Equity Vs Debt Funds

When it comes to mutual fund investing, there are broadly two types of funds: equity and debt. Equity mutual funds are those that invest in shares, bonds, and other securities. Conversely, debt mutual funds invest primarily in debt securities such as government and corporate bonds. There are many advantages to investing in equity mutual funds over debt mutual funds. Primarily, these funds offer higher returns and can even outperform inflation. However, as compared to debt funds, they are more risky and sometimes generate volatile returns.

In this article, we will study the key differences between equity and debt mutual funds and explore the various factors to keep in mind before investing. Also, we will analyse which option might be better for different investor profiles.

What are equity mutual funds?

A Mutual Fund scheme is categorised as an Equity Mutual Fund when it allocates over 65% of its total assets to stocks. They are also known as open-ended equity funds. The goal of an equity mutual fund is to provide investors with long-term capital appreciation by investing in stocks of companies that have the potential for growth.

What are debt mutual funds?

Debt mutual funds are mutual funds that invest primarily in fixed-income securities such as bonds, treasury bills, and commercial paper. The goal of a debt mutual fund is to provide investors with regular income and capital preservation.

Difference between equity and debt mutual funds

Both equity and debt mutual funds suit different investor profiles. Hence, to make an informed decision, investors must understand the key differences between them primarily related to:

• Portfolio composition
• Risk levels
• Returns
• Taxation
• Suitability for different types of investors

Let’s understand them in detail:

• Portfolio constituents

Equity funds aim to create long-term wealth by investing mainly in stocks and related financial instruments. On the other hand, debt funds focus on preserving capital and generating income. Usually, they invest in safer, fixed-income instruments like government and corporate bonds, treasury bills, commercial papers, and certificates of deposit.

• Investment risk

Equity funds have the potential for higher returns, but they also come with higher risk. This risk level usually varies depending on the type of equity fund. On the other hand, debt funds aim to preserve capital. Hence, they generally have lower to moderate risk compared to equity funds.

• Return on investment

Mostly, equity mutual fund schemes provide higher returns over the long term compared to debt funds. The returns from debt funds are usually lower to moderate when compared to equity funds.

• Taxation

Capital gains are classified as short-term or long-term based on how long you hold an asset before selling it. According to the Union Budget 2024, for equity mutual funds, gains are considered long-term if the holding period is 12 months or more. The resulting LTCG (long-term capital gains) is taxed at 12.5% (up from the previous limit of 10%).

On the other hand, if these units are held for less than 12 months, the arising gains are short-term. The resulting STCG (short-term capital gain) is taxed at 20% (up from the previous limit of 15%).

There is no distinction based on the holding period when it comes to debt mutual funds. All gains are taxed according to the investor’s applicable tax slab rates.

• Ideal for

Equity funds are suitable for investors looking to achieve long-term financial goals. Their ideal risk appetite lies between moderate and high. Comparatively, debt funds are more suitable for investors with a shorter investment horizon. They are also an ideal investment option for low-risk-appetite individuals seeking higher returns than traditional bank fixed deposits (FDs) and savings accounts.

Equity vs. debt mutual funds - A table overview

Equity mutual funds primarily invest in shares, bonds, and other securities. They aim for higher returns but also carry higher risks due to market volatility. In contrast, debt mutual funds focus on government and corporate debt securities. They offer more stable and lower-risk returns.

One of the key differences between these mutual fund types is that equity funds offer high returns and capital growth, while debt funds provide steady income and capital preservation. The choice between them entirely depends on your risk tolerance and investment goals.

For more clarity, let’s understand the major differences between them below:

Factors to keep in mind before investing in Equity Mutual Funds

Before investing in equity mutual funds, consider your risk tolerance and investment goals. Also, while analysing, assess its historical performance and the expertise of its management team. Such an assessment will help you pick the right mutual fund scheme that can support your long-term financial objectives.

For a better understanding, let’s study the various factors to consider before investing in equity mutual funds:

1. Risk Tolerance: Assess your risk tolerance and investment horizon. Equity funds can be volatile, and your ability to bear market fluctuations is essential.
   Read more about, What does risk tolerance mean?
2. Investment Goals: Define your financial objectives, whether it's long-term wealth creation or short-term gains. Different equity funds suit various goals.
3. Fund Selection: Research and choose funds that align with your goals. Diversify your portfolio by including large-cap, mid-cap, and small-cap funds.
4. Costs and Fees: Understand expense ratios, entry/exit loads, and management fees. Lower costs can significantly impact your returns over time.
5. Historical Performance: Analyse the fund's historical performance but remember that past performance doesn't guarantee future results.
6. Fund Manager's Expertise: Assess the experience and track record of the fund manager, as their decisions impact your investments.
7. Diversification: Diversify across different sectors and industries to spread risk and enhance returns.
8. Exit Strategy: Have a clear exit strategy to avoid impulsive decisions during market volatility.
9. Review Periodically: Regularly review your investment portfolio to ensure it still aligns with your goals and risk tolerance.
10. Tax Implications: Be aware of the tax implications of your investments, such as capital gains taxes, which can affect your returns.