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- Category: Beginners Guide
In an emerging market like India, financial literacy is on the rise, catching up at a rate never witnessed before. With so many billboards around, advertising so many varied investment products, with so many institutions and banks launching such innovative investor-awareness programs, with so many of our friends and colleagues talking about their different investment plans, one is bound to feel nervous about the utility of their savings as bank deposits and, confused about what’s the right investment plan for them and what’s not.
At FinnovationZ, we understand that every individual has his or her own unique investment objective, return requirements and risk preference. We also understand the importance of your savings and the need of channelizing your hard-earned money in a way that ensures the safety of your funds, but at the same time, provides you an appropriate rate of return to fund your individual future expenditure plans.
Serving your individual need to choose the right path of investment that helps you fund your future goals, and taking into account the limited financial skills you might have owed to your non-finance background, we have come up with the two most regular and simple investment plans for you.
Mutual Funds and Equity Investment
The whole objective of this article is to compare the two most easily accessible investment plans for a potential investor. Initially, we briefly discuss the concept of the two kinds of investments and then we shift our focus to their comparison or differences. In this article, we outline the suitability of the two categories of investment plans, for different needs.
The structure of differences between Mutual Funds and Equity Investments has been built upon the following factors that we would discuss in detail later:
Q.1: What are Mutual Funds?
A Mutual Fund is a commingled investment pool in which investors in the fund each have a pro-rata claim on the income and value of the fund. In simpler words, it’s one of the pooled investment vehicles where a number of investors pool their funds for the purpose of investment in a portfolio of securities such as stocks, bonds, money market instruments and similar assets. Every investor who has invested funds in that portfolio will have a pro-rata share of the profits or losses coming out it.
Q.2: How do these Mutual Funds work?
Every Mutual Fund will have a Mutual Fund Manager who (usually works for an Asset Management Company) is usually a qualified portfolio manager by profession. It is the Mutual Fund Manager who will have the authority and responsibility to create and manage the portfolio and, to decide the proportion of funds to be invested in each security under that portfolio. The manager then invests those pooled funds to generate returns by minimizing risks using his/her professional skills and knowledge of the market.
Q.3: How do we price a given Mutual Fund?
The value of a Mutual Fund is referred to as the Net Asset Value (NAV). It is computed daily based on the closing price of the securities in the portfolio. NAV is defined as the sum of the total market value of all the assets or shares held in a portfolio, less any liabilities, divided by the total number of outstanding shares. We buy and sell our shares in a mutual fund at its NAV
NAV = (assets-liabilities) / number of outstanding shares
Q.4: How many different types of Mutual Funds are there?
The type of a mutual fund depends upon the composition of its portfolio, that is, the kind of asset classes and securities it is composed of.
On the broadest basis, there are following types of mutual funds:
- Liquid Funds/Market Funds
- Equity Mutual Funds
- Debt Mutual Funds
- Hybrid Funds
First, let’s try understanding the most frequently used terms here, equity and shareholders.
Equity is simply the amount of money that general public lends to a company to fund its business operations. In other sense, the money that a company receives from the public is called Equity Capital. A company acquires funds from the general public by issuing shares. Anyone who wishes to provide equity to that company would buy those issued shares of that company and in turn, will become a shareholder.
Shareholders are simply the people who have provided funds to a given company. Shareholders are the owners of a company and the providers of equity capital. Shareholders are entitled to a company’s net value—that is, the residual value after subtracting all the company’s liabilities from its assets. Shareholders maintain control over the company through their power to elect the board of directors and vote for specified resolutions.
Q.1: What is Equity Investment?
Equity Investment is a huge and a complex concept. But in the simplest sense, equity investment involves investing in a publicly traded company (i.e. companies that are listed on stock exchanges) to earn returns based on the future expected performance of that company. Additionally, the shareholders also earn dividends based on the type of company they have invested in (i.e. high dividend, low dividend, or no dividend-paying company).
Q.2: How do we invest equity in a company?
