Difference Between Equity vs Debt Mutual Funds

difference between equity and debt funds

Mutual funds offer diverse investment choices tailored to your financial goals, investment durations, and risk preferences. Two popular categories within this framework are debt funds and equity funds. Equity funds require higher risk for higher returns, and debt funds are associated with lower risks but lower stable returns.

These options allow investors to allocate their capital effectively and aim to deliver consistent returns over time. Both are distinguished based on their risk factor.

Read on to understand the differences between debt funds vs equity funds and the risks associated with them to make a profitable investment.

Table of Contents

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What are Equity Mutual Funds?

Equity mutual funds, also known as "growth funds, " are a type of mutual fund that invests primarily in companies' shares or stocks. A professional (fund manager) manages them and invests the pooled amount in different companies' stocks.

These funds generate higher returns than term deposits or debt-based funds. However, they also carry risks, as their performance depends on various market conditions.

What are Debt Mutual Funds?

Debt mutual funds are also known as Fixed-Income Funds or Bond Funds. These instruments have pre-decided maturity dates and interest rates the buyer can earn on maturity. Debt funds are less volatile, which makes them less risky.

This scheme invests in fixed-income instruments, such as corporate and government bonds, corporate debt securities, and money market instruments. Therefore, mutual funds of debt are considered low-risk investment options.

Key Differences Between Debt Funds and Equity Funds

You can make an informed decision about our investment by analyzing the returns and risks associated with these funds. Here is a table representing the key differences between debt mutual funds and equity funds:

Aspect Equity Mutual Funds Debt Mutual Funds
Investment Instruments Primarily equities and equity-related instruments like derivatives. Money market instruments, CPs, CDs, T-Bills, NCDs, corporate bonds, and G-Secs.
Return on Investment Higher returns over the long term. Low to moderate returns.
Risk Appetite Suitable for investors with moderate to high-risk tolerance. Ideal for investors with low to moderate risk tolerance.
Expenses Higher expense ratios. Lower expense ratios.
Timing Considerations The timing of purchase and sale is critical due to market volatility. Investment duration is more critical than timing.
Suitability Best for long-term financial goals. It is used as a substitute for fixed deposits or savings and is suitable for short- to medium-term goals.
Taxation
  • Short-term gains (<12 months): 15% tax.
  • Long-term gains (>12 months): 10% tax after ₹1L exemption.
  • Less than 36 months: Taxed according to income tax slab.
  • More than 36 months: 20% tax with indexation.
Investment Period/Horizon Long-term investment horizon (typically 5+ years). Short to medium-term investment horizon (1-5 years).

Types of Equity Mutual Funds

Different types of mutual equity funds exist based on the investment style and return goals. Here's a breakdown of various categories of equity mutual funds:

Categorisation Fund Type Description
Investment Style-Based Categorisation Active Fund Fund manager actively observes the market and research companies and select the best stocks.
Passive Fund A fund manager creates a portfolio that mirrors a popular market index, such as Sensex or Nifty Fifty.
Market Capitalisation-Based Categorisation Large-cap Funds Invests 80% of total assets in equity shares of large-cap companies (top 100). Stable but lower returns.
Mid-cap Funds Invests 65% of total assets in mid-cap companies (101-250th ranked). Higher returns, more volatility.
Small-cap Funds Invests 65% of total assets in small-cap companies (251st and below). There is a higher risk but potentially higher returns.
Multi-cap Funds Combines large, mid, and small-cap investments (65% total). Fund manager rebalances based on market conditions.
Large and Mid-cap Funds Invests 35% in both mid-cap and large-cap companies. Aims for better returns with reduced volatility.
Investment Strategy-Based Categorisation Thematic or Sectoral Funds Invests in a specific theme or sector, such as international stocks or industry sectors. Higher risk.
Focused Equity Fund Invests in a maximum of 30 companies' stocks, with market capitalisation determined at launch.
Contra Equity Funds Follows a contrarian strategy, purchasing underperforming stocks, assuming they'll provide long-term returns.
Tax Treatment-Based Categorisation Equity Linked Savings Scheme (ELSS) Provides tax benefits up to ₹1.5 lakhs under Section 80C. Requires 80% investment in equity and has a 3-year lock-in.
Non-Tax Saving Equity Funds All equity funds other than ELSS, with returns taxed as capital gains. Requires 80% investment in equity.

