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Are you an investor looking for investment options to grow your wealth? Are you an investor looking for additional stable income? Or are you just here to experience the stock market thrills? Whatever your choice is, there is an investment option for each of you in the market.
The financial market offers varied investments like investing directly in the stock or bond market or investing through mutual funds. The mutual fund market also has varied offerings to its customers, depending on their risk and return expectations. Debt and equity funds are two common offerings by mutual funds. Today’s article discusses what are equity and debt funds and the differences between them.
What is an equity fund?
Equity funds are among the most popular mutual fund types. These are mutual funds that focus on investing in equities.
Fund managers invest the pooled money in stocks of different companies. The returns on these funds entirely depend on the company’s performance and growth.
Equity funds can further be classified into small-cap, mid-cap and large-cap funds based on the kind of companies that the funds invest in.
Features
- At least 60% of the fund must be invested in stocks for a fund to be classified as an equity fund. The remaining can be invested in debts and other instruments to balance the risk.
- These funds are mostly for long-term investors, as it takes time for a company’s stock price to grow and generate wealth.
Benefits and risks
Equity funds are known to generate high levels of returns for their investors. They are highly liquid, making it easy for investors to sell their holdings in the secondary market. Since the fund manager invests in stocks of different companies, equity funds allow investors to hold a diverse portfolio.
Besides, some equity funds provide dividends, giving investors the benefit of a stable income and capital appreciation.
However, risk is an inherent component of stocks. Equity funds expose investors to the risk of price fluctuations in the stock market. Stocks may or may not perform as expected, which makes profits and losses equally probable for investors.
What is a debt fund?
Debt funds, as the term suggests, invest primarily in debt instruments. A significant portion of funds go towards fixed-income instruments like bonds, debentures, treasury bills, etc.
These funds are usually considered safe since they provide a stable income to investors through periodic interest payments. Debt funds are further classified into short-term, medium-term and long-term, depending on the debt instrument’s maturity period.
Features
- At least 65% of the fund’s value is invested in debt instruments, while the rest is diversified across different avenues.
- These funds are less volatile and do not react rapidly to market events, making them suitable for those looking for stability.
- Most debt funds are liquid and allow investors to redeem their holdings at any time (A fee called exit load is charged for early redemption).
Benefits and risks
Debt funds are less volatile and do not fluctuate like stocks. Hence, these funds are preferred by investors who do not want to expose themselves to the stock market’s risks. Additionally, most debt funds provide interest income to investors, along with preserving their funds. The interest rate on such funds may be higher than regular bank account rates, making this an attractive and lucrative investment avenue.
However, debt funds are not free of risks. Though the risk of volatility is low, there are other risks, such as interest rate risks and credit risks. Credit risk is where issuers default on paying interest or repaying principal. Interest rate risk occurs when the market’s interest rate increases, making the existing bond less attractive.
Equity fund vs debt fund
| Equity funds | Debt funds |
| Highly volatile as they majorly invest in stocks | Less volatile and more stable |
| Invests in equities of different companies | Invests in debentures, bonds and other short-term fixed-income instruments. |
| May or may not offer dividends | Offers periodic interest payments |
| Offers capital appreciation | Offers capital preservation |
| Ideal for long-term investments | Suitable for short, medium and long-term |
Which one should you choose?
Equity fund:
- If you are looking to grow your wealth
- If you are open to exploring long-term investment avenues
- If wealth generation is your priority over consistent income
- If you are open to high degrees of risk
Debt fund:
- If you are seeking additional stable income
- If you want to explore short and medium options
- If you are risk-averse
Bottomline
Investment options with zero risks are seldom available in the market. However, the degrees of risk vary and so do the degrees of returns. The choice between equity and debt funds entirely depends on an investor’s risk tolerance and financial objectives.
Irrespective of the choice, a thorough understanding of the mutual fund’s terms and conditions is essential.
FAQs
A debt fund is better for investors who are not open to taking risks and want a stable and regular income. An equity fund is better for investors who are open to taking risks to generate higher wealth in the long term.
Dividends are subject to taxes based on the investor’s income tax rate. Short-term capital gains are subject to a 15% tax, and long-term capital gains are subject to a 10% tax.
Yes, returns from debt funds are taxable. Short-term gains are taxed as per the investor’s income tax rate. Long-term gains are taxed at 20%.
Some important factors to consider while choosing between equity vs debt funds are the duration of investment, the individual’s risk appetite, investment goals, required liquidity, tax liabilities, etc.
SIPs are applicable for both debt and equity. Investors can choose to invest through systematic investment planning, either in debt or equity, based on their investment objectives.