Equity vs Debt Funds: Definition and Key Differences

Equity funds predominantly invest in company equities and other equity-related instruments and aim to capitalise on their growth for long-term wealth accumulation. While debt funds invest in fixed-income assets such as bonds, money market, etc, and potentially provide a regular income with a low to moderate risk.

Based on your risk profile, investment objective and other factors, you can choose one to invest in and potentially grow a corpus over time.

As of FY26, in India, the popularity of mutual fund investment is growing and currently stands at 25.86 crore. With its growing popularity and to capture potential growth, learn about the differences between equity vs debt funds and invest smartly.

Understanding Equity and Debt Mutual Funds

Before diving into the differences between equity and debt funds, you must first capture the idea of what they are individually in detail. Equity mutual funds are a type of mutual fund scheme that invests in company shares with growth potential. The goal or aim of such a fund is to capture long-term capital appreciation from the growth of those shares.

However, being linked to equities, such an investment scheme is prone to short-term market volatility and is hence subject to market risks. However, with a higher risk, such funds have the potential to generate a higher return.

To emphasise further on debt funds vs equity funds, the debt funds invest in fixed-income securities. They include corporate and government bonds, money market instruments, etc.

Usually, the focus here is to instil stability and generate a regular income throughout your investment horizon. However, compared to equity funds, such schemes typically have a lower return.

Key Differences Between Equity vs Debt Funds

Now that you have an idea about the equity and debt funds and their primary aims, you must also consider further factors that make their differences more prominent. Take a look at the following table:

What are the Types of Equity Funds?

Equity mutual funds, also known as simply the equity funds, invest in company shares and equity-related investments, which include derivatives which trade on the stock exchanges. However, based on strategies, there are a few types of equity funds that you must make note of:

• Large-Cap Equity Funds

Now that you have the idea of the differences between debt and equity Funds, focusing on this type of fund might provide better clarity. Such funds primarily invest 80% of their assets in the top 100 companies with larger capital. Such funds are considered relatively stable.

•  Mid and Small Cap Funds

Mid-cap funds invest at least 65% of their assets across company stocks in mid-cap companies. Such companies usually rank between 101 and 250. Similarly, small-cap funds also invest 65% of their assets across small-cap companies that rank beyond 251.

• Sectoral Funds

As per the SEBI norms, sectoral mutual funds are those that invest at least 80% of their assets across equity or equity-linked assets in specified sectors. Such funds invest in companies from sectors such as pharmaceuticals, banking, technology, FMCG, etc.

Factors to Consider Before Investing in Equity Funds

Aside from understanding its types, you must consider some crucial factors before investing in an equity mutual fund. Here is a detailed breakdown:

• Fund Size

The fund size, commonly known as the Asset Under Management (AUM), usually indicates the entire wealth invested in a particular fund. A higher fund size generally indicates a higher number of investors invested in that fund. However, it does not necessarily mean that a higher fund size provides a good return, and thus, you must consider other factors.

• Expense Ratio

It is a fee that a fund house charges for active management of your investment in an equity scheme. As per the SEBI guidelines, equity funds should have an expense ratio between 1.05% and 2.25%. Therefore, based on your budget, you must look for it beforehand.

• Risk-Reward Ratio

It is an indicator of how much risk you are taking for every rupee you invest in the market through an equity scheme. It helps you compare returns from different equity fund schemes and examine the maximum risks you are taking to potentially achieve that return. Therefore, you must ensure that this ratio is in line with your risk tolerance level.

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What are the Types of Debt Funds?

Aside from noting the differences between the equity and debt funds, you must note some types of debt funds. It might help if debt funds seem suitable for you:

• Overnight Funds

As its name implies, such funds mature overnight. Therefore, your fund investment here matures within 1 day.

• Liquid Funds

Liquid funds are also a sort of short-term fund. These invest across fixed-income instruments with a maturity period of 91 days.

• Ultra Short, Low and Short Duration Funds

Ultra-short funds come with an investment duration of 3 to 6 months. You can invest in debt funds for 6 to 12 months with low-duration funds. Short-term funds have a maturity period of up to 3 years.

• Other Types of Debt Funds

Other types of debt funds include gilt funds, which invest 80% of their assets across government bonds with varying maturities. Corporate funds invest 80% across corporate bands that are usually of higher quality. They invest across bonds which have a rating of AA+ or beyond.

Factors to Consider Before Investing in Debt Funds

Similar to making an equity mutual fund investment, you must also look for some factors when choosing a debt mutual fund. Here is a detailed breakdown:        

•  Expense Ratio

Considering the differences between equity vs debt funds, the former also requires active management of funds and hence, management charges or expense ratio apply. However, compared to equity mutual funds, debt funds have a lower expense ratio. The range typically varies between 0.8% to 2%.               

• Exit Load

If you exit from a debt mutual fund before a specified time, fund houses typically impose an exit load. For example, short-term debt funds might charge up to 1% if you exit within 12 months. Thus, you must prefer funds that have a minimal exit load to reduce expenses.

• Risk Appetite

Although debt funds are a safer option than equity funds, they are still prone to credit risks, interest rate risks, etc. Therefore, you must have a low to moderate risk tolerance level, as these risks might also arise while you are invested in a debt mutual fund.

Debt and Equity Funds: Which Should You Choose?

Now that you have a clear idea of the differences between debt fund vs equity, you must choose one based on different factors:

• Financial Objective

If your objective is to enjoy a capital appreciation over the long term, you can opt for an equity fund. If you are looking for a capital preservation or a potential flow of regular income, a debt fund might be effective.

• Risk Tolerance

From the debt and equity funds differences, you have noted that equity funds are riskier. Hence, for a potential capital appreciation through an equity mutual fund, you must have a high risk tolerance level. If your risk tolerance is low, you can opt for a debt fund.

• Diversification

As an investor, for better diversification, you can opt for a scheme that is essentially a combination of equity and debt funds. Known as hybrid funds, you can get potential capital appreciation from its exposure to equities and stability from debt investments.

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Conclusion

As an investor, you might get confused between equity vs debt funds and wonder which one might be better. An equity fund provides potential capital appreciation over the long term at high risk. A debt fund generally provides stable and regular income at a much lower risk.

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FAQs on Equity vs Debt Funds

1. What is the difference between debt and equity funds?

One of the key differences between equity and debt funds lies in their underlying securities. Equity funds invest in company stocks and equity-related instruments. Debt funds invest in fixed-income instruments to potentially ensure stability.

2. Which is better: equity or debt funds?

Determining which one is better depends on your risk appetite, financial goals and other factors. Equity funds are usually risky but might provide capital appreciation in the long term. Debt funds are much safer and usually provide stable and regular income.

3. Are debt funds safer than equity funds?

Debt funds are usually safer as they invest in fixed-income securities, unlike highly volatile company stocks. However, interest rate risks, credit risks, etc., are present.        

4. Can I invest in both debt and equity funds?

Yes, you can invest in two of them separately. You can also opt for a hybrid fund. Based on scheme policies, you can get exposure to both equities for potential capital gains and stability from the fixed-income securities.    

5. How are debt and equity funds taxed?

An STCG of 20% with CESS applies to gains from equity funds if you sell units and make gains within a year. If you make gains by selling units after a year, an LTCG applies of 12.5% after an exemption of INR 1.25 lakh. For debt funds, you pay STCG and LTCG taxes as per your applicable income tax slab rate.

6. Who should invest in equity funds vs debt funds?

Investors with a higher risk appetite and a longer time horizon might opt for an equity fund. With a low to moderate risk profile and for stability, investors usually opt for debt funds.