Equity Vs Debt Fund - Which Is Better?

Introduction

Choosing the right mutual fund can significantly impact your financial health and future wealth. In FY24, equity-oriented mutual fund categories grew by 55% and now represent close to 45% of the overall assets under management (AUM) within the mutual fund space. In contrast, debt funds saw moderate growth of around 7% and account for approximately 25% of the total AUM. Asset under management or AUM is nothing but the financial assets managed by a financial institution or investment firm on behalf of its clients. 

Given these trends, it is crucial to understand the differences between equity vs debt funds to make informed investment decisions.

What Are Equity Mutual Funds?

Equity mutual funds are investment vehicles that primarily invest in equities and equity-related instruments. The primary objective of these funds is to seek long-term capital appreciation. Therefore, they are more suitable for investors with a higher risk appetite and a longer investment horizon. While equity mutual funds aim for growth over time, they can be volatile in the short term.

Equity funds are further categorised into various types based on specific investment focus and strategies. According to SEBI classification, equity mutual funds are broadly divided based on market capitalisation:

- Large-cap fund: This fund has at least 80% investment in large-cap stocks.
- Mid-cap fund: This fund has at least 65% investment in mid-cap stocks.
- Small-Cap Fund: This fund has at least 65% investment in small-cap stocks.

Beyond these, there are more than ten different categories of equity mutual funds. These include:

1. Multi-cap funds: These funds have at least 75% investment in equity and equity-related instruments. These types of funds are also referred to as diversified equity funds due to their investment across different sectors and segments of the market.
2. Flexi cap funds: These funds require at least 65% investment in equity and equity-related instruments, offering flexibility across market capitalisations.
3. Large & mid-cap funds: These funds have at least 35% investment in large-cap stocks and 35% in mid-cap stocks.
4. Dividend yield funds: These funds predominantly invest in dividend-yielding stocks, with at least 65% in equities.
5. Focused funds: These funds invest in a concentrated portfolio with a maximum of 30 stocks, requiring at least 65% in equity and equity-related instruments.
6. Sectoral/thematic funds: They have at least 80% investment in stocks of a particular sector or theme. For example, funds that invest in technology companies or companies operational in sustainability, etc.
7. ELSS (Equity-linked saving scheme): It requires at least 80% in stocks in accordance with the Equity Linked Saving Scheme, 2005, notified by the Ministry of Finance.

Also Read: What Is Large Cap Fund?

Factors To Keep In Mind Before Investing In Equity Mutual Funds

Investing in equity mutual funds can be rewarding but requires careful consideration. Here are key factors to keep in mind:

1. Risk tolerance

- Importance: Equity mutual funds are volatile. Therefore, it is important to know your risk tolerance to determine how much market downturn you can endure without panicking.
- Consideration: You can consider assessing your comfort with potential losses and your ability to stay invested during volatility.

2. Investment horizon

- Importance: Long-term horizons help ride out market fluctuations and benefit from compounding returns.
- Consideration: You can match your investment duration with your financial goals, ideally 5-10 years or more.

3. Financial goals

- Importance: Aligning investments with goals helps select suitable equity mutual funds.
- Consideration: It is important to define goals clearly, opting for growth strategies for long-term wealth creation or dividend yield funds for income.

3. Fund performance

- Importance: Historical performance offers insights into fund management, though it's not a future guarantee.
- Consideration: Before investing, you can review past performance over different cycles. You can also compare the data with benchmarks and peers.

4. Expense Ratio

- Importance: A higher expense ratio can erode returns over time. The expense ratio means the annual fees and other related charges that an investor has to bear.
- Consideration: You need to choose funds with lower expense ratios to maximise returns, understanding all associated costs.

5. Fund manager’s track record

- Importance: Experienced fund managers can significantly impact the performance of the funds.
- Consideration: You can research the manager’s experience, style, and performance before investing in any funds.

6. Diversification

- Importance: Diversification reduces risk by spreading investments across sectors and companies.
- Consideration: You can ensure that your fund’s portfolio is well-diversified.

7. Tax implications

- Importance: Understanding tax treatment is essential for maximising net gains.
- Consideration: You need to familiarise yourself with capital gains tax rules for equity mutual funds.

What Are Debt Mutual Funds?

Debt mutual funds, also known as income funds, invest primarily in bonds and other debt securities. They aim to provide regular income and capital preservation with lower risk compared to equity mutual funds. Debt funds invest in short-term and long-term securities issued by governments, public financial institutions, and companies. These securities include treasury bills, government securities, debentures, commercial paper, and certificates of deposit.

Debt funds can be further categorised based on the tenor of the securities held in the portfolio or the fund management strategies. Key categories include:

- Overnight fund: Investments in overnight securities with a maturity of 1 day.
- Liquid fund: Debt and money market securities with maturity of up to 91 days.
- Ultra short duration fund: Debt and money market instruments with a portfolio duration between 3 to 6 months.
- Short duration fund: Investments in instruments with a portfolio duration between 1 to 3 years.
- Medium duration fund: Investments with a portfolio duration between 3 to 4 years.
- Long duration fund: Investments with a portfolio duration greater than 7 years.

There are around additional categories of debt mutual funds based on investments in specific bonds such as corporate bond funds, banking and PSU funds, and gild funds.

Factors To Keep In Mind Before Investing In Debt Funds

Investing in debt mutual funds requires careful consideration of several factors to ensure they align with your financial goals and risk tolerance. Here are key factors to keep in mind:

1. Interest rate risk

- Importance: The value of debt securities is inversely related to interest rates. This affects returns, especially for long-duration funds.
- Consideration: You can consider choosing funds with durations that match your interest rate outlook. Short-duration funds are less affected by interest rate changes.

2. Credit risk

- Importance: Credit risk refers to the possibility of bond issuer default. Lower-rated bonds offer higher yields but come with higher risk.
- Consideration: Consider evaluating the credit quality of the fund’s portfolio. Higher exposure to government and AAA-rated bonds means lower risk.

3. Duration and maturity

- Importance: Duration and maturity determine a fund’s sensitivity to interest rate changes and liquidity.
- Consideration: To minimise this risk, you need to align the duration of the debt fund with your investment horizon. Short-term funds suit short-term goals, while long-term funds suit longer goals.

4. Liquidity

- Importance: Liquidity indicates how easily you can redeem your investment without loss.
- Consideration: You can check the fund’s liquidity profile. Liquid and ultra-short-duration funds offer high liquidity for short-term needs.

5. Yield to maturity (YTM)

- Importance: YTM estimates the fund’s potential returns.
- Consideration: You can compare YTMs of different funds. Higher YTM indicates higher expected returns but possibly higher risk.

6. Expense Ratio

- Importance: The expense ratio affects net returns.
- Consideration: You need to choose funds with lower expense ratios to maximise returns. Therefore, understanding all associated costs before investing is important.

7. Tax implications

- Importance: Interest income and capital gains are subject to taxation.
- Consideration: You can learn the tax rules for debt funds. Long-term gains (over three years) get indexation benefits, while short-term gains are taxed as per your slab.

8. Fund manager’s expertise

- Importance: A skilled fund manager can influence performance through effective risk management.
- Consideration: Research the manager’s experience and performance history.

What Are The Differences Between Debt And Equity Mutual Funds?