Equity vs Debt Mutual Funds: What's the Difference?

What are Equity Mutual Funds?

Equity funds will predominantly invest in the shares of companies that are listed. The fund manager will select the stocks in line with the scheme's investment objective which may be to invest in large caps, mid caps, small caps, a particular sector or a mixture of companies.

The value of an equity mutual fund is ultimately down to the performance of the shares it holds. Returns will be influenced by a whole range of factors including company earnings, the state of the economy, interest rates, sector specific developments and general investor sentiment.

Equity funds are generally viewed as being more exposed to market risk with share prices being quite volatile. They can also have the potential for greater long term capital growth depending on the performance of the market and the fund's own strategy.

These are funds that would generally be seen as appropriate for investors with a longer time horizon who can tolerate some short term volatility. Returns are not guaranteed and investors may lose money over the longer term.

What are Debt Mutual Funds?

Debt mutual funds invest predominantly in fixed income securities (government securities, treasury bills, corporate bonds, commercial paper and certificates of deposit). The securities are used by the issuers (the government, the bank, the company etc) to raise funds from investors.

Debt fund returns are a function of interest rates, the credit quality of the securities in the fund, the maturity profile and the state of the market at any given time.

For instance if market interest rates go up the prices of existing bonds may go down and that could in turn reduce the NAV of a debt fund. If interest rates go down the existing bonds may be worth more (depending on their nature).

Debt funds can be less volatile than equity funds in certain circumstances but are by no means risk free. There is credit risk (the risk that the issuer will be unable to meet its obligations) and there is liquidity risk (the risk that you won't be able to sell your securities at a good price).

Debt funds are typically used for short to medium term requirements (depending on the fund's portfolio and risk profile). They don't provide assured returns unless a particular product has that guarantee enshrined in law, which of course the standard mutual fund scheme won't.

Equity vs Debt Mutual Funds: Key Differences

The key difference is in the assets they hold and the risk they are prepared to take.

1. Investment objective

Equity funds are generally seeking capital appreciation via investment in shares of companies. Debt funds are primarily invested in fixed income securities and can be appropriate for investors looking at an income focused exposure or for portfolio diversification.

2. Risk level

Equity funds are subject to market risk as share prices can swing dramatically. Debt funds are exposed to interest rate risk, credit risk and liquidity risk. Neither of the two categories is in any way suitable for every investor and the actual level of risk will be determined by the nature of the fund's holdings and its strategy.

3. Return potential

Equity funds can potentially offer superior returns over the long term, but their performance is very much subject to volatility. Debt funds on the other hand are generally impacted by bond yields, interest rate movements and credit conditions. Performance in the past is no guarantee of future performance in either category.

4. Investment horizon

Equity funds are generally better suited to longer term goals as you have more time to ride out the market. Debt funds can be used for shorter or intermediate term goals but you need to ensure that the maturity of the scheme and the risk profile of the scheme is in line with the timing of your requirement.

5. Taxation

Tax treatment will vary depending on the type of mutual fund, the relevant rules and the date of investment or redemption. Equity funds and debt funds may be subject to different tax rules. Investors should check the current rules and seek the advice of a tax professional where appropriate.

An Example to Understand the Difference

Suppose an investor has Rs 50,000 to invest.

If the money is placed in an equity mutual fund the scheme could invest it in shares of a number of companies. If those companies do well and their share prices go up the fund's NAV will go up. If the market goes down the value of the investment will go down.

If the same amount is invested in a debt mutual fund the money will be invested in bonds and other debt securities. Its value will be a function of interest rate movements, credit quality and the portfolio's maturity. It can still go down in value if the market turns or an issuer goes into credit trouble.

These are examples of the two types behaving differently. Neither of them is guaranteed to make a profit and the actual outcome will of course depend on which fund you select and the state of the market.

Can Investors Hold Both Equity and Debt Mutual Funds?

Yes. Some investors use both categories to diversify their portfolios. Equity funds can provide exposure to stock-market performance, while debt funds may offer a different source of returns and help balance overall portfolio exposure.

An investor saving for retirement many years out may be quite happy to have some equity exposure for the long term growth, and will probably be quite happy to have a lot of debt as well for stability and for the more immediate needs. An investor saving for a goal which is due in a few years may be more focused on capital preservation and liquidity and may well be looking at the risks of the debt scheme they're going to use as well.

The appropriate allocation depends on financial goals, investment horizon, income needs, existing investments and risk tolerance. Diversification does not eliminate market risk or guarantee positive returns.

How to Choose Between Equity and Debt Mutual Funds

Before investing, consider the following:

• Your financial goal : To work out what you are saving for and when you will need the money.
• Your risk tolerance: Think about how you'd react if the investment value went down.
• The scheme's portfolio: review its holdings, its investment strategy, its credit quality and its riskometer.
• Costs and taxation: Check the expense ratio, exit load, applicable taxes and all other relevant charges.
• Liquidity requirements: Ensure the scheme's redemption terms are appropriate for your own requirements.

Investors can of course go and look at the scheme information, the factsheets and the disclosures prior to making a decision. Platforms such as Ashika Dhanush 2.0 can also be used to help users to explore their options and look at the relevant market information.

Final Thoughts

Equity and debt mutual funds are very different beasts. Equity funds are essentially shares of companies and are exposed to the risk of the share market. Debt funds on the other hand are invested in fixed income securities and are subject to interest rate and credit risk.

The decision shouldn't be based on which category has performed best in the recent past. You need to look at your own objectives, your time frame and your ability to take on risk before you pick a scheme or indeed a mix of both categories.