Investing equity in a company involves buying shares of that company at a price those shares are being traded at in the exchange.
Q.3: So how do we earn by investing in a company?
An equity investor will earn returns on his invested funds by two ways:
Dividends and Price Appreciation
Dividends: Dividends can be defined as the amount of money a company pays back to its shareholders, by sharing a proportion of its current period’s profits with its shareholders. In simpler words, if a company earns profits in the current period, and if it decides to share some of those profits with its shareholders, it will do so by paying them dividends.
Price Appreciation: Another way of earning returns from equity investments is to buy shares of a company at a given price and then selling those shares at a higher price. This movement of share price from a low price to high price is known as Price Appreciation.
Though understanding Price Appreciation is out of the scope of this article. It is a concept necessary only for Financial Analysts. But to understand its basic gist, all you would be required to know is that Price Appreciation of the shares of a company depends upon the future expected performance of that company. If a company is expected to perform well in the future, the price of its shares will appreciate, and if the same company is expected to perform relatively poor, its price will depreciate, i.e. its price will fall.
Q.4: How many different types of Equity Investments are there?
The classification here depends upon the performance and financial characteristics of the kind of companies one plans on investing in. On the broadest basis, the classification is as follows:
- Growth Stocks
- Value Stocks
- Dividend Stocks
- Large-Cap Stocks
- Mid-Cap Stocks
- Small-Cap Stocks
Differences Between Mutual Funds and Equity Investment
Horizon of Investment
Horizon of Investment means the period of time an investor wishes to keep his or her money invested. Factors that determine investment horizon primarily are the objective of investments, age at the beginning of investments and the target amount one intends to make through his or her investments. But how should one decide between the two investment options?
The rate of return required to reach the target amount within the determined horizon.
Risks and returns under Mutual Funds are less volatile as compared to those under Equity Investments. Volatility usually evens out over long periods of investment. This particular statistical fact makes an investor worry less about the safety of their funds invested in equities and concentrate more on the return profile of their investments. For a long-term investment, which is usually a period of 10 to 30 years or more, equity fits better because the risk averages-out to provide a smoother return profile, while a mutual fund would be a better fit for investment horizons up to 7 to 10 years. For reasons discussed below in the article, Mutual Funds would witness lesser price volatility since they significantly eliminate all the unsystematic risks present in the market and hence, earning returns at a lower rate than equity (higher risk translates into higher returns)
Example: Mrs. Jain at the age of 28 decides to fund her retirement through either of the two investment options, i.e. Mutual Funds or Equity Investments. Mrs. Jain has a considerably large investment horizon with her. Whatever be the target amount of her plan, an equity investment would be strongly advised. However, consider a scenario where Mrs. Jain wishes to fund her wedding plans. She estimates that she has at most 5 years in hand before she would need to use her savings. Under such circumstances, a Mutual Fund investment would be strongly advised to maintain the safety of the funds in the near future and to earn a modest rate of returns within a short span of time.
Risk and Return Factor
In the world of finance, there is one common rule:
An investor would be compensated for the level of risks he or she takes.
Now as discussed above, mutual funds are based upon diversification and thus take a passive approach to investments, earning modest and average or below average returns. Diversification tends to reduce the level of risk by way of spreading out the funds across various asset classes and securities present in the portfolio. Lesser risk thus translates into lesser returns. Whereas, Equity Investments don’t take diversification into account and hence, play with relatively higher levels of unsystematic risks. Accurate stock predictions, prudent investment strategies, and specialized set of analytical skills in Equity Investments directly translate into huge returns for the investors, out-performing all the other asset classes or securities by a substantial margin.
Thus, to put it in one line, Mutual Funds are characterized by low-risk, low-returns profile, while Equity Investments are known for their higher-risk, higher-return profile.
