With interest rates on fixed deposits (FDs) barely keeping up with inflation, many investors have been clamouring for better returns. Against this backdrop, investing in mutual funds can be a good bet.
There are numerous kinds of mutual fund schemes, including equity funds, debt funds, hybrid funds, solution-oriented schemes, etc. Investors can choose to invest in them as per their financial goals and risk appetite.
Below, we elaborate on equity and debt mutual funds—the two most popular mutual fund schemes, and what makes them suitable investing instruments.
What is Equity Mutual Fund?
A mutual fund which primarily invests in equity (i.e., listed securities) and equity-linked instruments is known as an equity mutual fund. SEBI has mandated that equity funds should invest at least 65% of their assets in listed equities.
An equity fund can be managed either actively or passively. Passive equity funds include index funds and exchange-traded funds (ETFs). These funds are suitable for long-term wealth creation.
What are the Types of Equity Funds?
There are multiple ways of categorising equity mutual funds, such as market capitalisation values, investment styles, sectors, country focus, etc. To illustrate, equity funds can be classified into large-cap, mid-cap, small-cap, micro-cap, and multi-cap funds based on the market capitalisation values of the underlying stocks.
Further, investors have the option to invest in thematic equity funds, which invest in specific sectors, such as banking, IT, healthcare, and pharma. Equity funds may also be classified as broad-based, single-country, or regional funds depending on whether they focus on domestic stocks or international stocks.
Equity-linked Savings Scheme (ELSS) is another subtype of an equity fund, under which at least 80% of the assets are apportioned to equity-related instruments. This fund can be both open-ended and close-ended. Investors can avail of tax deductions of up to Rs. 1.5 lakh under section 80C by investing in ELSS.
Read More About What is ELSS Mutual Fund?
What is Debt Mutual Fund?
Wondering what is debt fund?
A debt fund, alternatively called a bond fund or an income fund, majorly invests in fixed-income securities, including government bonds, certificate of deposit (CD), corporate debt securities, and other money market instruments. These securities are less volatile relative to equities, thus being an ideal investment option for risk-averse investors. The Income Tax Act classifies all funds investing under 65% assets in equities as debt mutual funds.
Debt funds can invest in both listed and unlisted debt instruments to profit from price appreciation, which is reflected in the fund’s net asset value (NAV). The performance of debt funds is predominantly impacted by interest rate changes.
What are the Types of Debt Funds?
Debt mutual funds are classified based on the type of bonds they invest in and the tenure of such bonds. The former includes money market funds, floating rate funds, gilt funds, and income funds.
Debt funds are also categorised as liquid, short-term, long-term, or dynamic funds based on their duration and maturity profile. For example, liquid funds invest in very short-maturity debt securities. Similarly, long-term funds are focused on bonds maturing after 7-10 years.
What is the Difference Between Debt and Equity Funds?
Now that we know the basics of debt and equity funds, let’s understand how both funds differ from each other.
Debt vs Equity Fund: Instruments
The primary difference between debt and equity funds lies in their investing instruments. Debt funds are focused on T-bills, government & corporate bonds, and money market instruments; these investments offer fixed returns and aren’t very volatile. Equity funds, on the contrary, target listed company stocks.
Debt vs Equity Fund: Suitability
Ideally, debt funds are most suited to risk-averse investors looking for regular income. Additionally, investors can choose to invest in liquid funds as a method to create a contingency fund. On the other hand, investors should opt for equity funds if they are new to investing or possess a small capital amount.
The investment choice will also depend on the end-use purpose. For example, if the aim is to generate funds for education expenses due in 3 years, then a debt investment is a suitable choice. But if the goal is to plan for retirement, then an equity fund investment is a better choice.
Debt vs Equity Fund: Returns
Returns from debt funds are generally range-bound, while equity funds hold the potential to generate relatively higher returns, especially when averaged out over long horizons.
Debt vs Equity Fund: Risks
Debt funds usually experience lower volatility levels than equity funds. Also, the probability of capital loss is way higher for equity funds. However, the equity fund returns are smoothed over the long term.
Debt vs Equity Fund: Time Horizon
Individuals should opt for equity funds if they plan to stay invested for the long term (20 years or beyond). Whereas, debt funds are more fitting for those with short time horizons. Further, investors can choose from liquid, short-term, dynamic debt funds, etc., when planning for immediate financial goals.
Debt vs Equity Fund: Taxes
Individuals can claim tax deductions up to Rs. 1.5 lakhs by investing in ELSS equity funds. Else, they are liable to pay a short-term capital gain (STCG) tax on equity funds held under 12 months at 15% and a long-term capital gain (LTCG) tax at 10% for other holding periods.
On the flip side, debt funds offer no tax savings. The gains made from debt funds are taxed per the applicable tax slab when held for less than 36 months. An LTCG of 20% (along with indexation benefits) is chargeable on debt funds held beyond three years.
Debt vs Equity Fund: Timings
To maximise returns from equity funds, it is vital that fund managers time the markets well. Only by buying on dips can equities yield the highest-ever returns possible. Unlike equity funds, debt funds are more concerned with the ‘duration’ of bonds.
Conclusion
Both equity and debt funds are excellent investment choices for adding diversity to portfolios. However, a more suitable option can be gleaned by accounting for the present financial position, financial goals, and risk profiles.
FAQs
FAQs
Which is better debt fund or equity fund?
Equity funds tend to have higher risk, but the highest possible returns is higher than the highest possible returns from debt mutual funds. Therefore, while diversifying, it is better to include some debt funds for stability and focus on equity funds for higher returns.
Should I invest in equity or debt mutual funds?
It is best to invest some funds in debt funds, some in equity funds and some more perhaps for investing with your own effort. This will give your portfolio the right balance of reward and risk.
Is debt fund safer than equity fund?
Yes. Because debtors are legally required to repay their debts, debt funds are safer than equity funds as companies are not obligated to always have increasing stock prices.
What are the disadvantages of equity funds?
Equity funds have significantly higher risk associated with them. If the economy as a whole sees a slowdown, the stock prices may see a dip that is disproportionate to the dip in revenues or profits.
