Mutual funds offer a range of solutions to cater to different investment needs of investors. Since each investor has a unique risk appetite, investment horizon, financial goal and purpose, he/she can find the right investment avenue within the broad mutual fund umbrella.
Broadly, mutual funds are categorised as equity and debt funds. Before making a choice, however, not many investors know how these two differ and what unique benefits each offers.
To aid better and well-informed investment decisions, here we will explain and compare equity funds and debt funds.
What are equity mutual funds?
Equity mutual funds pool money from investors to further invest the corpus primarily in stocks of different companies on behalf of investors. In most equity funds, at least 65% of the portfolio is made up of investment in equity and equity-related instruments.
What are debt mutual funds?
Debt mutual funds pool money from investors and invest in debt or fixed-income instruments. Some of the debt investments that these funds aim for are bonds (including corporate bonds), government securities, commercial papers, debentures, treasury bills, and certificates of deposits among others.
Difference between equity and debt funds
The table below highlights the main differences between equity and debt funds:
|Equity funds mainly invest in stocks that are traded publicly traded. They may also invest in equity-related instruments such as derivatives.
|Debt funds invest in debt and money market instruments. These aim to earn regular income through interest on such investments.
|Equity fund returns generally offer higher long-term returns than debt funds.
|Debt fund returns tend to be low or moderate as compared to equity funds.
|Suitable for investors with a medium to high risk appetite.
|Suitable for investors with a low risk appetite.
|Actively managed equity funds have relatively higher expense ratios.
|Debt funds may have comparatively lower expense ratios.
|Since equity funds are exposed to market volatility, they offer better returns in the long-term as against the short-term.
|Interest rates may fluctuate and investors must pick specific debt funds based on ongoing interest rates in order to maximise returns.
|15% tax is applicable on short-term capital gains from equity funds. Long-term capital gains are tax-exempt up to Rs 1 lakh and any gains beyond this are taxable at 10%.
|Short-term capital gains tax at the income tax rate applicable to individual has to be paid on debt fund investments. Investors can avail of indexation benefits for investing in debt funds for the long-term. Long-term capital gains tax is applicable at 20% post indexation benefits.
Which is better – equity or debt mutual fund?
Here are some of the factors that investors must consider while picking between equity and debt mutual funds:
Equity funds provide higher chances of positive long-term returns while debt funds may offer stable but relatively lower returns than equity funds. From a long-term perspective, equity returns tend to deliver inflation-beating returns whole debt funds may deliver returns in sync with inflation.
- Investment objectives
Different investors may have different investment objectives, such as regular income generation or long-term wealth creation. Debt funds are suited for investors who prefer regular and stable income. However, those looking for long-term wealth creation should opt for equity funds.
Debt funds are suitable for investors who have short-term or medium-term investment horizons whereas equity funds are ideal for longer investment horizons beyond 5 years.
In debt funds, there are very low chances of capital loss, while in equity funds, there is generally a higher risk of capital loss due to price fluctuations. However, in equity funds, the longer the investment period, the lower the variation in returns.
Equity investments can be relatively more tax efficient since an investor need not pay any tax on long-term capital gains of under Rs. 1 lakh. Debt funds attract short-term capital gains tax as well as long-term capital gains tax. Thus, if an investor has invested for more than three years, there is no tax difference irrespective of whether invested in equity or debt.
Equity mutual funds are an ideal investment avenue for beginners who want exposure to the stock market but lack a detailed understanding of the markets. Debt funds can also be included in an investment portfolio to balance the overall risk and return dynamics. Before picking either of these, investors must know the basic features and benefits of each.
Active investing is ideal for investors who prefer to fetch returns from actively managed portfolios and have some level of market know-how. These also have higher expense ratios. Passive investing is ideal for beginners who may not have sufficient market know-how and prefer to follow the returns of a benchmark index.
The level of interest earnings from a debt mutual fund will depend on the kind of debt fund one has invested in. In the current scenario, short-term debt funds may fetch higher returns as compared to medium or long-term funds.
A bank FD, although risk-free and stable, fetches lower returns than debt mutual funds. Debt mutual funds also provide investors with a wide range of schemes that one can pick as per investment preference.
Yes, you can invest in both equity and debt mutual funds at the same time to ensure appropriate portfolio diversification and balance between risk and returns.
Debt funds, although lower in risk, do carry some level of risk element such as interest rate risk, default risk, etc.