Diversification: The whole point of creating a portfolio in a Mutual Fund is to achieve Diversification. Diversification is thus an investment strategy where the investor invests not just in 2 or 3 companies (as is the case in Equity Investment), but across various asset classes (Debt, Equity, Commodities, etc.) and a plethora of securities within a particular asset class. Portfolio Managers employ such a strategy of diversification to minimize the unsystematic risks in their investments, thus bringing the overall level of risk down in the investment returns.
The maximum level of diversification investors can achieve under an Equity Investment is by spreading out their funds across Growth, Value and Dividend Stocks (Or Large Cap, Mid Cap and Small Cap Stocks), nothing more than that. Due to such a limited scope of diversification, investors get to experience a limited exposure in the financial markets.
Active/Passive Management: An active strategy is the one that aims to out-perform the related index or generally, the market. Out-performing translates into earning above-average returns in the market over a specified period. Passive Strategy, on the other hand, means linking the given portfolio to a specific index or generally, the market performance. In other words, when an investor adopts a passive approach to investing, he/she never aims to earn above-average returns in the market. Rather, he/she would be satisfied with the average returns that the market or the related index allows.
Mutual Funds take the passive approach to investment. Returns from a mutual fund would more or less track the performance of the related index. On the other hand, Equity Investments take a more aggressive approach to investment-an active strategy. Investments in equities have the potential to earn an investor abnormal returns in the market, thus out-performing an index or the whole market.
SIP or Lump-sum?
Another most important factor of difference between Mutual Funds and Equity Investment is the option of SIP. SIP stands for Systematic Investment Plan and provides a smoother and a much more disciplined approach to save funds for an investor.
Mutual Funds have an option of SIP, where an investor, based on his preference of frequency (monthly, quarterly or annually), periodically increases the funds in his/her portfolio by a pre-decided amount. Such an investment plan brings stability in an investor’s saving and spending pattern and is considered good for the financial health of an individual. Another benefit of adding SIP to a financial plan is that it brings the average cost of investment down. An investor buys more shares when the price is low and thus earns more during appreciation, and lesser shares when the price is high and limits losses during depreciation of the price.
Equity Investment allows only Lump-Sum Investments where the investor buys and holds his investment until the planned level of return has been reached. Though Lump-Sum Investment seems more return-friendly to many investors, it is only better suitable for those who have specialized knowledge in the field of investments, who have the required technical skills to predict the future performance of the market using complex financial models.
Cost of Investment
Cost related to an investment might be considered as insignificant by investors while choosing the mode of investments, but as the capital outlay increases, cost begin to form a bigger and bigger proportion of your funds, making it as important a factor, as any of the above.
Mutual Funds are large and thus benefit from the economies of scale. An Asset Management Company is in a much better position to negotiate with intermediaries than individual investors and therefore lead to lower overall costs. If an investor were to open a share trading account, they’ll probably end up paying 0.5%-1% of the trade as commission to the brokerage. However, due to the scale mutual funds have, they’ll end up paying much less than that. This benefit will indirectly be passed to you as a mutual fund investor.
However, investment in mutual funds comes with management fees. It’s the cost of service you pay the Mutual Fund Manager for managing your funds. SEBI, the market regulator, has made it compulsory for the management fees to include all associated costs. Look out for the expense ratio of funds to understand the cost of investing. This is a percent value that tells you how much the mutual fund charges you as fund management fee.
Tax consideration is again a huge factor in the decision while choosing between the two vehicles of investment. Now a better way to explain the tax effects from these two types of investment is to study the effects from both, separately.
- Short-term capital gains (defined as a period of less than 12 months) on the sale of equity shares are taxed at 15% irrespective of the tax slab.
- If total income including short-term capital gains is less than 2.5 lakh INR, then there would be no tax.
- Short-term capital loss can be deferred and used to set-off any short term or long term capital gains tax from any asset. But, short-term tax loss can only be carried forward or deferred for 8 years.
- Debts are short-term when sold within three years of holding them. Short-term gains from debts are taxed like any other income, basically as per tax slab rates applicable.
- Long-term gains from debt (sold after three years of holding) are taxed at 20% and the purchase price is indexed for calculating gains.
