Mutual funds offer a wide range of investment solutions for different investment needs, tenures and risk appetites. Different investors have different financial goals and risk appetites depending upon their stages of life and financial situations. Also, one investor can have multiple financial goals at any point of time. To select the right mutual fund scheme for your specific investment needs you need to compare equity funds vs debt funds as these are two most important assets.
Asset class classification
The main distinguishing factor between equity vs debt funds is risk e.g. equity has a higher risk profile compared to debt. Investors should understand that risk and return are directly related, in other words, you have to take more risk to get higher returns. At the same time, investors should also understand the linkage between risk and investment tenure, i.e. if you are taking more risk, you should have longer investment tenures.
Before we examine what is the difference between equity and debt funds, let us know more about these two assets -
What are Equity Funds?
Equity funds invest primarily in shares of companies and related securities like derivatives (i.e. futures, options) which trade in the stock market. The primary objective of investing in stocks is capital appreciation along with which stocks may pay dividends which provide income to investors. If you compare difference between equity and debt mutual funds, equity is more volatile asset class compared to debt. Investors need to have moderately high to high risk appetites with longer investment tenures for equity funds investments.
There are different type of categorization of equity funds which is largely based on market capitalization segments i.e. large cap, mid cap and small cap. Large cap funds invest primarily in the 100 largest companies by market capitalization. Mid cap funds invest primarily in 101st to 250th companies by market capitalization, while Small Cap funds mostly invest in 251st and onward companies by market capitalization.
What are Debt funds?
Debt funds invest primarily in debt and money market instruments. Money market instruments include commercial papers (CPs), certificates of deposits (CDs), Treasury bills (T-Bills) etc. Debt market instruments include non convertible debentures (NCDs), Government Bonds or G-Secs etc. Primary objective of investing in debt or money market instruments is getting income in form of interest payments. Though income is the primary investment objective in debt funds, some debt funds which take interest rate calls can also generate capital appreciation for investors. The main difference between debt fund and equity fund is that debt funds have considerably lesser risks compared to equity funds.
The other major difference between debt mutual fund and equity mutual fund is that there are many types of debt funds which help you invest even for one day to many years. For example - Overnight funds invest in instruments which mature overnight and have practically no interest rate risk. Liquid funds invest in securities which mature in less than 91 days. Ultra short and low duration funds whose durations range between 3 to 12 months has low to moderately low interest rate risk. Short duration funds whose duration range between 1 – 3 years have moderate interest rate sensitivity, while medium to long duration, long duration and Gilt funds whose durations range from 4 to 7 years or longer have high interest rate sensitivity.
Key difference between equity mutual fund and debt mutual fund
| Features | Debt Mutual Fund | Equity Mutual Fund |
|---|---|---|
| Instruments | Invest primarily in money market instruments, commercial papers (CPs), certificates of deposits (CDs), Treasury bills (T-Bills), non - convertible debentures (NCDs), corporate bonds and Government securities (G-Secs) etc. | Invests in equities or equity related instruments, like derivatives |
| Return on Investment | Low to moderate compared to equity funds | Relatively higher returns compared to debt funds in the long term |
| Risk Appetite | Low to moderate risk | Moderately high to high risk |
| Expenses | Expense ratio of debt und is much lower compared to equity funds | Equity fund expense ratio is much higher if you compare equity vs debt funds |
| Timings | Timing of buy sell is not that important. Duration of investment is more important in debt funds | Timing of buy sell of equities is very important as stock market is very dynamic and may be very volatile at times |
| Suitability | Debt funds give you investment option from 1 day to many years with lower to moderate risk. It can be used as alternate to fixed deposits and savings bank account | Equity funds are for long term and suitable to investors with moderately high to high risk appetite. Equity funds may help reach your long term financial goals |
| Taxation | Debt funds held for less than 36 months are taxed as per the income tax rate of the investor. Long term capital gains (more than 36 months) are taxed at 20% after allowing for indexation benefits | Capital gains from equity funds held for less than 12 months are taxed at 15%. Long term capital gains (more than 12 months) of up to Rs 1 lakh is tax exempt and taxed at 10% thereafter. |
| Tax Saving option | There is no option to save taxes | Yes, you can save taxes by investing upto Rs 150,000 in a year in ELSS mutual funds |
Conclusion
In this article, we discussed the difference between equity fund and debt fund and also the characteristics of these funds. Mutual funds are one of the most friendly investment options provided you are able to compare equity mutual funds vs debt mutual funds. While equity funds are risky in the in the short term, in the long term they can provide superior return over any other assets class provided you are ready to take high risk. On the other hand, debt funds can be your good friend if you cannot tolerate high risk and happy with low to moderate return and if the main aim is capital protection. Debt funds are also an alternative investment for fixed deposits and savings bank account.
Lastly, both equity and debt funds are tax efficient investment options when compared to other asset classes. In Summary, both help investors in meeting their various investment objectives depending upon the investors risk taking appetite and investments objective. Those who are not able to compare equity mutual funds vs debt mutual funds should consult with a financial advisor for taking an informed investment decision.
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