What Is More Beneficial; Equity or Debt Mutual Fund?

Oct 24, 2018 6:30 IST 980 views

Remember that famous conversation from Lewis Carroll’s Alice in Wonderland? “Would you tell me which way I ought to go from here? That depends a good deal on where you want to go.” What this timeless conversation indicates is that how you go about things depends to a large extent on where you want to reach. The same principle applies in the case of mutual funds too. When you start your financial planning exercise, you have the need for wealth creation, stability, regular returns, liquidity and tax efficiency at different points of time. It is this matrix of needs that will determine what is more beneficial to you; equity or debt funds. If it is getting too confusing, let us get down to the basics.

How Are Equity Funds and Debt Funds Different?

An equity fund collects money from thousands of small investors and allocates this money to equity shares of companies. When the fund manager creates a diversified portfolio of shares, it is useful in creating wealth over the long run. The debt fund, on the other hand, invests in debt instruments like government bonds, institutional bonds, corporate debt etc. There are long term debt funds and short term debt funds. The debt funds basically provide stability (bonds are not volatile like equities) and regular returns. Of course, you also have combination of equity and debt in the form of balanced funds but we will leave that for now.

Returns and Wealth Creation Perspective

If you are young and looking to create wealth over the next 25-30 years then equities is your best option. In fact, over the longer term the biggest risk is not taking any risk and hence equities are a must in your portfolio. Equity funds give returns of around 13-15% per annum and can compound to large numbers. Debt funds provide stability. You don’t see volatility in debt funds like in equity and hence they are more reliable in the short term to medium. But in terms of wealth creation capacity, equity funds score over debt funds.

Managing Risk as Your Risk Profile Changes

Your risk profile is a function of a variety of factors. It depends on your income levels, your outstanding liabilities, your age, your asset mix etc. The bottom-line is that as your risk appetite reduces, it is better to shift more of your money into debt. Exposure to equity funds should be the highest at an early age for two reasons. Firstly, that is when your risk appetite is the highest. Secondly, the power of compounding favours equity funds only when you start early and time works in your favour. Remember a slightly paradoxical rule. You need to take on more risk to reduce your risk of not being able to achieve your long term goals. That is what determines your equity fund – debt fund mix.

Making Liquidity Available When Required

This is an important aspect of your split between equity funds and debt fund. Let us say, you have pegged an equity SIP for your retirement. After 23 years, the SIP has done extremely well and you are due to cash this fund after 2 years. Prudence demands that you should shift a large part of your equity fund exposure into debt funds for the next 1 year and shift it entirely into liquid funds in the last one year. This will ensure that when you liquidity around important milestones like retirement, child’s education, child’s wedding etc; you are not stuck in the volatility of equity funds.

Don’t Forget Tax Efficiency

Equity funds are by default more tax efficient because LTCG is tax free and STCG is taxed at a concessional rate of 15%. A lot has changed in the Union Budget 2018. Firstly, the LTCG on equity funds are now taxed at 10% above Rs.1 lakh and there will be no indexation benefits. This is only marginally better than debt funds which are taxed at 20% on LTCG with the benefit of indexation. In fact, if equity funds and debt funds are held for a period of 5-6 years, then the equity fund needs to really outperform the debt fund to justify its outperformance in post-tax terms. You need to keep this point in mind when making your choice between equity funds and debt funds.

In a nutshell, your choice of equity funds versus debt funds is determined by your long term goals and specific liquidity, risk and tax considerations. Equity and debt funds do have a key role to play in your portfolio. It is not as simple and straightforward as making an either/or choice.

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