Why you should invest in equity mutual funds

why to invest in equity mutual funds

Written by Aryan Agarwal

August 10, 2020

Investing in the stock market is difficult as you will have to learn about the stock market and will have to subsequently apply that knowledge you acquired in picking the stocks and invest in them.

You can cut this process and instead invest in equity mutual funds and earn the same high returns that everyone keeps talking about the stock market without taking a significant risk by choosing individual stocks.

So let’s learn all about equity mutual funds today

What is a mutual fund?

A mutual fund is a pool of money that is collected by huge financial companies to invest in securities and assets like stocks, bonds, commodities, etc.

These funds are managed by professional managers who have degrees from top universities and experience in the stock market, who allocate the capital available to them to attempt to produce capital gains for the investors.

Therefore, these financial instruments allow access to small or individual investors, access to professionally managed portfolios, and their investing experience. Each mutual fund holder, therefore, participates proportionally in the capital gains or loss of the fund.

What is an equity mutual fund?

what is an equity mutual funds

Equity mutual fund is a type of mutual fund wherein the professionals invest in the stock market to try to get a higher return than the stock market and therefore beating them in returns given.

Most of the equity funds are actively managed, which means that the mutual fund managers actively trade the stock market to find the best deals and make money off them for the investors.

Equity mutual fund dividends

Some equity mutual fund passes on the dividend to the mutual fund holders. At the same time, some invest specifically in dividend giving shares. These funds pay dividends to investors in specific time period depending on the fund like monthly, quarterly or yearly.

The best feature of these funds is that they are consistent in paying. This makes them a great option with someone who is looking for a steady income from the stock market.

How do equity mutual funds work?

Equity mutual funds are managed by professional money managers, and these managers actively traded stocks to ‘beat the market’ by getting higher returns than the stock market index.

Once you invest your money in equity mutual fund, the money managers take that money and invest in into the stock market.

The gains and losses that the stocks give are directly passed over to the investor.

Load and Fees

Front Load Fees

Front-load fees are the sales charge or commission for the investment made. These fees can be a percentage of the amount you deposit or a flat fee depending on the mutual fund provider.

This fees is deducted from the initial purchase and therefore lowers the amount of money going into your investment.

This is a one-time fee when purchasing and are generally paid to financial intermediaries as compensation for selling you the mutual fund.

Exit load Fees

Exit load fees are the fees charged by the mutual fund company when the investors want to exit or redeem the mutual fund scheme before the lock-in period (generally 1 year). Not every mutual fund company will charge an exit load fees.

Before investing, you need to check the lock-in period of the mutual fund as well as the expense ratio.

No Load Fees

No-load means that the investor won’t have to pay any sales charge or commission to any intermediary. However, this doesn’t mean that no fees are charged. Exit load can be charged if the investor exits before the lock-in.

Management Fees

Mutual funds charge management fees to cover their operating cost like hiring and paying the money managers who manage the mutual fund’s portfolio and any other fees that are not included in expense ratio.

A mutual fund incurs a lot of expenses while running the funds apart from the transaction costs of the stocks like marketing, legal, auditing, customer service, etc. These expenses have recurred from the investor as the company is doing business and not charity by providing these services to the investors.

Management fees can anywhere 0.5% to 1% of the fund’s assets under management(AUM). This may look small, but considering that the AUM of a fund is in millions, the fees can be too high.

Management Expense Ratio (MER)

The transactional cost of buying and selling stocks are not covered in the management fees. These transaction costs are charged separately and mentioned under the trading expense ratio. Together the management fees and operating fees make up the MER.

The most significant expense of the mutual fund company is the hiring and retaining of the employees. That means that the management fees are the most important thing to look for in the expenses section before investing in the mutual fund.

Impact of Fees

Ultimately the fees are indirectly borne by the investor. You may not know that they are charging you any fees as they don’t charge it from your bank account. They directly deduct the fees from the money you invest.

These fees can eat up your returns because if you get a 10% APY and have a 2% MER, then your net return is only 8%. These fees add up over time and severely damage your returns in the long term.

Investment Horizon

When you invest in equity mutual funds, you need to know and decide how long you want to be invested in them. It’s alright if you don’t have any particular time frame or an emergency comes up, but you need to know that if you want to invest for a couple of years or for the long term like 10-15 years.

Investing in mutual funds should always be looked at as a long-term investment as that’s where you can actually see a considerable difference and subsequently earn a lot. This is because of a little thing called compound interest which causes the invested money to grow exponentially over time instead of linearly.

That means the longer you keep your money invested, the faster your money will grow.

Investing for the short term can work as well, but it doesn’t take advantage of compound interest as much as long term investing does. So if you want to make some big bucks, try to invest in equity mutual funds for the long term.

Equity mutual funds types

Domestic equity funds

As the name suggests, domestic equity funds invest primarily in domestic publicly listed companies.

International equity funds

International equity funds have to buy mostly international stocks that may or may not be traded in the domestic market

Growth stock mutual funds

These mutual funds focus on high growth stocks that can deliver good profits. Best examples of high growth companies are startups as startups generally grow extremely fast if it’s a good company. These funds typically invest in the domestic market.

