Equity funds versus debt funds, which one is better? This blog covers how these mutual funds work, their benefits and the 5 key differences between equity funds and debt funds.
Apart from the fact that they’re market-linked mutual funds, equity funds and debt funds don’t have much in common. That said we must explore the differences between equity funds and debt funds.
More importantly, we will help you understand who should invest in equity funds and debt funds.
Equity funds invest in shares of stock in companies from different market caps, sectors, themes, and countries. 60-65% of an equity fund’s portfolio consists of stocks.
The rest of the portfolio could be made up of debt and money market instruments to balance out the risks. A fund manager decides which stocks to buy and sell to generate profits.
If the fund is actively managed, the fund manager will constantly monitor the market to buy and sell stocks. These funds will have a higher expense ratio but a better chance of delivering lucrative returns.
On the other hand, if the fund is passively managed, the fund manager will put together a portfolio of stocks that mirrors an index like NIFTY 50.
The expense ratio would be lower but chances of delivering lucrative returns will depend on the performance of the index. Broadly speaking, the returns than you can expect from equity funds lie between 9-16%.
But equity funds do carry volatility and a comparatively higher risk than other mutual funds simply because they invest in direct equity (stocks).
Debt funds invest in debt and money market securities like treasury bills, commercial paper, reverse repo, corporate bonds, etc. Debt funds can generate returns in two ways:
Debt funds include options for the short and long term that are based on portfolio maturity. A debt fund like liquid funds or ultra short term funds that mature in a shorter time have low volatility.
Whereas other debt funds with longer maturity may be comparatively more volatile. Nevertheless, debt funds are safer and less volatile than equity funds while they can generate returns of 6-8%.
Equity funds primarily invest in several individual stocks that have a higher chance of growing and delivering returns. Stock picking is done to match the investment objective.
For example, multi-cap funds invest in stocks across market caps. This will allow a multi-cap fund to benefit from the potentially high returns of small-cap and mid-cap stocks along with the stable returns of large-cap stocks.
In comparison, debt funds generally invest in bonds and other debt instruments that generate low returns due to average interest rates or low price differentials.
For example, an overnight fund invests in overnight reverse repo, bank deposits, bills discounting, etc., all of which have a low lending and borrowing rate of interest.
Historically, equity funds have generated better returns than debt funds. Here’s a table that compares the performance of equity funds and debt funds:
Equity and debt are market-linked instruments that are correlated to a certain degree. But when the market falls, share prices are known to drop more compared to debt instruments (bonds, t-bills, etc).
Thus, debt funds are safer than equity funds. Furthermore, overnight funds, liquid funds, and ultra short term funds are considered to be the safest mutual funds in India.
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Equity funds are known to be volatile in the short term but have the potential to generate high returns over 3 to 5+ years. Thus, equity funds are suitable for the long term.
Debt funds are suitable for both the short and long term. Simply put, longer the portfolio maturity, longer the investment horizon. Case in point, liquid funds mature in 91 days, hence suitable for the short term.
Tax efficiency is a concern when it comes to debt funds. Short Term Capital Gains (< 3 years) are added to the investor’s income and taxed accordingly.
This may be an inconvenience for investors at a higher tax slab since they will end up paying more taxes. Long Term Capital Gains (> 3 years) on debt funds are taxed at 20% with indexation benefits.
However, equity funds can help you save tax. If you hold equity funds for more than a year, the returns will be exempt from tax up to ₹1,00,000. LTCG (> ₹1,00,000) taxed at 10% (+4% cess); STCG (< 1 year) is taxed at 15% (+4% cess).
ELSS funds, a type of equity fund, can offer tax benefits of up to ₹1,50,000 with a 3-year lock-in period.
*Note: Facts & figures are as of 01-07-2021.
Equity funds are high risk, high reward investments that may be suitable for investors with above-average risk tolerance and long term investment goals.
Debt funds are low risk, low reward investments that are suitable for risk-averse investors who want better returns than bank savings a/c and fixed deposits.
Some investors prefer to use debt funds as a means to an end and not the end itself. In a Systematic Transfer Plan (STP), investors choose to park their money in a liquid fund or overnight fund and transfer it to an equity fund periodically.
Several retail investors rely on word of mouth information or op-ed pieces for investment advice. But talk is cheap and generic advice may not work for every investor who wants to invest in equity and debt funds.
Investors need advice that suits their investment goals and risk profile. That's why apps like Cube Wealth give you access to curated mutual fund recommendations according to your risk profile, investment goals, age etc.
Buying mutual funds directly from a fund house is an option as well. While the investment cost may be low, the downside is that you'll have to pick your own equity and debt funds.
Here’s a snippet of the best equity funds and debt funds currently being recommended by our wealth advisor, Wealth First.
Equity funds are like Iron Man -- flashy and high flying risk-takers that deliver an impressive spectacle over a period of time.
Debt funds are like Captain America -- reliable, careful and methodical operators that get the job done with stability and poise. In the end, it would be wise to have both on your team.
In this instance, your team is your investment portfolio that can benefit from the diversification that high flying equity funds and relatively stable debt funds can offer.
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Note: Facts & figures are true as of 20-10-2021. All information mentioned is for educational purposes and relies on publicly available information. None of the information shared here is to be construed as investment advice. We strongly recommend you consult a Cube Wealth coach before investing your money in any stock, mutual fund. PMS or alternative asset.
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