Equity vs Debt Funds – Which One Should You Invest in?
Your mutual fund investments should be based on your financial goals, risk tolerance, and investment horizon, among others. Additionally, you should have a firm understanding of different asset classes, market cap, etc. When categorised on the basis of the asset class, equity and debt funds are two popular options for investors. But each comes with its set of benefits and limitations.
In this blog, we have dissected the key differences between equity and debt funds so that you can make informed investment decisions.
What Are Equity Funds?
Equity funds are mutual funds that invest predominantly in stocks of different companies in a bid to generate profits. Investments in equity funds are exposed to higher risks when compared to other mutual funds. However, these funds also have the potential to generate higher returns in the long-term.
What Are Debt Funds?
A debt fund is a mutual fund that invests in fixed-income or debt instruments such as government securities, corporate bonds, money market instruments and other debt securities that offer fixed-interest income.
Debt funds are also known as bond funds or income funds and are ideal for risk-averse investors who want regular income. Though debt funds carry lower risks compared to equity funds, they also tend to offer lower returns than equity funds.
Debt Vs. Equity Funds: Key Differences
Given below are the key differences between equity and debt funds:
| Features | Equity Fund | Debt Fund |
| Investment | Primarily invests in stocks of different companies | Primarily invests in fixed-income instruments |
| Risk | Carries high-degree of risk | Carries comparatively lower risk |
| Returns | Potential to generate higher returns than debt and hybrid funds | Generates more stable and consistent returns across the investment tenure |
| Expense Ratio | Equity funds can charge a maximum of 2.25% of the daily net asset as the expense ratio | Debt funds can charge 2% (annualised) of the daily net assets as the expense ratio |
| Taxability | 15% STCG tax is applicable if the investment holding period is less than 12 months + Cess + Surcharge. LTCG tax is applicable if the holding period is more than 12 months. But LTCG up to ₹1 lakh are tax-free. If the LTCG exceeds this limit, 10% tax + Cess + Surcharge | STCG tax is applicable if the debt fund units are held for less than 36 months. The capital gains are added to an investor’s taxable income and taxed as per his/her tax slab. From 1st April, 2023, capital gains on debt funds held for more than 36 months will be taxed as per your income tax slab rate, provided the fund invests more than 35% of its net assets in debt. |
| Tax Benefits | Investments in ELSS (Equity Linked Savings Schemes) qualify for tax deductions of up to Rs. 1.5 lakh under Section 80C of Income Tax Act | For investment horizons exceeding 3 years, investors were taxed at 20% with indexation benefits. However, from 1st April, 2023, this benefit won’t be available on debt funds which invest more than 35% of their net assets in debt instruments. The investor will be taxed as per their income tax slab rate. So, going forward, no tax benefit will be available on debt funds. |
| Suitability | Investors with a high-risk appetite and who wish to have a long investment horizon | Investors with a low risk-appetite, who are looking for a better alternative to FDs |
| Suitable Investment Tenure | 5 – 10 years | 3 – 5 years |
Equity Funds vs Debt Funds: Which One to Choose?
Let us look at the advantages of both equity and debt funds to better understand the suitability of these schemes:
Advantages of Investing in Equity Funds
Discussed below are the advantages of investing in equity funds:
- Equity mutual funds ensure portfolio diversification as the schemes invest in stocks across various industry sectors. By diversifying across different sectors, equity funds mitigate overall risks.
- Purchasing equity fund units is more convenient than buying multiple stocks across various industry sectors.
- Historically, equity as an asset class has outperformed other asset classes in the long run.
- Investing in Equity Linked Savings Schemes or ELSS can help you save taxes of up to Rs. 1.5 lakh u/s 80C of the IT Act.
- You can build a significant corpus by investing a minimum of Rs.500 every month via SIPs (Systematic Investment Plans) in equity funds.
Advantages of Investing in Debt Funds
Discussed below are the benefits of investing in debt funds:
- Debt mutual funds offer stable and regular sources of returns as they primarily invest in fixed-income instruments.
- Investment in debt funds offers higher returns than traditional investment options like banks’ fixed deposits and savings accounts.
- Debt fund investments are associated with low risks, which makes it an ideal investment option for risk-averse investors.
- Adding these funds to your portfolio, which may also have equity funds, can help you balance your risk-return profile.
- Can help protect your portfolio against market volatility when equity funds underperform.
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Is there any Risk in Investing in Equity or Debt Funds?
All mutual funds are market-linked products, and thus, they do not offer any guaranteed or assured returns. In fact, there are a number of risks associated with investing in both equity and debt funds.
