Equity Investment In India: What You Need To Know

Equity investment is money that is invested in a company by purchasing shares of that company in the stock market. These shares are typically traded on a stock exchange. The primary objective of making any investment is to earn returns on it and grow your wealth. Returns on investment can either be market-linked or fixed. In the case of equity investment, the amount is invested in the stocks and equity derivatives of listed and unlisted companies.

Equity investment in India has been on the rise, with the country receiving US$13.5 billion in private equity funding in 2007, and this funding is only expected to increase. The Indian market is unique and requires a solid understanding of its dynamics and some behavioural adjustments from new investors to maximise returns.

Equity investment offers the possibility of high returns in the form of capital gains and dividend income. It also provides investors with the opportunity to diversify their portfolios and reduce risk concentration. However, it is important to note that equity investment comes with a higher level of risk compared to other investment options.

The types of equity investment in India

Equity funds are a type of investment that allows investors to participate in the stock market without buying individual stocks directly. The fund manager tries to offer great returns by spreading investments across companies from different sectors or with varying market capitalizations.

There are various ways to categorize equity funds, including by investment strategy, market capitalization, tax treatment, and investment style. Here is a detailed look at the different types of equity funds in India:

Investment Strategy-Based Categorization

Thematic or Sectoral Funds

These funds follow a specific investment theme or sector of the market, such as BFSI, IT, or pharmaceuticals. They carry a higher risk due to their focus on a specific area.

Focused Equity Fund

This type of fund invests in a maximum of 30 stocks of companies with market capitalization as specified at the launch of the scheme.

Contra Equity Fund

These funds follow a contrarian strategy by analyzing the market to find underperforming stocks and purchasing them at low prices, assuming they will recover in the long term.

Market Capitalization-Based Categorization

Large-Cap Funds

These funds primarily invest in the top 100 companies by market capitalization, which are known for their size, market dominance, and robust financial health. They are considered more stable and less risky, attracting higher valuations.

Mid-Cap Funds

Mid-cap funds focus on companies ranking from 101st to 250th by market capitalization, targeting relatively younger entities. They are considered riskier but often showcase higher growth trajectories and the potential to become large-cap entities.

Small-Cap Funds

Small-cap funds invest in companies ranked 251st and beyond by market capitalization, which are viewed as high-risk entities. Despite the risk, they present opportunities for considerable long-term growth.

Multi-Cap Funds

These funds invest in large-cap, mid-cap, and small-cap companies in varying proportions. The fund manager rebalances the portfolio to match market conditions and the scheme's investment objective.

Large and Mid-Cap Funds

A blend of large-cap and mid-cap funds, these funds invest in both large and mid-sized companies, offering a balance of stability and growth potential.

Flexi-Cap Funds

These flexible funds invest in companies of all sizes, with the fund manager shuffling investments based on market conditions and prospects.

Tax Treatment-Based Categorization

Equity Linked Savings Scheme (ELSS)

ELSS is the only equity scheme offering tax benefits of up to Rs. 1.5 lakh under Section 80C of the Income Tax Act. These funds have a minimum investment of 80% in equity and equity-related instruments, along with a 3-year lock-in period.

Non-Tax Saving Equity Funds

All equity funds other than ELSS are non-tax saving schemes, meaning the returns are subject to capital gains tax.

Investment Style-Based Categorization

Active Funds

These funds are actively managed by fund managers who handpick the stocks they want to invest in.

Passive Funds

Passive funds track a market index or segment to determine the stocks they will invest in. The fund manager does not play an active role in stock selection.

Other Equity Investment Options

Shares

Shares are units of partial ownership of a company, and they are traded on designated stock markets such as the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). Shares can also belong to unlisted companies and may be privately exchanged through off-market transactions.

Equity Mutual Funds

Equity mutual funds pool money from multiple investors and primarily invest in listed market securities. They are suitable for investors who have a limited understanding of which stocks to invest in due to a lack of time or knowledge. These funds offer diversification, professional fund management, transparency, and the ability to regularly invest small amounts through SIPs.

Future and Options (F&O) Contracts

F&O contracts allow investors to buy or sell underlying stocks at the current price but defer delivery to a future date. Futures contracts are legally binding, while options contracts give investors the right but not the obligation to execute the agreement. These investments are derivatives, and their performance depends on the underlying equity they are derived from.

