For far too long, there has been much confusion and debate over where one should invest in - equity or debt funds. Understanding the difference between debt and equity funds will help an investor decide on where to allocate their assets.

Debt funds: A debt fund is a type of mutual fund that invests shareholder's money in fixed income securities such as bonds and treasury bills. A debt fund may invest in short-term or long-term bonds, securitized products, money market instruments or floating rate debt.

Equity funds: An equity fund, also known as stock fund, is a type of mutual fund that invests shareholder's money principally in stocks. The equity mutual funds are principally categorized according to company size, the investment style of the holdings in the portfolio and geography.

Nature of the fund

Debt: In Debt funds, the money pooled from people are invested in fixed income instruments like government bonds, corporate bonds, non-convertible debentures and other highly-rated instruments.

Equity: In Equity funds, the money raised from investors are put into equity and equity-linked instruments. For example, if a fund invests more than 65 per cent of their portfolio in stocks, they are generally considered as equity funds.

Risk factor

Debt: Debt funds are safer as compared to equity funds as they primarily invest in rated and risk-free government and corporate bonds. There is virtually no risk in government bonds but for corporate bonds - the investor should check rating of the bond by different credit rating agencies. The bond prices are sensitive to interest rate changes and hence there will be a corresponding fluctuation in the NAV of the fund.

Equity: Equity funds are considered risky as compared to debt funds. Equity securities are volatile by nature and are sensitive to economic factors such as inflation, tax rates, currency fluctuations, bank policies etc. Thus any change in market prices will have a corresponding impact on the Net Asset Value (NAV) of the fund. The best way to be safe in market volatility is to select a good equity mutual fund scheme that will invest their corpus in multiple companies or industries providing diversification.

Tax Liabilities

Debt: Debt funds, which are held for more than 36 months, are taxed at 20 per cent with indexation. In case of short-term debt funds, the capital gain is added to the total income of the investor and then taxed according to the income tax slab he/she falls under.

Equity: The long term equity funds (which are kept for 12 months or more) are exempt from capital gains tax. Equity funds held for 12 months or less are taxed at a flat rate of 15%.

Return

Debt: Debt funds can give you steady returns but in a constant range. Since debt funds invest money in treasury bonds, there's much less risk associated with them. Debt funds are good investment option when market is volatile.

Equity: Equity mutual funds give good returns over the long period to time as compared to debt funds. However, the possibility of losses and negative returns is also higher when market is volatile. Equity funds are good when the markets are booming.

Deciding between Debt vs. Equity

• Investment objectives - The objective could be to income generation or wealth creation. Debt is advisable for those looking to generate income through their investments because it provides more certainty of return. However for growth and wealth creation, equities would be a better option depending on the investment duration and return expectation.
• Investment duration - Investors should select the asset class based on the time period at the end of which they will need the money, for example, 20 years. Debt funds are better for shorter durations, preferably 5 years or less. Equity funds should ideally be held for duration longer than 5 years.
• Returns expected - A number of investors choose an asset class (Debt or Equity) with unrealistic expectations. Returns from each come with varying degrees of risk and uncertainty. On a long-term average basis, returns for debt are in the region of 9% and equity in the region of 16%.
• Risks involved- Risks involved should be in line with investment objective and return expectation. The variation of returns in debt is usually small and therefore a long-term average of 9% implies that actual returns would be in a band of 8-10%. This means that there is a high degree of certainty that investors would get returns near the long-term average. The risk of capital loss is also very low. On the other hand equity returns vary in a broad range. There is also a high risk of capital loss due to this. However, the longer the holding period, narrower the range of returns variation. In a simplistic way the decision between equity and debt is the decision between almost certain 9% return and an uncertain 16% return.
• Tax applicable – Equity investments are highly tax efficient with zero tax for holdings longer than 1 year. Debt funds, on the other hand, attract short-term capital gains tax before 3 years and long term capital gains with indexation after 3 years. For an investor investing for longer than 3 years, there is no difference in tax between equity & debt.

The decision is therefore a complex one involving many parameters. To make it simpler, we recommend that while being aware of all criteria, you choose one criterion that is most important to you and make your choice.

Once the selection is made, investors can take the next step of picking up the right funds in the selected asset category. It is important to select funds solely based on facts and data rather than brand names. You should diligently research and analyze fund performance before investing your money. Your decision should ignore personal preferences, un-informed recommendations, advertising and brand names. To help you with your decision, various websites track fund performances and make this data freely available. If you lack the inclination or expertise to understand these figures, there are few automated platforms which recommend pre-selected portfolio of right funds to invest in.