Difference between Equity funds and Debt funds

Published On: 20-May-2022

mutual funds have been steadily emerging as a preferred investment option and have become one of the attractive avenues to invest money. Such preferences arise from the convenience of investing in mutual funds and a wide range of mutual fund schemes investors may choose from. However, investors may often be spoilt for choices amongst the available options and may be struggling to find the right mutual fund scheme that best suits their financial plans and risk appetite.

Different mutual fund schemes are categorized into five categories – equity funds, debt funds, hybrid funds, solution-oriented funds and other funds. However, equity and debt funds occupy the lion’s share in the mutual fund industry among the five categories. As per the data released by the Association of Mutual Funds in India (AMFI), equity fund and debt funds occupy around 72% of the overall industry AUM (Assets Under Management) as of April 30, 2022 with an AUM of Rs. 27.61 lakh crores out of the total AUM of Rs. 38.04 lakh crores (Source – www.amfiindia.com). This article aims to demystify equity funds and debt funds to help investors decide between the two categories.

What are Equity Funds?

If a mutual fund scheme invests predominantly in equity shares and equity-related securities, such mutual funds are categorized as equity funds. Equity funds can be categorized into different types based on market capitalization, sectors, fund composition, investment objective, etc. The different categories of equity funds that mutual funds can offer are multi cap fund, large cap fund, large & mid cap fund, mid cap funds, small cap fund, dividend yield fund, value fund, contra fund, focused fund, sectoral/ thematic fund, and ELSS (Equity Linked Savings Schemes).

What are Debt Funds?

If a mutual fund scheme invests predominantly in debt and money market securities like Commercial Paper, T-Bills, Corporate bonds, etc., such schemes may be classified as debt funds. Debt funds include short- and long-term options that are based on average portfolio maturity. Different categories of debt funds offered by mutual funds can be further categorized based on duration funds, credit opportunities fund, gilt funds, etc. Different debt funds as allowed under SEBI Guidelines are overnight fund, liquid fund, ultra short duration fund, low duration fund, money market fund, short duration fund, medium duration fund, medium to long duration fund, dynamic bond, corporate bond fund, credit risk fund, banking & PSU fund, gilt fund, gilt fund with 10-year constant duration, and floater fund.

Difference between Equity Funds and Debt Funds

Owing to their inherent features, equity funds and debt funds may be suitable for different financial goals and risk appetites of the investors, depending upon their stages of life and financial situations. One must select the suitable mutual fund scheme for their specific investment needs and financial goals. To help the investors make an informed decision, here are the primary differences between equity funds and debt funds:

  1. Suitable Investment Horizon
    Equity funds may not be suitable for short term financial goals, as equity markets are inherently volatile over the short term. In contrast, debt funds tend to be relatively less volatile with predominant investments in debt and money market securities. As such, debt funds may be more suitable over the short term. 
    However, debt funds are less suited for long term financial goals owing to their relatively moderate returns. On the other hand, short-term volatility for equity markets tends to moderate over the long term. Equities tend to generate healthy returns in the long run as also and accordingly, equity funds may be an ideal investment for long-term financial goals.
  2. Risk
    In the world of investments, risk-reward trade-offs are universal—the higher the risk undertaken by the investor, the higher returns an investor may expect. Thus, while equity funds equip the investors with the potential of better returns, such funds also carry a higher risk for the investors. However, the investors may manage their investment risk by choosing the right category of equity funds best suiting their risk appetite.
    In contrast, debt funds are less volatile than equity funds as they primarily invest in corporate bonds and government securities. Most of the debt funds have low to moderate risk. However, the degree of investment risk tends to vary across different debt schemes.
  3. Key Evaluation Parameters
    Equity funds are evaluated through statistical ratios like standard deviation, beta, dividend yield, Price/ Earnings Ratio etc. Such numerical ratios denote the volatility of returns for the investment portfolio and its comparison with benchmark indices.
    In contrast, debt funds are evaluated based on the credit profile of the investment portfolio, modified duration, Yield to Maturity (YTM), etc. Such financial ratios are more suitable to evaluate debt investment options like bonds, etc.
  4. Taxation 
    As per the tax laws, the tax rates and cut-off holding period for classifying gains as Short Term Capital Gains (STCG) and Long Term Capital Gains (LTCG) are different for equity funds and debt funds. The cut-off period for equity funds is 12 months, while for other funds, including debt funds, the specified cut-off period is 36 months. Gains from investments with shorter holding periods are classified as STCG, and gains with more extended investment periods are classified as LTCG.
    The tax rate for STCG from equity funds is 15% (plus applicable cess and surcharge), while the tax rate for LTCG is 10% (plus applicable cess and surcharge) without indexation benefit. Additionally, LTCG from equity shares and equity funds of Rs. 1 lakh in aggregate every year are taxed at a zero rate. In contrast, STCG from debt funds is taxed at regular tax rates applicable to the investor, while LTCG from debt funds is taxed at 20% (plus applicable cess and surcharge) with indexation benefit. 

Basis the above points of difference, investors should make an informed decision on choosing between equity funds and debt funds, as best suiting their financial goals, risk appetite and investment horizon. 

Note: The tax provisions mentioned in the article are for illustrative purposes only and are updated as per the Union Budget presented in the Parliament in February 2022. The tax rates for capital gains are exclusive of the applicable cess and surcharge, and such tax rates will be as per the tax laws applicable on the date of redemption/ sale and not on the date of investment.