Arbitrage Funds

Arbitrage funds are a type of equity-oriented hybrid fund that invests in equities, equity derivatives, and debt/money market instruments. They simultaneously purchase and sell securities to take advantage of price mismatches on different exchanges, ensuring profits regardless of market direction. However, this strategy often involves thin net margins, increasing the expense ratio and reducing potential returns.

Alternative Investment Funds (AIFs)

AIFs are a relatively new concept in India and are tightly regulated. They are privately held and managed investment funds pooled from domestic or foreign investors, including high-net-worth individuals (HNIs). Examples include hedge funds, angel investment schemes, real estate investment trusts (REITs), and infrastructure funds. AIFs are considered one of the riskiest investments but also offer the potential for high returns.

The risks of equity investment

Equity investments are a risky business, with the potential for high returns but also high losses. Here are some of the key risks to be aware of when considering equity investment in India:

Market Risk

Market risk is the possibility of losing money due to factors beyond the control of the investor, such as an economic slowdown or other negative influences on the overall health of the financial markets. Market risk is also known as systemic risk as it affects all industries, though to varying degrees. While diversification can help manage this risk to some extent, it is always a factor when investing in equities.

Performance Risk

Performance risk refers to the possibility that individual stocks or entire sectors may not perform as expected. This can be due to various factors, such as company-specific issues or industry-wide challenges. Performance risk is particularly relevant for sectoral or thematic funds, which focus on specific industries or themes. To mitigate this risk, mutual funds typically diversify their portfolios across industries, themes, and market capitalizations.

Liquidity Risk

Liquidity risk is the possibility that an investor may be forced to sell their investment at a lower price than the fair market value, especially in an emergency. This risk is higher for stocks with low trading volumes on stock exchanges. Mutual funds can manage this risk by investing a portion of their assets in more liquid debt and money market instruments.

Social/Political/Legislative Risk

Social, political, and legislative changes can impact the performance of businesses and, consequently, the price of their shares. For example, policies that favour domestic industries over foreign companies can affect the share prices of multinationals operating in India. Diversification across industries and national borders can help manage this risk.

Currency/Exchange Rate Risk

Currency risk, also known as exchange rate risk, arises from fluctuations in exchange rates between currencies. This risk primarily affects investors with exposure to foreign equity markets or businesses that derive a significant portion of their earnings from international operations. One strategy to mitigate this risk is to maintain a cash reserve or hold highly liquid assets that can be easily adjusted to offset exchange rate changes.

Business-Related Risks

Shares of a company are closely tied to its performance. A company that consistently makes good profits will generally see its share price increase, while a poorly performing company may struggle to sustain itself in the long term. Various factors, such as competition, political and economic conditions, foreign currency risks, and operational risks, can impact a company's share price. Therefore, it is crucial for investors to thoroughly research a company's fundamentals before investing.

The benefits of equity investment

Equity investment in India involves investing in the stocks and equity derivatives of listed and unlisted companies. It is a market-linked investment, meaning that returns are dependent on the performance of the underlying asset. Equity investments can be made directly or through mutual funds.

High Returns

Equity mutual funds are among the highest-returning funds in the mutual fund spectrum. They offer greater return percentages than other low-risk funds, providing a high potential for wealth creation. Historically, stock indexes have consistently outperformed returns on debt and other investment instruments in the long term.

Tax Benefits

Equity investments offer tax advantages. In India, long-term capital gains (LTCG) of up to Rs. 1 lakh from equity investments are exempt from tax. LTCG above Rs. 1 lakh is taxed at a rate of 10% without indexation benefits. Short-term capital gains (STCG) from equity investments are taxed at 15%.

Beating Inflation

Equity investments can help protect against inflation by delivering higher rates of return compared to other investment options. The rate of return on equity investments can potentially exceed the inflation rate, thereby facilitating wealth creation over the long term.

Diversification

Equity investments provide an opportunity to diversify one's investment portfolio. By adding stocks to a portfolio, investors can achieve greater risk-adjusted returns. Equity investments are independent of other investments such as bonds and real estate, helping to reduce risk concentration.

Voting Rights and Dividends

Equity investors become shareholders in the company and enjoy voting rights. They also receive dividends, which are distributions of surplus profits by the company. Dividend income provides an additional source of revenue for investors.

