Equity Funds Vs Debt Funds: Understand the Difference Between Equity and Debt Fund

Mutual funds are synonymous with risk-free investment and wealth creation. And when it comes to investing in one, you have two options – equity and debt mutual funds. Both mutual fund types are quite popular because they cater to the distinct investing needs of different investors. 

If you are new to mutual fund investments, you may wonder whether to invest in equity or debt funds. That is why it is essential to understand the difference between debt and equity mutual funds so you can make your investments worthwhile. 

In this blog, we will explore the difference between debt and equity mutual funds. We will also help you pick the right mutual fund to realize your investing goals. So, let’s dive straight in. 

What are equity funds?

Equity mutual funds primarily invest your money in shares of companies and related securities like futures, options, etc., trading in the stock market. According to the Securities Exchange Board of India an equity fund must invest at least 65% of the corpus into companies’ equity. 

These funds aim to generate returns by investing in the ownership of businesses. And, since equity funds invest in stocks that trade in the stock exchange, their value fluctuates with the performance of the underlying assets and the stock market. 

Equity funds are generally more popular among investors because they generate higher returns compared to other mutual fund types. They are also the perfect option if you want to invest your money for the long term. 

But as mentioned earlier, their returns depend on the performance of the shares in the stock market. They are more volatile to the impacts of market conditions and government policies. As a result, they carry significant risks as well. 

Factors to keep in mind before investing in equity mutual funds

Before investing in equity mutual funds, it's important to consider several key factors to ensure the fund aligns with your financial goals and risk tolerance. Here are some factors to look out for:

1. Fund size: Look at the total asset under management (AUM) of the mutual fund. While large funds come with better liquidity, they may struggle to keep up with market changes, which can impact their performance. However, large funds may also have more resources for research and analysis. Therefore, it's important to consider your goals, risk tolerance, and the fund's objectives to make an informed decision.

2. Expense ratio: The expense ratio is the annual fee levied by the fund for administrative costs, management fees, and other operational expenses. A higher expense ratio can increase your cost of investment, reducing your overall returns.

3. Risk-reward ratio: The risk-reward ratio is a measure of the potential returns generated by an investment compared to the risk involved. Remember, investments with a high return potential also come with higher risk. Therefore, it's important to carefully evaluate your options and select a fund that aligns with your risk tolerance.

Key features of equity funds

1. These funds invest at least 65% of the investors’ money into shares.

2. Returns on your equity fund investment depend on the performance of underlying shares, stock market trends, and government policies. 

3. Returns are in the form of capital appreciation and dividends.

4. You pay a 15% short-term capital gains tax if you sell your units within one year, regardless of your income tax slab. 

5. You can claim tax deductions on long-term capital gains of under Rs 1 lakh. 

What are debt funds?

As the name suggests, debt mutual funds invest your money in debt or fixed-income securities like bonds, debentures, government securities, and money market securities like treasury bills, commercial papers, etc. 

Unlike shares in equity funds, the underlying credit instruments of debt funds are not exposed to market fluctuations. As a result, they are particularly popular among investors with a lower risk appetite.  

Returns you earn are in form of interest payments. However, it is important to note that returns are lower than equity funds, but they are stable. So mutual funds are ideal if you want a regular stream of income. 

Besides, debt funds are a better option than keeping your money in a savings account or a fixed deposit if you have a short-term or medium-term investment horizon.

Factors to keep in mind before investing in debt mutual funds

When investing in debt mutual funds, make sure to consider the following factors:

1. Expense ratio: The expense ratio is a fee levied by the fund to cover administrative, management, and operational costs and is deducted annually from the fund’s returns. Opt for funds with a low expense ratio as they leave you with more money to grow.

2. Management fee: The management fee is the amount paid to fund managers for their expertise in managing the fund’s portfolio. A well-managed fund may have a higher management fee if it consistently outperforms its benchmark.

3. Risk appetite: Risk appetite is your ability to take on investment risk. It's important to assess your risk tolerance when comparing mutual funds to make the right choice.

Key features of debt funds

1. Debt funds primarily invest in fixed-income securities like debentures, bonds, and money market securities. 

2. They offer comparatively lower returns than equity funds.

3. Returns on debt investments depend on prevailing interest rates and the quality of underlying securities. 

4. As of April 1, 2023, debt funds are taxed as per the investors’ income tax slabs, irrespective of the holding period. 

5. No tax benefits are available. 

Difference between debt and equity funds: a head-to-head comparison

Let’s make a detailed equity vs debt investments comparison so you can pick the best mutual fund to invest your money in.

Equity vs debt funds: Which mutual fund should you invest in?

Now that the difference between debt and equity mutual funds is clear, which is the perfect investment for you? 

Before making a decision, assess your financial station and risk appetite, and clearly lay out your investment goals. 

For instance, suppose you are investing to build a corpus for a long-term goal like retirement. At the same time, you are willing to keep your money locked in for extended periods and can deal with the ups and downs of the share market. In such a situation, equity funds are the perfect investment instrument. 

However, if you want to avoid exposing your investment to stock market risks, you should invest in debt funds. Besides, they are also perfect if you want to earn returns at a stable rate, irrespective of your investment horizon. 

Ideally, you should aim to diversify your portfolio regardless of your investment type. For instance, you can invest 60%-70% of your money in equity funds and remaining in debt funds. That way, you can generate regular income from debt funds and benefit from the growth potential of equity funds. 

Diversification allows you to balance the overall risk. When the equity market faces a downturn, debt funds can reduce the volatility of your portfolio and vice-versa.

Conclusion

If you're new to investments, it's important to understand the difference between equity funds and debt funds to make informed decisions. Equity funds primarily invest in equity and equity-related instruments and typically come with a higher growth potential. But at the same time, they are also more volatile and risky. On the other hand, debt funds provide more stable returns and are ideal for conservative investors.

The best choice between the two depends on your financial goals, risk tolerance, and investment horizon. A balanced portfolio with both equity and debt funds can help spread out the risk while optimizing returns.

Frequently Asked Questions (FAQs)

1. Which is better debt fund or equity fund?

The choice between debt and equity funds depends on your risk tolerance and investment goals. Equity funds have the potential to generate higher returns but also come with higher risk. Debt funds are ideal if you have a low-risk tolerance and are looking for stable returns.

2. Is a debt fund safer than an equity fund?

Yes, debt funds are generally safer than equity funds because they invest in fixed-income instruments like bonds and government securities. However, they still carry some risk.

3. When to invest in debt or equity?

Invest in equity funds if you have a high-risk tolerance and are looking for long-term capital appreciation. Debt funds are better when you seek more stable, short-to-medium-term returns with lower risk.

4. Can I invest in equity and debt mutual funds at the same time?

Yes, you can invest in equity and debt mutual funds at the same time. Diversifying your portfolio will help spread the risk and optimise returns.

5. Do debt funds come with zero risk?

No, debt funds do not come with zero risk. While they are less risky than equity funds, they still carry risks like interest rate risk and credit risk.