. They can be:

1. Equity based
2. Debt based
3. Money market based
4. Balanced

An equity fund invests most of its corpus in equity shares. The type of companies to invest in depends on the fund philosophy. A debt fund invests in bonds, deposits and government securities. The money market fund invests in the money market. The balanced fund mixes equity and debt is proportions as determined by the fund philosophy.

We would focus on the equity based mutual funds in this article.

Current income
The quantum of current income from an equity mutual fund depends on its fund payout choice. The choices generally are:

1. Dividend payout option
2. Dividend reinvestment option
3. Growth Option

In the dividend payout option, the fund manager pays out a portion of the growth in the fund value as dividend. This becomes income in our hands. The Net Asset Value (NAV) of the fund decrease as a result of the dividend payout. People who need funds on a regular basis can prefer this option. The amount of dividend, however, will depend on the market conditions.

In the dividend reinvestment option, the dividend is declared, but the payout is reinvested in the same fund to buy more of the units in the same fund. This way we will get more units in our investment.

In the growth option, there is no dividend paid. The growth in the investment is reflected only in the increase in the NAV. There is no change in the number of units held by the investor. A long-term investor can make use of this option.

Capital appreciation
Capital appreciation is the major benefit from any mutual fund. The current income from any asset class gets converted into a capital appreciation when it is received in the form of a mutual fund. The difference is in the tax treatment of current income and capital appreciation. Capital appreciation tends to be treated with less tax at all times compared to current income.

The average return over the last 5 years period from the top 15 diversified equity mutual funds has been 31% compounded annually.

Risk
Equity mutual funds suffer the same risk as equity shares in general. However, fund managers have tools like dedicated research, diversification and hedging at their disposal, which could reduce the risk considerably.

Fluctuations in the NAV can be expected on a daily basis, as the funds cannot disconnect themselves from the equity market. Several researches have shown that in the long run the returns from the stock market are much higher than any debt instrument.

Liquidity
Any mutual fund scores high on the liquidity and transparency front. Generally redemptions reach the investors within four days from the application for closure.

Partial closures can also be done to meet our cash requirements. Some times this convenience of quick withdrawal and closure proves to be counter productive as even the slightest need for money or fear of a market fall leads one to reach out to the redemption form.

Tax treatment
Equity mutual funds have a favorable tax treatment. Any investment that is over one year old (365 days from the date of investment) suffers zero per cent capital gains tax. The long-term capital gains tax is zero - that too within a very short period of one year. Normally the short-term capital gain tax is 10% of the gains.

We can also get Section 80C benefits from certain equity mutual funds called Equity Linked Saving Schemes (ELSS). However it has the 3 years lock-in period. All mutual fund houses have ELSS funds in their kitty.

Convenience Factor
Mutual funds score the highest with the convenience. In fact there is a whole list of convenience benefits from mutual funds - equity funds in particular.

As individual investors we do not have knowledge about different industries, the companies in them and the methods to analysis which is a good investment. This is provided by the teams of researchers employed by the funds. Even if we have the knowledge, we may not have the time to do all the research and do the actual investing. As a small investor, to diversify risk, we need to invest in a number of shares. To do this, we need a lot of money. Definitely, we cannot manage this with as little as Rs 500 per month. The mutual fund is able to deploy even Rs 500 fruitfully as there will be many numbers of people like us investing small amounts. The pooled amount can now buy shares that need to be bought.Mutual funds offer even monthly investment of small amounts. This is convenient for small investors and salaried people.

With a little discipline to be invested for the long term and to invest regularly, the returns can be maximised from equity mutual funds at reduced risk.

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