Global growth stock mutual funds

These funds invest in high growth stocks from all around the world. This opens up a lot of potential for money growth as they can invest in untapped markets and make money from it within the countries regulations.

Equity mutual funds classification

Large Cap

In the large-cap fund, a large part of the investment is completed in companies with large market capitalization. Large caps are large, well-established businesses of the equity market. These businesses are strong, reputable and reliable.

Large-cap funds have reduced growth potential and provide investors with lower returns on investment compared to mid and small-cap funds. But provide decent stability in returns on investment, even if invested for a longer duration.

Liquidity of stocks of the large-cap fund is quite high since they’re reputed, mature and firmly established players in the industry.

Mid Cap

In mid-cap funds, a large part of the investment is done in companies with medium market capitalization, i.e. are a bunch of businesses in a market after large-cap businesses

Stocks of mid-cap companies are riskier than large-cap but much less risky investment tool as small-cap

Mid-cap funds have greater growth potential and provide investors with greater returns on investment compared to large-cap funds

Investment in mid-cap companies is best suited to investors with moderate risk appetite and is most popular among investors.

Liquidity of stocks of mid-cap companies is more as compared to small-cap funds.

Small-Cap

In small-cap funds, a large part of the investment is completed in companies with small market capitalization.

Stocks of small-cap companies highly insecure and volatile investment tool.

Small-cap funds have exponential growth potential and provide investors with high returns on investment

Investment in small-cap is most appropriate for investors with higher risk appetite and have a great understanding of the stock market.

Liquidity of stocks of small-cap companies is least.

Returns

Equity Mutual funds can vary from funds to funds as their manager will be different and make different decisions. I have seen the historical rate of returns from 10.83% APY to only 4% APY over a 50-year period. So, it all depends on your choice in equity mutual funds

Vanguard found that Index funds have given a 9.71% APY since 1928 while fixed income has given a 5.33% APY since 1928.

Vanguard dividend growth fund (VDIGX) has been giving an 8.45% APY since 1992.

Risk

Due to the equity part of the equity mutual fund, it can be risky as the stock market is considered a relatively risky investment to start with, although that risk comes with chances of a great return.

A study showed that only 23% of the ‘actively’ managed stock mutual managed to beat ‘passive’ index funds. That’s less than a quarter of the total funds while charging aa much higher fees than index funds.

Index funds, on the other hand, like vanguard S&P 500 index fund(VOO) has only 0.03% compared to actively managed funds with 0.5% to 1% fees.

Bonds and fixed-income funds are safer in nature and therefore give you a lower return.

That doesn’t mean that stock mutual funds are bad or unsafe. They are safe and reliable, you just need to select a good fund, and if you don’t want to do that, then you can’t go wrong with index funds.

Taxation

If the capital gains are short-term, meaning the fund manager sold an investment that the fund had held for less than 12 months, you’ll pay ordinary income rates on the distribution. Long-term capital gains are taxed at the lower capital gains rate.

If your fund pays a dividend, you’ll also be taxed on this. Dividends are taxed as ordinary income unless specific IRS qualifications are met. Investors must pay taxes on any dividends received, even if you reinvest those dividends.

To avoid paying taxes on mutual fund distributions in the year they are received, hold the fund in a tax-deferred account, such as a traditional individual retirement account or 401(k). With tax-deferred accounts, you won’t pay taxes until you withdraw the money from your account.

Pros

Diversification

Ask any investor, and they will say that diversification is a must. Mutual funds are an excellent investment considering they diversify their portfolio for you. Vanguard Total stock market index fund(VTSMX) holds and invests in 3,654 stocks.

Professional Money Management

Mutual funds are managed by professionals having university degrees and education. Their sole focus is on investing and dedicate their entire time to analyzing and finding potential stocks to buy.

Systematic investment and withdrawal plan

Mutual funds allow a systematic investment plan(SIP) so that you can start an investment and forget about it. This is nice as investing should be done consistently. Systematic withdrawal plan(SWP) is also offered where you can withdraw a certain amount every money.

Multiple asset exposure

You can buy mutual funds with invest in specific stocks like growth, low volatility and value. That is useful because even professional managers face difficulty finding certain stocks.

Cons

Costs

Stock mutual funds have higher fees than passive index funds. Many mutual funds also require minimum investments, lock-in periods, fees and commissions.

Lack of intraday liquidity

Mutual funds are not traded on the stock market, so their price is calculated once per day at market close time. So you can buy at different times of the day and will get the same price.

Taxation

Mutual funds are a pass-through investment. That means that any charges and taxes while transacting stocks will be passed on to the investor.

Lots of choices

There are a lot of mutual funds on the market and selecting the right one can be a hassle and time-consuming.

Conclusion

Equity mutual funds may not be perfect, but depending on your needs and risk appetite, you should look to invest in equity mutual funds.

It’s essential to weigh the pros and cons before investing and finding the right mutual fund for your needs.

Let me know which one you select or if you have any query in the comments below.

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