How to Compare Equity and Debt Mutual Funds: Merits & Demerits

Mutual funds offer an excellent avenue for stock market investment, offering key advantages such as diversification. This means that when you hold a mutual fund and it underperforms, your potential loss is typically lower compared to investing in individual stocks. Additionally, mutual funds often yield higher returns, potentially resulting in greater profits on your investment.

There are primarily two widely recognized categories of mutual funds: Equity Mutual Funds and Debt Mutual Funds. Let's delve into a comprehensive analysis of the distinctions between these two fund types.

What is a Mutual Fund?

It is an investment instrument through which an asset management company pools money from different individual and institutional investors having common investment objectives and invests it in different stocks, bonds, etc., as per the scheme mandate.

Mutual Funds could be classified as below:

Equity funds: invest in listed equity shares and other equity-oriented instruments.
Debt Funds: invest in fixed-income instruments like treasury bills, commercial papers, certificates of deposit, corporate bonds, and government bonds.
Hybrid Funds: invest both in equity and fixed-income instruments. The proportion of equity and debt investment depends on the type/ category of the scheme.
ELSS Funds: Essentially equity funds. Save taxes under Section 80C of The Income Tax Act 1961 by investing up to ₹1,50,000 in a year in these funds (being the present limit).

Equity Funds

Investing primarily in shares of listed companies is either active or passive. An active fund manager researches companies from different sectors and invests in companies likely to outperform the index in the future. On the other hand, a passive fund invests in a basket of stocks mirroring a market index, e.g. NIFTY or Sensex, directly proportional to the index.

Based on market capitalisation composition, equity funds are grouped under the following heads:

Why To Invest in Equity Mutual Funds?

Category	Large Cap Allocation	Midcap Allocation	Small Cap Allocation	Risk Profile	Investment Tenure
Large Cap Funds	80% or more	-	-	Moderately high	4 – 5 years
Midcap funds	-	65% or more	-	High	5 – 7 years
Small Cap funds	-	-	65% or more	High	7 – 10 years
Large and Midcap Funds	35% to 65%	35% to 65%	-	High	5+ years
Multi Cap Funds	25% or more	25% or more	25% or more	High	5+ years

If the table above was not enough, then here are some more reasons for considering

Historically Best performing asset class in the long term: BSE Sensex has given 11.6% CAGR returns which is significantly higher than other asset classes like bank fixed deposits and gold. (Period: 1st October 1990 – 30th September 2020)
Risk Diversification: A diversified portfolio of stocks across different sectors considerably reduces company or sector-specific risks.
Professional fund management: Stock selection requires expertise and experience in investment management. The track record of fund managers of an AMC is available in the public domain.
Start investing with small amounts: Invest through the Systematic Investment Plan (SIP) mode with installments of just ₹100 or ₹500 a month, depending on the fund house. On Fi Money, you can take this to the next level by completely automating your investments. You can invest by choosing pre-defined conditions like investing in a fund daily or when you order food online, for example, and forget about manually investing.
Tax Advantage: Significant tax advantage over most other investments.
Long-term (investments held for more than 12 months) capital gains are tax-free up to ₹1 Lakh in a financial year and taxed at 10% thereafter.
Short term (investments held for less than 12 months) capital gains are taxed at 15%.

Debt Funds

A fixed-income or debt mutual fund scheme invests a significant portion of its portfolio in fixed-income securities like government securities (G-Sec), corporate bonds, and money-market instruments (e.g. Commercial Paper (CP), Certificate of Deposit (CD), etc.).

Depending on their maturity or duration profiles, credit quality, and type of instruments they invest in, the SEBI has divided debt mutual funds into 16 categories:

Category	Type of securities	Maturity / Duration*	Interest rate risk	Credit risk	Risk Profile	Investment horizon
Overnight funds	Overnight securities e.g. CBLO	Matures overnight	Virtually no risk	No credit risk	Very low	Few days
Liquid funds	CP, CD, T-Bills etc.	Matures within 91 days	Low	Depends on credit quality**	Low	Few days to few months
Short duration funds	Usually bonds, money market instruments, G-Secs	Duration: 1 to 3 years	Moderately low	Depends on credit quality**	Moderately low	2 to 3 years
Banking & PSU funds	Debt and money market instruments of banks, Public Sector Undertaking	Duration: Flexible (based on fund manager outlook)	Depends on fund duration	Low credit risk	Moderately low	2 to 3 years
Corporate bond funds	Corporate bonds (predominantly in highest rated instruments)	Duration: Flexible (based on fund manager outlook)	Usually moderate	Low credit risk	Moderate	2 to 3 years
Dynamic Bond funds	Bonds, G-Secs	Duration: Flexible (based on fund manager outlook)	Depends on fund duration profile but usually high	Depends on credit quality**	Moderate	3 years plus
Gilt funds	G-Secs	Duration: Flexible but usually long	Usually high	No credit risk	Moderate	3 years plus

Why invest in Debt Mutual Funds?

