Mutual funds have become a popular investment avenue for many investors in India. They provide the benefit of portfolio diversification along with professional management. When it comes to mutual funds, two major categories are equity funds and debt funds. But which one is better for wealth creation over the long term? This blog post compares equity and debt mutual funds across various parameters to help you decide.
What are Equity Mutual Funds?
Equity mutual funds invest predominantly in stocks of companies across market capitalisations. Based on the market cap focus, they are further classified into:
- Large-cap Funds: Invest a minimum of 80% in large-cap stocks.
- Mid-cap Funds: Invest a minimum of 65% in mid-cap stocks.
- Small-cap Funds: Invest a minimum of 65% in small-cap stocks.
- Multi-cap Funds: Invest at least 25% across large, mid and small cap stocks each. i.e. 75% is invested in equities.
- Flexi-cap Funds: Invest a minimum of 75% across market caps.
- Sectoral Funds: Invest a minimum of 80% in stocks of companies involved in a particular sector.
Equity funds aim to generate optimal returns over the long run through capital appreciation. However, they carry higher risk, especially over the short term, due to volatility in stock prices.
What are Debt Mutual Funds?
Debt mutual funds invest primarily in fixed-income securities like bonds, certificates of deposit, money market instruments, etc. They are less risky than equity funds but may generate lower inflation-adjusted returns over the long run. Debt funds are categorised based on the duration or types of instruments they invest in:
- Liquid Funds: Invest in cash and cash equivalents
- Ultra-Short Duration Funds: Invest in instruments with duration between 3 to 6 months.
- Short Duration Funds: Invest in instruments with 1-3 years duration.
- Medium Duration Funds: Invest in instruments with 3-4 years duration.
- Long Duration Funds: Over 7 years duration.
- Bond Funds: Invest in bonds issued by the government or corporates.
Debt funds aim to potentially provide stable income through interest payouts. They also provide moderate capital appreciation. They may serve as a suitable avenue for short-term goals or for investors with lower-risk appetites.
Key Differences between Equity and Debt Mutual Funds
| Basis of Difference | Equity Funds | Debt Funds |
| Returns Potential | Higher over the long term | Comparatively lower over long term |
| Risk Profile | Very high | Relatively low to moderate |
| Investment Horizon | 5 years or more | 6 months to 5 years |
| Volatility | Very high | Relatively low to moderate |
Which is Better for Wealth Creation in the Long Run?
Equity mutual funds may be the better choice for wealth creation if you have an investment horizon of at least 5-7 years. Here’s why:
- Higher Returns Potential: Equity funds may have potentially high returns and may beat inflation by a good margin. Debt funds returns may be lower.
- Benefit from India’s Economic Growth: Equity funds allow you to participate in India’s economic growth by investing in shares of potentially high-quality companies. As the earnings of companies grow, so does your wealth.
- Power of Compounding: The potentially high, optimal returns of equity funds get compounded over a long tenure of investments, creating significant wealth.
- Tax Efficiency: Equity funds enjoy a lower 10% LTCG tax if held for over 1 year compared to normal income tax slabs for debt funds.
However, equity funds come with higher short-term volatility. So, to withstand this volatility you may need to be invested for a longer time period. For goals under 3 years, debt funds may be a suitable option.
Conclusion
Focus on long-term wealth creation should primarily be through equity mutual funds to harness their high return potential. Debt funds may potentially be less volatile, providing a balance in your overall portfolio. Assess your risk appetite and time horizon to decide the right allocation for your needs. Over a long tenure, equity funds may potentially deliver substantially higher inflation-adjusted wealth.