Types of Debt Funds

Debt funds are available in different forms based on the maturity period. Knowing them enables us to choose the one which suits us for better returns. The following are the various types of debt funds:

Fund Type Description
Liquid Fund Invests in money market instruments with a maximum maturity of 91 days. They offer better returns than savings accounts, ideal for short-term investments.
Money Market Fund Invests in money market instruments with a maximum maturity of 1 year. Suitable for low-risk, short-term, stable returns.
Dynamic Bond Fund Invests in debt instruments of varying maturities based on interest rates. Suitable for moderate-risk investors with a 3-5 year horizon.
Corporate Bond Funds Invests at least 80% of total assets in high-rated corporate bonds. Suitable for lower-risk investors looking for high-quality corporate bonds.
Banking and PSU Fund Invests at least 80% in Public Sector Undertakings (PSUs) debt securities. Lower risk but higher interest rate risk.
Gilt Fund Invests a minimum of 80% in government securities with varying maturities. No credit risk but a higher interest rate risk.
Credit Risk Fund Invests at least 65% of assets in corporate bonds with lower-than-highest ratings. Carries credit risk and offers better returns than high-quality bonds.
Floater Fund Invests at least 65% in floating-rate instruments. Low interest rate risk, making it attractive to investors.
Overnight Fund Invests in debt instruments with a maturity period of one day. Considered highly safe due to minimal credit and interest rate risk.
Ultra-Short Duration Fund Invests in money market instruments and debt securities for 3 to 6 months in Macaulay. Provides short-term returns.
Low Duration Fund Invests in money market instruments and debt securities with a Macaulay duration of 6 to 12 months.
Short Duration Fund Invests in money market instruments and debt securities with a Macaulay duration of 1 to 3 years.
Medium Duration Fund Invests in money market instruments and debt securities with a 3 to 4-year Macaulay duration.
Medium to Long Duration Fund Invests in money market instruments and debt securities with a 4 to 7-year Macaulay duration.
Long-Duration Fund Invests in money market instruments and debt securities with a Macaulay duration of over 7 years.

Benefits of Investing in Debt Funds and Equity Funds

Knowing the benefits of investing in debt and equity mutual funds enables one to make a wise choice while investing. The following table depicts the benefits of investing in both funds:

Benefits Debt Mutual Funds Equity Mutual Funds
Return Potential It gives stable returns more than the conventional savings account returns. Potential for higher returns in the longer term.
Liquidity Generally offers good liquidity, allowing investors to redeem units relatively quickly, though some funds may have exit loads for short-term redemptions. It also offers liquidity; however, due to market volatility, the value at redemption can fluctuate significantly, and some funds may impose exit loads for short-term exits.
Expense Ratio Typically, they have lower expense ratios than equity funds, making them cost-effective for conservative investors. Generally, they have higher expense ratios due to the active management and research required to invest in equities.
Diversification Provide diversification within fixed-income instruments. Thereby reducing the risk. Provide diversification across industries and companies. This way, they reduce the risks of holding a particular stock.
Income Generation Mainly concentrates on income generation through interest from debt papers, appealing to income-oriented investors. Equity funds primarily target capital gains, though some will also offer dividends. These are not predictable, like in the case of debt funds.
Regulatory Changes Recent regulatory changes have affected taxation changes. All gains are taxed according to the income tax slab rates applicable to the investor, and there is no longer a distinction between short-term and long-term holdings. The Union Budget 2024 changes the taxation rates, with short-term gains taxed at 20% and long-term gains taxed at 12.5%, which would affect investors' after-tax returns.

