Equity Funds vs Debt Funds

Anil is a 30-year-old engineer, who finally feels settled in life. He has a good job and family. He wants to invest his savings in mutual funds. When he starts researching mutual funds, he discovers that there are different kinds of mutual funds that have different risks, investment periods, annual fees, and returns.

Anil decides that he wants to invest in either equity funds or debt funds. To make a more informed decision, he researches the distinction between equity and debt funds. Here is what he finds:

What are equity funds?

Equity funds are funds that primarily invest in shares of companies and related securities which trade in the stock market. Equity funds have the potential to provide the highest returns but are also the riskiest of all mutual funds. The investor’s return depends on the performance of the company.

 Investors with moderately high to high-risk appetites and longer tenure for investments invest in equity funds. Based on market capitalization segments, equity funds are divided into large-cap, mid-cap, and small-cap funds. 

Large-cap funds invest in the top 100 companies in terms of market capitalization. Mid-cap funds invest in the top 101 to 250 companies in terms of market capitalization and small-cap funds invest in the top 251 and onwards companies by market capitalization.

What are debt funds?

Debt funds are mutual funds that invest in securities that generate fixed income. These securities include treasury bills, commercial papers, government securities, corporate bonds, government securities, and many other money market instruments. 

These securities are fixed income securities i.e. these instruments have a pre-decided maturity date and interest rate that the buyer can earn on maturity. Debt funds are low-risk investments because the returns on these securities are not affected by market fluctuations.

Based on the maturity period, debt funds can be classified into the following types: 

Liquid Fund – which are good alternatives to short-term investments, money is invested in money market instruments having a maturity of a maximum of 91 days. 

Money Market Fund – which is a low-risk debt securities investment in money market instruments with a maximum maturity of 1 year.

Dynamic Bond Fund – which are moderate-risk investments in debt instruments of varying maturities for the tenure of 3 to 5 years.

Corporate Bond Fund – which is a high-quality corporate bond investment with a minimum of 80% of its total assets in corporate bonds having the highest ratings.

Banking and PSU Fund – which invests at least 80% of its total assets in debt securities of PSUs (public sector undertakings) and banks.

Gilt Fund – which is a credit-risk free investment of a minimum of 80% of its investible corpus in government securities across varying maturities.

Credit Risk Fund – which is a slight credit-risk investment with a minimum of 65% of its investible corpus in corporate bonds having ratings below the highest quality corporate bonds.

Floater Fund – which is low interest-rate risk carrying investments of a minimum of 65% of its investible corpus in floating rate instruments.

Overnight Fund – which is an extremely safe investment in debt securities having a maturity of 1 day.

Duration fund – which invests in money market instruments and debt securities for varying Macaulay durations.

Key differences between equity funds and debt funds

Risk – Equity funds carry a higher risk than debt funds. Equity funds are directly related to market fluctuations, while debt funds are not. However, the returns are also higher in equity funds and they depend on the performance of the stock market.

Debt funds are highly recommended to investors with lower risk tolerance. Debt funds ensure stable returns with diversified securities. The returns are usually in the expected range, though there are no guarantees.

Expense ratio –This is an important aspect while investing in debt funds. The expense ratio is a fee towards the fund management services, it is a percentage of the fund’s total assets. 

Since the returns in debt funds are not very high, a high expense ratio can dent your earnings. Looking at lower expense ratio schemes and staying invested for a longer term is recommended.

The frequent buying and selling of equity shares often impact the expense ratio of equity funds. The Securities and Exchange Board of India (SEBI) has capped the expense ratio at 2.5% for equity funds. A lower expense ratio translates into a higher return for investors.

Tax saving option – For equity funds, short-term capital gains (STCG) are taxable at the rate of 15%. the long-term capital gains (LTCG) are taxable at the rate of 10% if the gains exceed Rs 1 lakh a year.

In the case of debt funds, short-term capital gains or STCG is added to your taxable income and are taxed according to the applicable tax slab. Long-term capital gains or LTCG are taxed at 20% with indexation benefits.

Diversification –By investing in equity funds, you get exposure to several stocks, and you get this benefit by investing a nominal amount. However, your portfolio will face the risk of concentration. Debt funds offer diversified securities only.

Timings – Equity funds are affected by time and the fluctuations that the industry goes through.  In Debt funds, time to buy and sell is not that important. Duration of investment is more important.

Conclusion

Mutual funds are popular investment options. When choosing a mutual fund it is important to keep in mind your financial goals, investment tenure, risk appetite, etc. While equity funds are risky in the short term, in the long term they can provide a superior return over any other asset class provided you are ready to take high risk. 

On the other hand, debt funds are amazing for risk-averse people who are happy with low to moderate returns and whose main aim is capital protection. Debt funds are also an alternative investment for fixed deposits and savings bank accounts. 

Lastly, both equity and debt funds are tax-efficient investment options when compared to other asset classes. In Summary, the best mutual fund between equity and debt funds depends on the investor’s objective and risk appetite.