Liquidity

Stocks are generally considered liquid assets, as they can be easily bought, sold, or held. The high average daily volume of transactions on the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) indicates active participation by buyers and sellers in the market.

Collateral for Loans

Equity investments can be used as collateral for loans. Shareholders can pledge their investments in qualified shares or equity mutual funds with a bank to secure a loan. Banks typically allow loans of up to 50% of the eligible shares or the value of equity mutual funds owned.

The process of equity investment

Equity investment is the process of investing money in a company by purchasing shares of that company, usually on a stock exchange. The steps involved in equity investment are as follows:

• Research and Due Diligence: Before making any investment, it is crucial to conduct thorough research and due diligence. This includes analyzing the company's financial health, business model, competitive advantage, management team, industry, and overall market conditions. It is also essential to assess your own risk tolerance and investment goals.
• Choosing a Broker or Investment Platform: To purchase shares, you will need to use a broker or an online investment platform. Compare different options to find one that suits your needs, considering factors such as fees, available investment options, and customer support.
• Opening a Brokerage Account: Once you have selected a broker, you will need to open a brokerage account. This typically involves providing personal information, verifying your identity, and funding the account.
• Placing a Buy Order: When you are ready to invest, you will place a buy order through your broker or investment platform. This involves specifying the number of shares you want to purchase and the price you are willing to pay.
• Monitoring and Managing Your Investment: After purchasing shares, it is important to regularly monitor the performance of the company and your investment. Stay informed about news and developments that may impact the company's stock price. Depending on your investment strategy, you may choose to hold the shares for the long term or actively trade them.
• Receiving Dividends: If the company pays dividends, you will receive a portion of their profits proportional to your share ownership. Dividends can be paid out periodically, usually quarterly or annually.
• Selling Your Shares: When you decide to sell your shares, you can place a sell order through your broker or investment platform. The selling process is similar to the buying process, and you will receive the proceeds from the sale into your brokerage account.
• Understanding Taxes and Fees: Equity investments may be subject to various taxes and fees, such as capital gains tax, brokerage fees, and dividends tax. Ensure you understand the tax implications and any associated costs before investing.
• Diversifying Your Portfolio: Diversification is a crucial aspect of investing. It involves spreading your investments across different companies, industries, and asset classes to reduce risk. Consider building a well-diversified portfolio over time to balance your risk and return potential.
• Staying Informed and Seeking Expert Advice: Stay updated with market news and seek advice from financial advisors or experts if needed. The equity investment landscape can be complex, and it is beneficial to have a good understanding of the market and access to reliable information sources.

It is important to remember that equity investment carries risks, and there is always the potential for losses as well as gains. Conducting thorough research, understanding your risk tolerance, and diversifying your portfolio can help mitigate these risks.

The regulation of equity investment in India

Reporting Requirements:

All AIFs must submit quarterly reports to SEBI and provide annual financial reports and risk details to investors within 180 days of the year-end. Category III AIFs must also submit quarterly reports on leverage and calculate the net asset value for disclosure to investors.

Manager and Sponsor Requirements:

The AIF manager does not need separate registration but is regulated by SEBI. The manager and sponsor must satisfy the 'fit and proper person' criteria and maintain a continuing interest in the AIF, with the manager located in India. The key investment team of the AIF manager must include individuals with relevant qualifications and experience in finance, investment management, or a related field.

Foreign Investment:

Foreign investors can invest in domestic pooling vehicles through automatic routes, and such investments are deemed domestic if control vests with Indian-owned and controlled sponsors or managers. Foreign investors typically route their private equity investments through Foreign Direct Investment (FDI) vehicles, with most sectors in India permitting up to 100% FDI under the automatic route. However, certain sectors like insurance, telecom, and defence have FDI thresholds and require approvals.

Regulatory Developments:

Recent regulatory developments include mandatory government approval for foreign investment from bordering countries and mandatory security clearance for directors who are citizens of bordering countries. Additionally, the Supreme Court has ruled in favour of enforcing foreign arbitral awards, enhancing foreign investor confidence in India.

Other Regulatory Bodies:

Apart from SEBI, AIFs structured as limited liability partnerships or companies are also regulated by the Registrar of Companies under their respective legislation. The Reserve Bank of India (RBI) imposes restrictions on Indian banks' investments in AIFs, with caps on direct investments and prohibitions on investing in certain categories of AIFs.

Frequently asked questions