Taxation Rules of Equity Funds and Debt Funds

Different taxes are levied on equity and debt funds. Knowing them is necessary to make an informed decision to invest our money. The following discusses the types of taxes levied on the equity and debt mutual funds:

Type of Mutual Fund Investment Duration Type of Capital Gain Tax Rate Additional Notes
Equity Mutual Funds Up to 1 year Short-Term Capital Gains (STCG) 20% -
More than 1 year Long-Term Capital Gains (LTCG) 12.5% (if above ₹1.25 lakh) No indexation benefit
- Dividend Distribution Tax 10% Tax deducted at source (TDS)
Debt Mutual Funds Up to 3 years Short-Term Capital Gains (STCG) As per the income tax slab Added to taxable income
More than 3 years Long-Term Capital Gains (LTCG) 20% With indexation benefit

Equity Funds or Debt Funds: Which is Better?

Choosing the best fund can be tricky, as each fund has its benefits and drawbacks. Being clear about your investment duration, potential returns, and risk factors will help you arrive at a better investment plan that suits you.

1. Investment Period

Equity funds are suitable for long-term investments, usually seven years. Debt funds are suitable for short-term investments, usually five years. So, if you are new to investment and have fewer resources, choose debt funds.

2. Return Expectation

Equity funds have a high potential to return with more market risk. Debt funds are stable in returns, usually 9%, but they have lower returns than equity funds. Therefore, debt funds stand out from equity funds.

3. Risk

Equity funds are risky, with market fluctuations and capital loss. Debt funds have a lower risk and very minimal chances of capital loss, making them more lucrative than equity funds.

4. Liquidity

Equity funds have a minimum lock-in period of three years, which means they have minimum liquidity. Debt funds do not have any lock-in period but are charged if redeemed before three years.

In essence, although equity mutual funds are risky in the short term, they fetch good returns in the longer term by accumulating wealth. The debt mutual funds are suitable for new investors who do not want risk but plan for stable income generation and capital protection.

Both equity and debt funds are tax-efficient investment options. Choosing between the two may seem challenging. However, understanding your investment goals and the type of returns you seek can help you make a better decision.

Disclaimer: The information provided on this website is for general informational purposes only and should not be construed as financial, investment, or legal advice. While we strive to provide accurate and up-to-date content, we do not guarantee the completeness, reliability, or suitability of the information for your specific needs.

We do not promote or endorse any financial product or service mentioned in these articles. Readers are advised to conduct their own research, consult with financial experts, and make informed decisions based on their unique financial circumstances. Any reliance you place on the information provided here is strictly at your own risk.

FAQs about Debt vs Equity Mutual Funds

Who should invest in equity mutual funds?

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Equity funds suit investors with a high-risk threshold and long-term goals. It creates wealth in the long run.

Who must invest in debt mutual funds?

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Debt funds are best for risk-averse investors who want to earn stable returns. They can easily be adapted to meet short-term requirements.

Which of them gives higher returns: equity or debt mutual funds?

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Equity funds provide higher returns but are more volatile. Debt funds are less volatile and offer stable returns.

How do market fluctuations affect equity and debt funds?

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Equity funds are market-sensitive, while debt funds are not volatile and interest-rate-sensitive. Debt funds are best suited for predictable returns.

What is the average tenure for investing in equity and debt funds?

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The average tenure for investing in equity funds is at least 5-7 years, while debt funds are often suitable for shorter durations like 1-5 years.

What are the tax implications for equity and debt funds?

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Equity funds attract 10-15% tax on gains; debt funds are taxed as per your income slab or 20% with indexation.

How do expense ratios compare between equity and debt funds?

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Equity funds generally have higher expense ratios due to active management, while debt funds have lower ratios. Lower ratios reduce investment costs.

Which fund is better for wealth accumulation equity or debt fund?

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Equity funds are a better option for wealth creation over time. They capitalise on the growth of the market for massive returns.

Can equity and debt funds be held in the same portfolio?

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Yes, both work well together. The combination helps balance risk and stability, and diversification helps achieve varied financial goals.

What is the level of risk in equity and debt mutual funds?

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Equity funds carry more risk, while debt funds are safer and less volatile. Therefore, check your risk appetite before investing.

How do the liquidity levels compare between equity and debt funds?

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Debt funds are generally more liquid, while equity funds are market-time dependent. Debt funds are more accessible for short-term cash requirements.

Which type of fund is best suited for tax saving equity or debt fund?

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Equity-linked saving schemes (ELSS) under equity funds provide tax benefits. They are best for tax saving and also provide long-term capital growth.

