If you are looking for an answer to this question, you are not alone. Many investors are confused about the difference between equity and debt funds, and which one is better for their financial goals. In this blog post, we will explain the basic features of equity and debt fund, their advantages, and disadvantages, and how to choose the right one for your portfolio.
What are debt funds?
Debt funds are mutual funds that invest primarily in debt and money market instruments such as government and corporate bonds, commercial papers, certificates of deposits, treasury bills, etc. The primary objective of investing in debt funds is income generation through interest payments.
Debt funds are also classified into different categories based on various factors such as maturity duration, credit quality, interest rate sensitivity, etc. For example, liquid funds invest in very short-term instruments (up to 91 days), ultra short-term funds invest in instruments with slightly longer maturity (3 to 6 months), short-term funds invest in instruments with medium maturity (1 to 3 years), medium-term funds invest in instruments with longer maturity (3 to 5 years), long-term funds invest in instruments with very long maturity (more than 5 years), credit risk funds invest in lower-rated instruments with higher interest rates but higher default risk, gilt funds invest in government securities with no default risk but higher interest rate risk, etc.
The main advantage of debt funds is that they offer lower risks than equity funds because they are less affected by market fluctuations and volatility. Debt funds also offer regular and stable income through interest payments. Debt funds also have lower expenses than equity funds because they have lower brokerage fees, transaction costs, fund management fees, etc.
However, debt funds also have lower returns than equity funds over the long term because they invest in less profitable and less risky instruments. Debt funds also suffer from inflation risk, which means that the purchasing power of your money decreases over time due to rising prices. Debt funds also suffer from interest rate risk, which means that the value of your investment decreases when interest rates rise and vice versa.
Therefore, debt funds are suitable for investors who have a low-risk appetite and a short-term investment horizon (up to 3 years or less). Debt fund can help you achieve your short-term financial goals such as emergency fund creation, tax saving, liquidity management, etc.
What are equity funds?
Equity funds are mutual funds that 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 equity funds is capital appreciation, along with which stocks may pay dividends which provide income to investors. Equity funds are classified into different categories based on various factors such as market capitalization, sector, theme, style, etc. For example, large cap funds invest in the top 100 companies by market capitalization, mid cap funds invest in the next 150 companies, small cap funds invest in smaller companies, sectoral funds invest in specific sectors like banking, IT, pharma, etc., thematic funds invest in specific themes like infrastructure, consumption, etc., value funds invest in undervalued stocks, growth funds invest in high-growth stocks, etc.
The main advantage of equity funds is that they offer higher returns than debt fund over the long term because they invest in more mature and profitable companies. Equity funds also benefit from the power of compounding, which means that the returns earned on your investment are reinvested to generate more returns over time.
However, equity funds also have higher risks than debt funds because they are subject to market fluctuations and volatility. Equity funds can lose value if the stock market crashes or if the companies, they invest in perform poorly. Equity fund also have higher expenses than debt fund because they have to pay brokerage fees, transaction costs, fund management fees, etc.
Therefore, equity funds are suitable for investors who have a high-risk appetite and a long-term investment horizon (at least 5 years or more). Equity funds can help you achieve your long-term financial goals such as retirement planning, wealth creation, children’s education, etc.
How to choose between equity and debt funds?
Equity funds are mutual funds that invest primarily in stocks of various companies across different sectors and market capitalizations. They aim to generate capital appreciation over the long term by participating in the growth potential of the stock market. Equity funds are suitable for investors who are willing to take higher risks and can withstand market volatility.
Debt funds are mutual funds that invest mainly in fixed income securities such as bonds, treasury bills, corporate debentures, etc. They aim to provide regular income and preserve capital by earning interest from the underlying securities. Debt funds are suitable for investors who seek lower risks and stable returns over the short to medium term.
The choice between equity and debt fund depends on various factors such as your risk profile, investment objective, time horizon, tax implications, etc. Here are some general guidelines to help you make an informed decision:
- If you have a high-risk appetite and a long-term investment horizon (more than 5 years), you can invest more in equity funds than debt fund. This will help you earn higher returns and achieve your long-term financial goals. However, you should also diversify your portfolio with some debt funds to reduce the overall risk and volatility.
- If you have a low-risk appetite and a short-term investment horizon (less than 3 years), you can invest more in debt funds than equity fund. This will help you preserve your capital and earn steady income. However, you should also allocate some portion of your portfolio to equity fund to beat inflation and enhance your returns over time.
- If you have a moderate risk appetite and a medium-term investment horizon (3 to 5 years), you can invest in a balanced mix of equity and debt fund. This will help you optimize your risk-return trade-off and benefit from both capital appreciation and income generation. You can also adjust your asset allocation according to your changing needs and market conditions.
- Apart from your risk profile and investment horizon, you should also consider the tax implications of your fund choices. Equity funds are more tax-efficient than debt funds as they enjoy lower capital gains tax rates and longer holding periods for tax benefits. Debt funds are taxed at your marginal income tax rate if you redeem them within 3 years and at 20% with indexation benefit if you hold them for more than 3 years. You should also factor in the exit load and expense ratio of the funds while comparing their returns.
The choice between equity savings funds and debt funds depends on various factors such as your investment objective, risk profile, time horizon and tax implications. Equity savings funds may offer higher returns than debt funds over the long term, but they also carry higher volatility and market risk. Debt funds may offer lower returns than equity savings funds over the long term, but they also have lower volatility and credit risk.
From 1st April 2023, the tax treatment of equity savings fund and debt fund will change as per the new budget proposals. Equity savings funds will be classified as equity-oriented funds and will be subject to long-term capital gains tax (LTCG) of 10% on gains exceeding Rs. 1 lakh in a financial year. Debt funds will be classified as non-equity-oriented funds and will be subject to LTCG of 20% with indexation benefit on gains exceeding three years of holding period.
Therefore, if you are looking for a tax-efficient investment option with moderate risk and return potential, you may consider investing in equity savings funds instead of debt funds from 1st April 2023. However, you should also factor in your investment horizon, liquidity needs and asset allocation before making a decision. On other hand choosing between equity and debt funds is not a one-time decision but a dynamic process that requires regular review and rebalancing of your portfolio. You should also consult a financial advisor or planner if you need professional guidance and advice on your fund selection.