Why diversified equity mutual funds are good long term investment choice

Sep 22, 2017 / Pradip Chakrabarty | 189 Downloaded | 10076 Viewed | |
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Equity Mutual funds are the best choice for retail investors as far as creating long term wealth is concerned. This is simply because in the long term, equity mutual funds are the best options because equities as an asset class outperformed other asset classes over a sufficiently long investment horizon as per available historical data.

Within various equity mutual fund categories, diversified equity mutual funds could be a preferred choice for investors as it invests in equity shares of listed companies across different sectors and market capitalization segments. This helps investors reduce investment risks.

Why choose diversified equity mutual funds

There are broadly three market capitalization segments - Companies with over Rs 15,000 to 20,000 Crores of market capitalization are classified as large cap companies. But, as you may know, the universe of listed large cap companies in India is limited.

Companies with market capitalizations ranging from Rs 5,000 Crores to Rs 15-20,000 Crores are classified as midcap companies and companies with market capitalization of below Rs 5,000 Crores can be classified as small cap companies. While the stocks of mid and small cap companies are more volatile than large cap companies, but they have the potential to give higher returns too in the long term. Having stocks of these companies in the mutual fund scheme portfolio helps the investors achieve portfolio diversification and portfolio returns over the long period but of course it comes with higher risk too.

You can read this to know more about investing in large cap funds versus midcap equity mutual funds

But what if we combine the stability of large cap stocks with the volatility and long term potential of mid and small cap stocks into one single portfolio? That is the objective of a diversified equity fund as it essentially invests in in large cap, midcap and small cap companies and is not limited to one sector or one market cap.

Diversified equity funds buy and hold securities with the objective of generating capital appreciation over a long investment horizon. Fund managers may churn their portfolios (based on the scheme mandate) from time to time and the profits booked in the process are either distributed in form of dividends to investors (those who have invested in dividend options) or reinvested in the scheme to generate future profits through the power of compounding (in growth options).

Would you like to know which a better investment option in mutual fund is: dividend or growth?

As the different segments of the market outperform each other in different market cycles, the diversified equity funds benefit from it as it invest across all sectors and market caps. For example -large cap companies may outperform the mid and small cap companies in bear market conditions while during bull market rallies, the valuations of large cap stocks can run up fast and the valuations can look stretched. This is when the mid and small cap companies start outperforming large cap companies in the most of the phases of the bull market cycles.

Therefore, as a retail investor you can enjoy beneficial ownership of a diversified equity portfolio through a relatively small amount of investment (e.g. Rs 5,000 or even lower in case of ELSS Mutual Funds). Hence from the perspectives of risk as well as capital appreciation objectives, diversified equity funds are ideal choice for long term investments.

How to invest in diversified equity mutual funds

You can invest in diversified equity funds both through lump sum and systematic investment plans (SIPs) provided you have a minimum investment horizon of 5 years.

Read whether you should invest in lump sum or through SIPs

The benefits of disciplined investing through monthly systematic investment plans (SIP) is that you can save and invest a portion of your savings every month to be used for meeting you long term financial goals. As you may know, the SIP amount decided by your is automatically debited from your specified bank account on a specified day every month. Some AMCs provide even weekly, fortnight and quarterly SIPs.

Did you know why you must remain invested with your SIPs for the long run

Over a period of long time you can accumulate a fairly large corpus through SIPs in diversified equity funds. For example, if you save Rs 5,000 every month and invest through SIP in a diversified mutual equity fund scheme, over a 20 year period you can accumulate Rs 50 Lakhs, assuming you get a 12% return on your investments. In case, you assume the return a bit higher at 15%, you will be able to accumulate a corpus of around Rs 76 lakhs.

The above figures are against your total invest of Rs 12 Lakhs only over 20 years period (monthly SIP of Rs 5,000 x 240 months). As you can see the wealth creation potential through SIP investments in diversified equity funds is huge.

Please refer this tool to calculate the future value of your SIP https://www.advisorkhoj.com/tools-and-calculators/systematic-investment-plan-calculator

Tax benefits when you invest in equity mutual funds

While making investment decisions, investors often ignore the impact of taxes. Taxes can reduce the net returns of investors significantly and therefore, the effect of taxes in investments must be factored in while investing. Equity mutual funds, as an asset class, enjoy significant tax advantages compared to other asset classes. Long term capital gains tax (investments held for more than 12 months) in equity funds are tax free. Short term capital gains taxes (investments held for less than 12 months) are taxed at 15%. Dividends paid by equity funds including the diversified equity mutual funds are also tax free.

Historical returns of diversified equity mutual funds

Historical data shows that, equity is the best performing asset class over a long investment period outperforming asset classes like gold and fixed income (debt). In the last 20 years, the BSE Sensex has given 11.1% annualized returns (Source: BSE India), while gold has given 9.3% (Source: World Gold Council) and fixed deposits have given 7.6% annualized returns (SBI FD rates) respectively. Rs 1 lakh invested in the Sensex twenty years back would have grown to Rs 8.2 lakhs, while the same amount invested in gold and fixed deposit would have grown to Rs 5.9 lakhs and Rs 4.3 lakhs respectively.

Diversified equity mutual fund as a category has given over 17% and 11% annualised returns in the last 5 and 10 years respectively (source: Valueresearch) compared to S&P BSE 500, NIFT and Fixed deposits which have given 8.19%, 7.88% and 8.06% annualized return in the last 10 year period (Source: Advisorkhoj).

Conclusion

As we can see the diversified equity mutual funds are the best wealth creating investment options in the long term for investors as they can be suitable for a variety of long term financial goals like children’s education and marriage, retirement planning and simple wealth creation needs. As such these funds should form a substantial part of an investor’s mutual fund portfolio. Investors should consult with their financial advisors if diversified equity mutual funds are suitable for their investment portfolios.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.

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