Let us look at the risks associated with equity and debt mutual funds:
1. Equity Funds
- Equity instruments are subject to market movements, so there remains a possibility of risk if the market’s down.
- Investors need to be aware of the price risk because the prices of shares are subject to daily and unpredictable fluctuations.
- Event risk is an important thing to consider, as company or sector-specific events can lead to considerable losses.
- The lock-in period of 3 years for ELSS funds can result in liquidity risks. Apart from that, settlement periods and trading volumes can significantly restrict the liquidity of equity investments.
2. Debt Funds
- Interest rate risk is one of the main risks associated with debt mutual funds. A rise in market interest rates is accompanied by a fall in the prices of fixed-income securities.
- Spread risk is another essential factor to consider with respect to debt investments. The credit spreads on corporate bonds differ with varying market conditions. Moreover, the market value of debt securities may fall in case the credit spreads widen.
- Credit risk occurs when the issuers fail to make interest/principal amount payments in time. A default will result in the fall of the NAV of the entire scheme. Moreover, when the issuer’s credit rating falls, the prices of its debt securities will also fall.
Things to Consider Before Investing in Debt and Equity Funds
Keep the following parameters in mind when choosing between equity and debt funds:
1. NAV
Net Asset Value (NAV) is the market value (minus fund expenses) of all shares in a portfolio divided by the total number of units available. It determines gains and losses in a mutual fund. Whenever there is a rise in a fund’s profit, NAV increases without any change in total units. This determines that there is an income on the investment.
2. Expense Ratio
The expense ratio refers to a yearly fee that the fund houses levy on investors to cover operational costs including fund manager’s fee. Low expense ratio reduces the overall cost of the fund.
3. Experience of the Fund Manager
For active mutual funds, such as equity and debt funds, fund managers are actively involved in all investment decisions. Accordingly, the performance of the scheme depends on the skills and knowledge of fund managers. In that regard, it is essential to consider a fund manager’s experience when selecting a scheme.
4. Investment Mode
You can invest in mutual fund schemes in lump sum or via SIP (Systematic Investment Plan). Choose your preferred investment mode based on your expertise. Usually, beginner investors consider SIPs as you can start investing with a smaller amount.
5. Past Returns
Though past returns are no way a yardstick to influence your investment decisions, however, analysing a fund’s past performance could help you gauge its consistency and stability, especially if the fund has weathered market downturn.
Final Word
Both equity and debt funds have their own advantages and limitations. You need to assess your risk tolerance, financial goals and investment horizon before investing in equity or debt funds.
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FAQs
Ans: The mutual funds that invest most of their AUM (Assets Under Management) in shares of companies with the largest market capitalisation, such as HUL and ITC, are known as large-cap funds. Large-cap funds tend to generate consistent and stable returns over a period of time. However, they might be outperformed by small and mid-cap funds, especially in a growing economy.
Ans: Gilt funds are debt funds that invest a minimum of 80% of their assets in government securities. As government bonds used to be issued in golden-edged certificates, they earned the nickname ‘gilt’. Though these funds don’t carry any risk of non-payment of interest, they get affected by interest rate movements.
Ans: The period during which the investor cannot redeem their investment, either partially or wholly, is known as the lock-in period of mutual funds. Most mutual funds don’t come with a lock-in period in India. Exceptions are close-ended mutual funds and ELSS (Equity Linked Saving Scheme), which carries a lock-in period of 3 years.
Ans: Investments in debt instruments generate fixed returns and repay the principal amount over a fixed tenure. As per this definition, PPF forms an integral part of an individual’s debt portfolio and is considered to be a safe investment option as they are backed by the Government of India. But liquidity is not their strong point as they have a lock-in period of 15 years.
Ans: When an individual directly invests in mutual funds without involving any distributor or agent, he/she has invested in a direct plan. It has a lower expense ratio than a regular plan, as no commissions/distribution fees are involved. So, investors can get much higher returns over time compared to regular plans. Another important feature is that a fund’s direct plan has a higher NAV than its regular plan.
Ans: Every investor has different investment objectives, and he/she needs to analyse them well before choosing an investment option. For example, investors who prefer stable and regular income will find debt funds suitable. However, people who aim for long-term wealth creation should opt for equity funds.
Ans: Financial experts recommend that investors follow goal-based investment strategies. For example, they may advise some people to build a 60/40 investment portfolio, i.e. people should invest 60% of their investment corpus in equities and 40% in debt funds. However, investment strategies can vary with different risk appetites and financial goals.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
