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Equity Vs. Debt Mutual Funds – Which One is Better?

Trading

CA Shefali Mundra

9 Dec, 2022
8 mins read

Financial uncertainties can step in at any point and bring life to a standstill. In response, setting financial goals and investing in mutual funds judiciously can provide an incredible opportunity to grow and thrive forward.

Mutual funds have attained greater importance in the last decade and have been identified as one of the best avenues to invest funds in the Indian stock markets. It offers access to various investment options based on investment needs, fund availability, tenures, and investors’ risk appetites. It helps in diversification, reduces investment risk, and earns higher returns than an individual stock.

The two most popular ones are Equity mutual funds and Debt mutual funds. Let’s gain an in-depth understanding of equity and debt mutual funds to make an informed decision.

What Are Equity Funds?

Equity funds primarily invest a significant chunk of the pooled corpus in the shares and stocks of the companies. As per the SEBI-prescribed Mutual fund guidelines, an equity fund should invest 65% of its portfolio in equities and equity-related instruments. The balance can be freely invested in debt or money-market securities. Equity funds are further categorized into large-cap, mid-cap, and small-cap funds based on market capitalization. Large-cap primarily invest in the 100 largest companies, mid-cap predominantly invest in 101st to 250th companies, and small-cap investment starts from 250th and above companies by market capitalization.

The primary objective of investing in equity shares are capital appreciation and dividend payments providing a periodic income to the investors. Equity funds offer a higher return and involve higher risk exposure.

What Are Debt Funds?  

Debt funds are characterized as the safest form of investment with guaranteed returns. Debt funds essentially invest in debt and fixed-income generating instruments like commercial papers (CPs), treasury bills, government bonds, debentures of listed companies, and certificate of deposits. Debt funds are an ideal form of investment for risk-averse investors with a stable income in the form of interest. Debt funds are less volatile and less risky in comparison to equity funds.

It is pertinent to note debt mutual funds taking an interest rate call option can also result in capital appreciation for the investors.   

How to Choose Between Equity Mutual Funds and Debt Mutual Funds?

Although both the funds have significant importance, a comparative analysis will help an investor make the right choice. Here’s a quick insight into what an investor should know before investing.

       1. Expected Returns.

Equity funds predominantly invest in stocks and shares of listed companies and have the potential to deliver higher returns over the long term. Alternatively, debt funds are low-cost structures providing stable returns in line with or higher than inflation. Returns on equity funds are averagely in the range of 15-16% and on debt funds in 8-10%.

       2. Risk Associated.

Equity funds are more volatile and riskier than debt funds. Equity funds are exposed to high risk subject to market fluctuations. However, with the increased risk, equity funds hold the potential to give higher returns in the long term. Investors with moderately high to high-risk appetites should invest in equity funds.In contrast, debt funds are less volatile and offer stable returns. Investors with moderate to low-risk appetite should invest in debt funds to stay afloat.

       3. Tax Implications.

The Income Tax Act 1961 specifies the taxability of equity and debt mutual funds. In the case of equity funds, if there is short-term capital gain (sold within 12 months), then the tax rate of 15% is applicable. Alternatively, if there is a long-term capital gain, the investor will get an exemption of Rs.1,00,000, and the rest is taxable at 10% without the benefit of indexation.Additionally, investing in Equity Linked Savings Scheme (ELSS) is recommended to save taxes up to Rs. 1,50,000 and reduce the overall taxable income.

In contrast, short-term capital gain (held for less than 36 months) on debt funds is taxable as per the income tax slab, and long-term capital gain is taxable at 20% after the indexation benefit.

       4. Investment Objectives.

The overall choice of the funds boils down to the fund’s objective, i.e., income generation or wealth creation. Debt is suitable for investors looking for a stable income with a certainty of return. In contrast, investors should prioritize equity investment depending on return expectation and duration for wealth creation.

       5. Market Timing.

Market fluctuations have a significant impact on equity funds. The buy and sell timing of equity is crucial as it directly in the performance of the stock market influences it. The timing of buying and selling is not that important for debt funds, but investment duration holds greater importance for them.   

       6. Expense Ratio.

Nothing comes for free, and mutual funds are no different. The expense ratio reflects the amount paid to the Asset Management Companies (AMC) for managing the fund. The expense ratio is different for additional funds and calculated as a percentage of the investment value. For instance, if a mutual fund comes with a 2% expense ratio, then an amount of 2%/365=0.0054% will get deducted from the investment value daily. The expense ratio of equity funds tends to be higher than the debt funds.

 

Conclusion.

Looking at the current scenario, an aspiration to fulfill financial goals largely depends on the disciplinary approach of investing wisely in mutual funds. However, it calls for a deep understanding of equity and debt funds before investing. A comparative analysis of risk appetite, the quantum of returns, expenses, and tax implications is essential to making a wise investment choice.

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