How to compare equity and debt mutual funds for their merits and demerits?

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There are enough videos on YouTube to tell you how many different classes of mutual funds exist out there, and that each is different in its own right. For the purpose of this article, let’s just two of the most hotly debated mutual funds - equity and debt mutual funds. Equity mutual funds, as you know, are mutual funds that invest in the equity market (or the stock market). What what are debt funds, and what’s difference between equity and debt mutual funds?

Let’s start right at the beginning:

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:

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

Why invest in Equity Mutual Funds?

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 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-definied 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 stable returns than traditional products:  Debt funds have outperformed bank FDs on an average, despite FD’s assured returns. Relatively lower capital risk as compared to other asset classes, e.g. equity. 

Equity vs Debt mutual funds

So, you’ve learnt about both the 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

In a nutshell

I hope after reading this piece, your prejudices and doubts have been put to rest. Fi offers a wide selection of funds to choose from for all types of investors and can be done in a matter of minutes! If you’re still unclear about equity and debt mutual funds, it’s advised that you consult with a financial advisor to make an informed investment decision.

FAQs

Which is better: equity or debt mutual fund?

How do you decide whether to invest in debt or equity funds? Let’s understand the critical difference between debt and equity funds:

An equity mutual fund principally invests its assets in equities, i.e. listed stock market securities. Per SEBI Mutual Fund guidelines, an equity fund is mandatorily required to invest at least 65% of its assets in equities and equity-related instruments with a balance 0-3 to be utilized in debt or money market securities.

A debt fund, on the other hand, invests in fixed-income securities such as government securities, corporate bonds, certificate deposits and other money market instruments. Per Income Tax Act, any fund with less than 65% of its total assets invested in equities should be termed as a debt fund.

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

Returns

By and large equity fund remittances are relatively higher over long periods, whereas debt funds may provide returns in accordance with inflation or marginally higher than inflation. On a long-term average basis, returns for debt are in the region of 9% and equity in the range of 16%.

Investment objectives

Be it income generation or wealth creation. Debt is recommended if the expectation is to create income through their investments because it provides more certainty of return. However, for growth and wealth creation, equities would be a better option depending on the investment duration and return expectation.

Duration

Investors should select the asset class based on the period at the end of which they will need the money, for example, 20 years. Debt funds are better for shorter durations, preferably five years or less. Equity funds should ideally be held for a duration longer than five years.

Risks

The variation of returns in debt is usually small, and therefore, a long-term average of 9% implies that actual returns would be in a band of 8-10%. It means that there is a high degree of certainty that investors would get returns near the long-term average. Capital loss risk is also very low. 

Equity returns vary in a broad range resulting in a high risk of capital loss. However, the longer the holding period, the narrower the range of returns variation. The decision between equity and debt is fundamentally a decision between an almost certain 9% return and an uncertain 16% return.

Tax Applicable

Equity investments are highly tax efficient with zero tax for holdings greater than one year. Debt funds attract short-term capital gains tax before three years and long term capital gains with indexation after three years. For an investor investing for longer than three years, there is no difference in tax between equity & debt.

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