Debt Vs Equity Fund
Mutual funds offer a wide range of investment options to suit different financial goals and risk profiles. Among these, debt funds and equity mutual funds are two of the most popular categories. Debt funds focus on generating stable returns through fixed-income securities, while equity funds aim for higher growth by investing in stocks. Understanding the differences, types, and functions of these funds is essential for you as an investor. Read on to understand debt and equity mutual funds, the different types of funds available under each, and considerations when choosing between them.
Key Highlights
- Debt funds offer stable returns with lower risk, while equity funds have the potential for higher returns but higher risk.
- Debt funds generate income through interest, while equity funds generate income through dividends and capital gains.
What is a Debt Fund?
A debt fund is like a money pool that holds two kinds of investments – debt (like bonds) and equity (like stocks) – all in one place. When people invest in this fund, they get a mix of stable things that pay interest regularly (debt) and a chance for their money to grow more (equity). How much goes into each type depends on the fund's aim. The part in stocks hopes to make more money over time, while the stable part gives a steady income through interest. This fund is made for people who want to balance their investments, benefit from both stable and growing options and not put all their money into just one thing.
Read More: What is a Debt Fund?
What is an Equity Mutual Fund?
An Equity Mutual Fund is like a big pot where many people combine their money to buy shares of different companies. When you invest in this fund, you become a part-owner of those companies. The goal is to grow your money over time as the companies do well. The fund manager, who is like the boss, decides which shares to buy and sell to make the most profit for everyone in the fund. It's a way for people to invest in the stock market without needing a lot of money or knowing a lot about individual stocks.
Characteristics
Basic Characteristics
Debt Funds
Invest in fixed-income securities, minimising defaults. Common holdings include non-convertible debentures, corporate bonds, and government bonds.
Equity Funds
Invest in equity shares and linked instruments, with diversified portfolios to mitigate volatility.
Characteristics
Tax Liabilities
Debt Funds
Tax rate of 20% with indexation for holdings over three years; taxed as per income slab for holdings under three years.
Equity Funds
Long-term equity funds (held over 12 months) attract no capital gains tax; short-term equity funds (12 months or less) are taxed at a flat rate of 15%.
Characteristics
Risk Factors
Debt Funds
Considered relatively low-risk, but not entirely risk-free. Sensitive to interest rate changes affecting corporate bond prices.
Equity Funds
Deemed riskier due to market volatility, influenced by economic factors such as tax rates, inflation, and currency changes.
| Characteristics | Debt Funds | Equity Funds |
|---|---|---|
Basic Characteristics | Invest in fixed-income securities, minimising defaults. Common holdings include non-convertible debentures, corporate bonds, and government bonds. | Invest in equity shares and linked instruments, with diversified portfolios to mitigate volatility. |
Tax Liabilities | Tax rate of 20% with indexation for holdings over three years; taxed as per income slab for holdings under three years. | Long-term equity funds (held over 12 months) attract no capital gains tax; short-term equity funds (12 months or less) are taxed at a flat rate of 15%. |
Risk Factors | Considered relatively low-risk, but not entirely risk-free. Sensitive to interest rate changes affecting corporate bond prices. | Deemed riskier due to market volatility, influenced by economic factors such as tax rates, inflation, and currency changes. |
Returns | Provide steady and stable returns, especially during market instability. | Likely to yield better long-term returns, responsive to market performance and fluctuations. |
In comparing Debt Mutual Funds to Equity Mutual Funds, investors should consider factors like their risk tolerance, investment horizon, and financial objectives to make well-informed decisions.
Types of Equity Funds
SEBI (Securities and Exchange Board of India) has categorised equity funds into various types based on their investment focus.
Large-cap funds: These funds invest mainly in large, well-established companies with a strong track record. They are relatively less volatile and ideal for conservative equity investors.
Mid-cap funds: These focus on medium-sized companies with significant growth potential. Mid-cap funds carry higher risk but also offer the possibility of higher returns.
