What are the advantage and disadvantages of equity funds?

Mutual funds offer diversification as they invest in a basket of securities that may belong to various asset classes and money market instruments. Fund houses that run mutual funds amass financial resources from investors sharing a common investment objective and invest the accumulated sum across money market instruments to generate capital appreciation.

Investors with a very high risk appetite prefer investing in equity funds because they carry a high risk rewards ratio. Today we are going to discuss equity funds and some of the advantages and disadvantages of these market linked schemes

What is an equity fund?

An equity fund is an open ended mutual fund scheme that invests majority of its investible corpus in equity and equity related instruments of publicly listed companies. Equity funds invest in stocks of various companies and build an underlying portfolio that may generate income through diversification of risk.

As they predominantly invest in the stock market, equity funds carry a very high risk profile. Retail investors may have to understand their risk appetite and invest accordingly.

Advantages of equity funds

  • The biggest advantage of equity funds is that they are ideal for achieving long term financial goals like buying a new house, planning for your child’s wedding, or building a corpus for their higher education or any similar long term goals. Equity funds invest in stocks. We all know that investing in the stock market for the short term can prove to be volatile. However, over the long term the stock market has always provided decent returns.
  • Equity funds are the highest grossing mutual fund scheme compared to debt funds, hybrid funds or any other mutual fund scheme. They may be a high volatile investment, but they also have the potential to generate returns who no other investment avenue can offer.
  • Equity funds are professionally managed. Every equity fund has a fund manager, sometimes a team of fund managers who actively buy and sell securities depending on market movement. This is why even a ‘know-nothing’ investor can invest in equity funds as their money is handled by a team of expert fund managers who try their best to help the equity scheme generate returns.
  • If you invest in Equity Linked Savings Scheme (ELSS) a tax saving equity scheme, you can receive tax benefit for an investment of up to Rs. 1.5 lakhs under Section 80C of the Indian Income Tax Act, 1961.

Disadvantages of equity funds

  • Equity funds are highly volatile in nature and over the short term one may even face losses. They carry the highest amount of investment risk as compared to any other mutual fund scheme. Without a long term investment horizon, investing in equity funds may not be a good idea.
  • Equity funds do offer professional fund management but that comes at a high expense ratio. The expense ratio of equity funds is higher than passive funds like index funds. A high expense ratio may devour a large chunk of your capital gains in the long term.
  • An equity scheme like ELSS may come with a tax benefit but it also comes with a predetermined lock-in period of three years. This means investors cannot liquidate their ELSS investments till the lock-in period is over, thus limiting the liquidity offered.

If you are investing in equity funds for the long run and wish to mitigate overall investment risk, you can opt for Systematic Investment Plan (SIP). With SIP one can invest small fixed sums at regular intervals instead of making bulk investments and exposing their entire investment sum to market risk.