- Dividend income from equity shares is exempt from tax unless your dividend income exceeds `10 lakh in a financial year. If so, such excess (and not total dividend) is taxed at 10%.
To find out how gains from the sale of mutual funds are taxed, you can follow a simple principle. Find out where your mutual fund primarily invests. A mutual fund is either equity-based or debt-based. Equity Mutual Funds invest at least 65% of their holdings in equities. All others are debt funds. Therefore, Equity Mutual Funds and Equity Investments are taxed exactly the same way as gains from direct purchasing of equity shares, discussed above. Whereas gains from Debt Mutual Funds are taxed the way gains from direct purchasing of debts are taxed.
Customization Factor simply translates into the degree of control an investor has over his/her funds, or over his/her portfolio. Investors, who direct their funds to mutual funds, lose the control over the composition of the portfolio their money is invested in. Moreover, they lose the flexibility of investing in or divesting from a particular asset as they see appropriate. Additionally, Mutual Funds have the criterion of minimum investment required periodically under SIP. The only control they have is the type of mutual fund they wish to invest in and for how long. Other than that, the rest of the decisions are beyond their reach.
Equity Investments, to a contrast, provide absolute freedom to the investor in deciding what stocks to invest in, what stocks to divest from, the proportion of funds in the stocks they choose to hold, and the composition of their stock portfolio. Additionally, a number of funds they choose to set aside for investment purposes is completely their decision. In other words, Equity Investments can be customized or tailor-made to suit an investor’s expectations with regard to tax mitigation, prudent risk management, investment strategies and investment goals.
An investor might also choose to see the degree of freedom and control in a different light. In other words, Customization Factor could also translate into the efforts and time required to manage one’s portfolio. With Mutual Funds, the investor is not required to devote any time and efforts to the analysis of investment or management of his/her portfolio/funds. Mutual Funds are quite relaxing that way. All one needs to decide is the objective of investment, type of fund that fits the objective, and frequency and amount of the periodic payments. However, Investing in equity needs a greater deal of expertise and efforts to ensure the safety of funds, and to ensure that the required rate of return would be reached. An investor would need to consider every decision discussed above and more, in isolation and in conjunction before investing.
Performance of a mutual fund depends hugely upon the competency of the Portfolio Manager responsible for that fund. The kind of strategies a Fund Manager employs, their specialization, their risk aversion profile, past performance, educational background, work experience, etc. may help an investor in evaluating a Fund Manager. Moreover, understanding the composition of each asset class, and the number and type of securities in each asset class also helps in anticipating the future performance track of a fund.
Evaluating stocks is a whole different concept altogether. Performance of a stock would depend upon the social, political and macroeconomic factors of the country it operates in the performance of its industry, its competitors, its operational history, its financial record and ratios, future expectations of profits and cash flows, etc.
Going into the details of evaluating a stock or a mutual fund is way beyond the scope of this article and is suitable for only the analysts. However, the most important point here for an investor to know is that Mutual Funds and Equity Investments have their own separate criteria of measuring performance, to figure out whether the given mutual fund or stock is performing better than expected, as expected or worse than expected. An investor is not advised to use the criteria generally used to measure a mutual fund’s performance, to calculate the performance of a stock.
Though this factor shouldn’t really hold much importance, it must be borne in mind before an investor formulates any plan of investment in any of the two alternatives.
Investment in Equity would require a Bank Account and a DMAT account (additionally, an overseas trading account if the investor chooses to invest in foreign stocks), which would involve more documents and paperwork than what would be necessary while investing in a Mutual Fund.
Investment in Mutual Funds requires nothing but one Bank Account that usually every individual has from even before the inception of any plan to invest anywhere.
NOTE: There are no hard and fast rules here, and how an investor perceives a given level of risk is relative. Every manager or
an investor would have a different opinion and perception about the suitability of the two investment vehicles discussed here.
However, on a very broad and a general basis, we have attempted to provide you some level of context for you to begin with.