Small-cap funds: These funds invest in smaller companies with high growth potential. They are highly volatile and suitable for investors with a high-risk tolerance.
Multi-cap funds: These funds allocate investments across large-cap, mid-cap, and small-cap companies, offering diversification.
Sectoral or thematic funds: These funds invest in specific sectors like technology or healthcare or follow a particular theme. They are riskier due to their concentrated focus.
ELSS (Equity Linked Savings Scheme): ELSS funds offer tax benefits under Section 80C of the Income Tax Act. They have a mandatory three-year lock-in period and are a popular choice for tax-saving investments.
Types of Debt Funds
SEBI has also categorised debt funds into various types based on their investment focus and the duration of instruments they hold.
Liquid funds: These funds invest in money market instruments with a maturity of up to 91 days. They are low-risk and ideal for short-term parking of surplus funds with moderate returns.
Ultra-short duration funds: These funds invest in debt instruments with a maturity of 3 to 6 months. They offer slightly higher returns than liquid funds, with limited interest rate risk.
Short-term funds: These funds invest in instruments with a maturity of 1 to 3 years. They suit conservative investors looking for better returns than fixed deposits with moderate risk.
Corporate bond funds: These funds allocate at least 80% of their assets to high-rated corporate bonds, offering relatively stable returns. They are suitable for investors seeking safety and moderate income.
Dynamic bond funds: These funds actively manage portfolio duration based on interest rate trends. They can invest in both short-term and long-term instruments, making them suitable for seasoned investors.
Gilt funds: Gilt funds invest exclusively in government securities, making them risk-free in terms of default. They are, however, exposed to interest rate fluctuations.
Credit risk funds: These funds invest in lower-rated corporate bonds to earn higher returns. They carry higher credit risk and are suitable for investors with a higher risk appetite.
Fixed maturity plans (FMPs): These are closed-ended funds that invest in fixed-income instruments with a fixed maturity period. They provide predictable returns and are less affected by interest rate changes.
Read More: Types of Debt Funds
Choosing Between Debt And Equity Funds:
Investors often face difficulty selecting between debt and equity funds, offering potential returns but accompanied by distinct advantages and drawbacks. It's crucial to thoroughly understand these factors before making a decision. Careful selection of equity funds is vital to manage risks and volatility.
Consider the following factors when deciding between debt and equity funds:
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Investment Duration: Customize your choice based on the time you need funds. Debt funds work well for shorter durations (up to five years), while equity funds are better for longer investment horizons (at least seven years).
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Potential Returns: Maintain realistic expectations regarding returns. On average, long-term potential returns are around 9% for debt funds and 16% for equity funds, each with its level of risk and uncertainty.
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Risk Factor: Understand the risk potential for both types. Debt funds offer less risk, a lower chance of capital loss, and reduced potential returns. In contrast, equity funds involve more risk, a higher chance of capital loss, and greater potential returns.
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Investment Objectives: Align your choice with your investment goals. Debt funds are suitable for income generation with guaranteed returns, while equity funds may be more fitting for wealth creation.
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Tax Consequences: Consider tax implications. Equity funds have zero taxes for investments held over 12 months. Debt funds are taxed for short-term gains (before three years) and long-term gains (after three years with indexation), with no distinction after three years compared to equity funds.
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Lock-in Duration: Debt funds are highly liquid with no lock-in period but attract short-term capital gains tax if closed before three years. Equity funds have a minimum lock-in period of three years.
Conclusion
Selecting between debt and equity funds is a complex decision, given the multitude of differences between the two. To make an informed choice, start by defining your investment objectives and carefully considering various parameters, ensuring a thorough understanding before making any trading decision.
This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their own research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.
Investments in securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI prescribed Combined Risk Disclosure Document prior to investing. Brokerage will not exceed SEBI prescribed limit.