Variety of solutions for different investment needs: Invest in funds of low to moderately low to moderate risk profiles appetite and different investment tenures, e.g. few days, weeks, months, or 1, 2, 3 years or even longer. Suitable for Systematic Transfer Plan (STP) in equity or hybrid funds.
Liquidity: Redeem open-ended debt funds anytime. No charges if redeemed after the exit load period. Some debt fund categories may not have any exit load at all.
Tax efficiency: Tax is payable only on redemption.

Short-Term Capital Gains (STCG) - if the investments were held for less than 3 years
Long-Term Capital Gains (LTCG) - for tenures of 3 years or more. LTCG is taxed at 20% after allowing for indexation, reducing your tax outgo.

Potential higher and more stable returns than traditional products: Debt funds have outperformed bank FDs on average, despite FDs’ assured returns. Relatively lower capital risk as compared to other asset classes, e.g. equity.

Equity vs Debt mutual funds

So, you’ve learned about both types of mutual funds and both of them seem enticing, so why not compare both before for more clarity

Features	Debt Mutual Fund	Equity Mutual Fund
Instruments	Invest primarily in money market instruments, commercial papers (CPs), certificates of deposits (CDs), Treasury bills (T-Bills), non - convertible debentures (NCDs), corporate bonds and Government securities (G-Secs) etc.	Invests in equities or equity-related instruments, like derivatives
Return on Investment	Low to moderate	Relatively higher returns in the long term
Risk Appetite	Low to moderate risk	Moderately high to high risk
Expenses	Expense ratio of debt fund is much lower	Equity fund expense ratio is much higher if you compare equity vs. debt funds
Timings	Timing of buy-sell is not that important. Duration of investment is more important in debt funds	Timing of buy-sell of equities is very important as stock market is very dynamic and may be very volatile at times
Suitability	Debt funds give you investment options from 1 day to many years with lower to moderate risk. Can be used as alternative to fixed deposits and savings bank account	Equity funds are for long term and suitable to investors with moderately high to high risk appetite. Helps reach long term financial goals
Taxation	Debt funds held for less than 36 months are taxed as per the income tax rate of the investor. Long term capital gains (more than 36 months) are taxed at 20% after allowing for indexation benefits	Capital gains from equity funds held for less than 12 months are taxed at 15%. Long term capital gains (more than 12 months) of up to ₹1 lakh is tax exempt and taxed at 10% thereafter.
Tax Saving option	There is no option to save taxes	Yes, you can save taxes by investing upto ₹150,000 in a year in ELSS mutual funds

Conclusion

In conclusion, equity and debt mutual funds are two distinct investment options with different characteristics. Equity funds invest in listed equity shares and aim for long-term capital growth, while debt funds focus on fixed-income instruments and provide stability and regular income. Equity funds have historically offered higher returns, diversification, and tax advantages, while debt funds offer variety, liquidity, and potential stable returns. Understanding the differences between equity and debt mutual funds can help investors make informed decisions based on their investment goals, risk tolerance, and time horizon.

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Frequently Asked Questions

1. Are equity or debt mutual funds better?

The superiority of equity or debt mutual funds depends on the investor's specific financial goals and risk appetite. Equity funds have the potential for higher long-term returns but come with greater volatility and risk. Debt funds, on the other hand, offer stability and income generation with lower risk but may have relatively lower growth potential. Ultimately, the choice should align with the investor's investment objectives and risk tolerance.

2. Which SIP is better debt or equity? How to choose between the two?

Choosing between a debt or equity SIP depends on your financial goals, risk tolerance, and investment time horizon. If you seek stability and regular income, a debt SIP may be suitable. On the other hand, if you have a long-term investment horizon and are comfortable with market volatility, an equity SIP offers the potential for higher returns. Consider your financial objectives, risk appetite, and investment horizon to make an informed decision that aligns with your needs.

3. Is SIP equity or debt?

SIP (Systematic Investment Plan) can be associated with both equity and debt mutual funds. It refers to a method of investing a fixed amount regularly over time, and investors can choose to invest in either equity or debt funds through SIPs based on their investment goals and risk preferences.

4. Which scheme invests in both debt and equity funds?

A hybrid mutual fund scheme invests in both debt and equity funds. It combines the characteristics of both asset classes to create a diversified portfolio. The allocation between debt and equity investments in a hybrid fund can vary based on the fund's mandate and the fund manager's strategy.