What factors should be considered when choosing between equity and debt funds?

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Before making a decision, consider your risk appetite, financial goals, and investment horizon. Align your choice with your investment strategy.

Which is better, a debt fund or an equity fund?

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The better option depends on your risk appetite and investment goals. Equity funds offer higher returns with more risk, while debt funds provide stability with moderate returns.

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

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Yes, you can invest in both simultaneously to balance risk and returns and create a diversified portfolio based on your financial goals.

Are debt mutual funds tax-free?

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No, debt mutual funds are taxable. Short-term gains are taxed as per your income slab. Meanwhile, long-term gains are taxed at 20% with indexation benefits.

Is an equity fund safer than a debt fund?

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No, since equity funds bear more market risks due to share price fluctuations, debt funds are relatively safer as they provide lesser but stable returns.

What are the main differences between debt funds and equity funds?

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Debt and equity funds mainly vary due to risk, returns, and investment goals.

  • Risk & Returns: Debt funds are less risky and have moderate and stable returns, while equity funds are highly risk-generating and potentially have higher returns.
  • Liquidity & Lock-in Period: Equity funds have a lock-in period. For example, ELSS has a lock-in for three years, whereas debt funds have no lock-in, and liquidity is better.

Other Important Articles about Mutual Funds

What is Growth Mutual Fund?
CAGR vs Absolute Return
What is Interval Fund?
What is Mutual Fund?
ETF vs Index Funds
What is Lock in Period in Mutual Fund?
What is Systematic Investment Plan(SIP)?
Types of Mutual Funds in India
Arbitrage Fund vs Liquid Funds
Flexi Cap vs Multi Cap Funds
How Mutual Funds are Taxed?
What are Arbitrage Funds?
Gold Mutual Fund vs Gold ETF
What are Debt Funds?
What is Equity Fund?
IDCW vs Growth
What is Hybrid Fund?
Types of Mutual Fund Returns in India
What is Statutory Liquidity Ratio?
What is Index Fund?
Open Ended Fund vs Closed Ended Fund
What are Multi Cap Mutual Funds?
SIP vs Mutual Funds
What is Income Fund?
Sharpe Ratio vs Treynor Ratio
What is International Fund?
Direct vs Regular Mutual Funds
Index Funds vs Mutual Funds
IDCW vs SWP
What are Corporate Bond Funds?
Difference Between Smallcase and Mutual Funds
Value Funds vs Growth Funds
SIP vs PPF
Mutual Fund Charges or Fees
XIRR vs CAGR
What is Money Market Fund?
ETF vs Mutual Funds
What is XIRR in Mutual Fund?
Fixed Deposit vs Mutual Funds
What are Leveraged Funds?
Liquid Funds vs Debt Funds
Active Funds vs Passive Funds
What is Lumpsum in Mutual Fund?
What are Commodity Mutual Funds?
NPS vs Mutual Funds
Sharpe Ratio vs Sortino Ratio
Bonds vs Mutual Funds
ELSS vs SIP
Balanced Funds vs Equity Funds
Mutual Fund vs Life Insurance
What is Exchange Traded Fund?
Equity Funds vs Debt Funds
Growth Fund vs Dividend Fund
What are Sectoral Funds?
PPF vs Mutual Funds
SIP vs Lumpsum in Mutual Funds
ETF vs FOF
What is ELSS?
What is Capital Protection Fund?
Annualised Return vs Absolute Return
SIP vs RD
What is a Balanced Fund?
Mutual Funds vs Stocks
Mutual Funds vs Hedge Funds

Disclaimer

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  • This is an informative article provided on 'as is' basis for awareness purpose only and not intended as a professional advice. The content of the article is derived from various open sources across the Internet. Digit Life Insurance is not promoting or recommending any aspect in the article or its correctness. Please verify the information and your requirement before taking any decisions.
  • All the figures reflected in the article are for illustrative purposes. The premium for Coverage that one buys depends on various factors including customer requirements, eligibility, age, demography, insurance provider, product, coverage amount, term and other factors
  • Tax Benefits, if applicable depend on the Tax Regime opted by the individual and the applicable tax provision. Please consult your Tax consultant before making any decision.

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