Equity Funds vs Debt Mutual Funds – Meaning and Differences

Equity funds and debt funds are the two most common types of mutual funds in India. As their names suggest, the former invests primarily in stocks and other related instruments and the latter invests primarily in debt securities. Both these investments are appropriate for different financial objectives due to the difference in their risk levels, potential returns and other key features.

Now, before investing in mutual funds, you must understand the concept of equity funds vs debt funds. 

What Are Equity Funds?

Mutual fund schemes in which investments are made primarily in shares or stocks of companies are called equity funds. As per current SEBI Regulations, an equity mutual fund scheme must invest at least 65% of the assets in equities and equity related instruments. Equity funds carry higher risk due to stock market volatility but are usually known to generate higher returns. Typically, equity funds are beneficial for long-term investments.

Equity funds can be managed actively or passively. Actively managed funds are those in which a fund manager conducts extensive market research to determine which stocks offer the best returns. In passively managed funds, the fund plays a passive role as they simply have to replicate a given market index, say Sensex or Nifty Fifty. 

Benefits of Investing in Equity Mutual Funds

Equity funds are an ideal option for those with long-term investment goals. A well-planned investment can generate good returns in the longer run. These are some benefits of investing in equity mutual funds:

● Better inflation-adjusted returns: Equity mutual funds have the potential to generate better inflation-adjusted returns when compared to traditional investment options such as Fixed Deposits (FDs). When people invest in equity funds, they can get the benefit of capital growth over a long investment horizon. 

● Diversification: A well-diversified portfolio of an equity scheme ensures that it has exposure to various sectors of an economy. Moreover, it also lets investors invest across various market capitalisations. As investments are diversified across different stocks, risks also get distributed. So, the underperformance of a few stocks can be offset by other stocks that perform really well. 

● Tax saving: According to Section 80C of the Income Tax Act, people who invest in ELSS funds can avail of tax benefits up to Rs. 1,50,000. ELSS funds come with a lock-in period of 3 years which is the shortest lock-in period among tax-saving investments in our country. Further, if you hold equity funds (other than ELSS) for more than 12 months, you enjoy the benefit of a lower tax rate of 10%. 

Risks Involved in Equity Mutual Funds

Equity mutual funds offer good returns, but with returns, there are certain risks involved as well. The risks involved are market volatility risk and liquidity risk. Company stocks undergo fluctuations, and therefore volatility risks arise.

The following are some of the risks of investing in equity funds:

• Liquidity Risk 

When investors face difficulty in redeeming their investments without incurring a loss, it is known as liquidity risk. Liquidity risks are also applicable when settlement periods are extended due to unavoidable circumstances. Although it is true that securities listed on the stock exchange carry lower liquidity risk, low trading volumes can make certain stocks hard to sell, especially small-cap stocks. When a fund manager is unable to sell off securities listed on a fund’s portfolio, it may lead to a decline in the value of the securities held by the fund and subsequent losses to the fund. 

• Event Risk

When any company or sector-specific events lead to price risks, it is referred to as event risks. This includes any geopolitical or economic events affecting a particular sector/industry. Recent examples include the pandemic caused by the spread of the Covid-19 virus and the Russia-Ukraine war.

• Price Risk

People who invest in equity mutual funds should note that their investments are quite volatile and will be subject to price fluctuations on a regular basis. This is referred to as price risk. When the market falls, all stocks are impacted, leading to poor performance of equity funds.

• Risk of loss of principal investments

There is always a risk of losses associated with equity mutual fund investments. So, investors need to be ready to bear some losses in the short term when investing in equity funds.

What Are Debt Funds?

Debt funds are mutual funds in which investments are made in debt instruments such as corporate bonds, government bonds, money market instruments, etc. The issuers of the underlying debt instruments pre-decide the interest rate you will receive as well as the maturity period. Hence, they are also known as ‘fixed-income’ securities. 

Also known as bond funds or income funds, these MF schemes carry lower risk than equity funds. However, they do carry certain risks that depend on the duration of lending and the credit rating of the borrower. 

Benefits of Investing in Debt Mutual Funds

Debt mutual funds generate steady interest income and capital appreciation. Hence, they carry more stability in comparison to equity mutual funds. Here are the benefits of debt schemes:

• Stability: Debt funds are relatively less volatile than equity funds and can provide stability to an investor’s portfolio.
• Safer investment: Debt funds are a safe investment option for conservative investors whose priority is to have a fixed interest income. 
• Higher returns than Fixed Deposits: Debt funds invest in debt and money market instruments like CPs, CDs, Corporate Bonds, T-Bills, G-Secs etc., that pay interest at predefined intervals and the principal upon maturity. The yields of many of these instruments are usually higher than bank FD interest rates of similar maturities. 
• Tax Advantage: If debt funds are held for more than 36 months, your gains (long-term capital gains) are taxed at a lower rate of 20% after the benefit of indexation. This cumulatively makes LTCG on debt funds almost tax-free.

Risks Involved in Debt Mutual Funds

Debt mutual funds are stable; however, they also have certain risks. The risks are as follows:

● Interest rate risk

The market value of fixed-income securities shares an inversely proportional relationship with the interest-rate movement. As a result, an increase in the interest rate is accompanied by a fall in the prices of debt instruments and vice versa. The maturity of a security and its coupon rate determines how much its price will rise or fall. 

● Credit risk

The possibility of issuers of debt instruments defaulting on their obligations to pay interest or principal amount is called credit risk. In such situations, a debt fund may have to bear losses. This results in the decline of the scheme’s NAV. Even if the issuer doesn’t default, the price of a security may change with changes in the credit rating of the issuer.

One can avoid credit risk by investing in debt funds that invest in the highest-rated bonds or government securities.

● Liquidity risk

The convenience with which one can sell debt securities at or near their YTM (Yield-to-Maturity) value or true value is referred to as liquidity risk. People must remember that the liquidity levels of securities in the market change from time to time. 

There are certain securities which would have less liquidity as compared to others or there could be an economic environment where the liquidity of debt securities decreases. In both instances, mutual funds are unable to sell these securities and repay investors. 

● Prepayment risk

When there is a high chance that a borrower will pay off his/her loan much before the due date, prepayment risk arises. To elaborate this further, it is the risk of losing the interest payments on a debt instrument due to early repayment of the principal amount. This results in a change in the tenor and returns that a debt fund generates.

Differences between Equity Funds and Debt Funds

The differences between equity and debt mutual funds have been explained on the basis of various parameters in the table below:

Final Word

Understanding the concept of equity funds vs debt funds can help you make an investment plan which suits your risk appetite and returns expectations. Make sure to analyse the market dynamics and the financial goals for which you are investing. These factors will help you choose the right investment.

Frequently Asked Questions