Equity versus debt mutual funds

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Equity and debt are the building blocks of an investment portfolio. Including both assets in a portfolio not only encourages diversification but also reduces risk exposure as their underlying risk-return profile and the way they respond to market fluctuations is so different. While equity is known as the wealth creator, debt has earned the reputation of a portfolio stabiliser. Given the rising popularity of mutual funds in recent years, this article explores the differences between equity and debt funds in detail.

Key investment traits, time horizon and suitability
Debt mutual funds invest in fixed income instruments such as government securities, corporate bonds and money market products. Their main aim is to offer capital preservation and moderate returns, making them suitable for investors with low to moderate risk and short- to medium-term horizon. Such funds are apt for meeting goals such as creating an emergency fund and going on vacation.
Equity mutual funds invest predominately in equity and equity-related instruments with an objective of capital appreciation. These funds are specifically for investors with higher risk-taking ability and longer investment horizon. The corpus generated from these funds is used for long-term goals such as retirement, children’s wedding, etc.
Risk and returns parameters
Mutual funds are market-linked products and do not assure returns. There is no guarantee that the investment objective of the scheme will be attained. Hence, returns from equity and debt funds are dictated by the underlying market scenario.
Between the two, however, equity funds are more prone to risks in the short term because of exposure to the vagaries of the equity market. Market risk is key, wherein prices of the underlying securities fluctuate in response to adverse issuer, political, regulatory, market, or economic developments.
Equity funds are also subjected to the concentration risk, wherein the investment is restricted to one particular company or sector, and management-related risk owing to changes in the management team and pledging of shares.
Debt funds, on the other hand, are subjected to interest rate risk (sensitivity of a fund’s portfolio value to the changes in the interest rate), credit risk (risk of default in payment of coupon and/or principal by an issuer), liquidity risk (need to liquidate the invested assets in case of dire circumstances), and reinvestment risk (cash flows are reinvested at a rate that is less than the coupon rate of the bond).
Careful evaluation of these risk factors and mapping them to investors’ risk appetite is necessary for optimising portfolio returns.
Types of equity and debt funds
In October 2017, SEBI first unveiled the guidelines for categorisation of mutual fund schemes. The new classification helped rationalise and categorise schemes, making it easier for investors to make informed decisions. As per the new classification: equity funds are divided into 10 categories and debt into 16. Choice of funds should be in line with the investors’ investment objective, their risk-return profile and investment horizon.

Equity (10 categories) 
Multi-cap fund

Investment in large cap, mid-cap, small cap stocks; minimum investment in equity – 65% 

Large cap fund

Minimum investment in equity and equity-related instruments of large cap companies – 80% of total assets

Large & mid-cap fund


Investment of 35% each in large cap and mid-cap stocks

Mid-cap fund

Investment primarily in mid-cap stocks (65% of total assets) 

Small cap fund

Investment primarily in small cap stocks (65% of total assets) 

Dividend yield fund

Investment primarily in dividend yielding stocks (65% of total assets) 

Value fund^

Following a value investment strategy with 65% of total assets invested in equity 

Contra fund^

Following a contrarian investment strategy with 65% of total assets invested in equity 

Focused fund

Focused on the number of stocks (maximum 30); 65% of total assets invested in equity 

Sectoral/thematic fund

Equity investment of 80% of total assets in a particular sector/ particular theme

ELSS

Equity investment of 80% of total assets, offering tax benefit and lock-in period of three years 

Debt (16 categories)
Overnight fund

Investment in overnight securities having the maturity of one day

Liquid fund

 Investment in debt and money market securities with maturity of up to 91 days 

Ultra short duration fund

Investment in debt and money market instruments such that the Macaulay duration* of the portfolio is between 3 and 6 months


Low duration fund

Investment in debt and money market instruments such that the Macaulay duration* of the portfolio is between 6 and 12 months

Money market fund

Investment in money market instruments having maturity up to one year

Short duration fund

Investment in debt and money market instruments such that the Macaulay duration* of the portfolio is between 1 year and 3 years

Medium duration fund

Investment in debt and money market instruments such that the Macaulay duration* of the portfolio is between 3 and 4 years

Medium to long duration fund

Investment in debt and money market instruments such that the Macaulay duration* of the portfolio is between 4 and 7 years

Long duration fund

Investment in debt and money market instruments such that the Macaulay duration* of the portfolio is greater than seven years

Dynamic bond

Investment across duration

Corporate bond fund

Minimum investment of 80% of total assets in highest rated corporate bonds

Credit risk fund

Minimum investment of 65% of total assets in below-highest rated corporate bonds

Banking and PSU fund

Minimum investment of 80% of total assets in debt instruments of banks, public sector undertakings, and public financial institutions

Gilt fund

Minimum investment of 80% of total assets in government securities across the maturity

Gilt fund with 10-year constant duration

Minimum investment of 80% of total assets in government securities such that the Macaulay duration* of the portfolio is equal to 10 years

Floater fund

Minimum investment of 65% of total assets in floating rate instruments

 

* Macaulay duration is indicative of the sensitivity of a portfolio to the change in interest rates 

^Mutual funds will be permitted to offer either value or contra fund.

Source: SEBI 

Taxation

Mutual funds bear two types of taxes: 

  • Dividend distribution – Investors who prefer a regular inflow of money from mutual fund investments can choose the dividend option. They have to pay dividend distribution tax (DDT) on the dividend income they receive from the mutual funds. 
  • Redemption – Here tax is paid based on the period of investment – short-term capital gains (STCG) if the units are held for less than three years or long-term capital gains (LTCG) if the period of holding is more than three years. 

 

 Debt funds                                                                                          Equity funds 

Capital gains tax* DDT on dividend 
STCG tax for less than 3 years = as per individual’s tax bracket of 10%, 20% and 30%, which along with 4% is 10.4%, 20.80% and 31.20% 25% + 12% surcharge + 4% cess = 29.12%
LTCG tax after 3 years = 20% with indexation + 4% cess = 20.80%
Capital gains tax* DDT on dividend 
STCG tax for less than 1 year = 15.6% (15%+4% cess) 10% + 12% Surcharge + 4% cess = 11.648%
LTCG tax after 1 year = 10% without indexation = 10.4% (10%+4% cess)

Note – Health and Education Cess to be levied at the rate of 4% on aggregate of base tax and surcharge 

*Capital gains illustration excludes surcharge. Surcharge of 15% on the base tax is applicable where income of an individual/HUF unit holder exceeds Rs 1 crore and at 10% where income exceeds Rs 50 lakh but is less than Rs 1 crore. 

Summing up

Awareness of differences between equity and debt funds can help investors prudently allocate money between the two in line with their goals and risk profile. 

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