Mutual funds are mainly categorized into equity funds and debt funds. Let us look at each of them in greater detail –
Debt Mutual Funds:
When one invests in debt mutual funds, he or she is invested in instruments that carry minimal risk. In this form of investment, the idea is capital protection with some degree of profits. The instrument types in which a person invests through debt mutual funds include government bonds, commercial paper, company fixed deposits and company debentures.
Please note that the returns are not guaranteed but there is a high amount of certainty that you will get stable, regular income that may be on-par or slightly above the rate of inflation. Debt funds are much better that conventional modes of investments like fixed deposits, because the former offer better post-tax returns.
There are different types of debt funds like liquid funds, ultra short term funds, short term funds and so on. Liquid funds are as good as cash in bank but offer higher returns than your bank account would give. These invest in extremely short-term debt instruments with a maturity period of less than 91 days, which means they carry the lowest risk among debt funds. They are a good choice, if you want to invest money for a period of 1 year or less and earn better interest (around 7 percent) than your savings bank account.
Ultra short-term and short term funds invest in commercial papers, certificates of deposit and bonds with a maturity of more than 91 days and more. They also contain low risk and are good if you have a short-term goal, like saying buying a car, within 2 years.
Debt funds are meant for shorter duration; for goals that have a time-frame of below 3 years. These funds also include short-term capital gains tax if you redeem the investment before 3 years. If redeemed within 3 years, the gains are taxed according to the applicable income tax slab. If the investor holds on to debt funds for more than 3 years, it is termed as ‘long term capital gain’ and taxed at 20 percent after indexation.
Equity mutual funds:
While the major objective of debt mutual funds is capital protection, equity mutual funds are focused on capital growth. Equity as an asset class is meant for substantial wealth creation on a long-term basis with inflation beating returns. Investing in an equity mutual fund does include risk, but with the rupee-cost averaging functionality involved in an SIP investment, the benefits clearly outweigh the risks, as seen from historical performances of equity mutual funds.
Please bear in mind that the moot thing to know while investing in an equity mutual fund is long-term commitment, a minimum of 5 years. This is not really a tough call, considering people anyway keep money for years in a bank account, where money grows at a much slower pace compared to inflationary trends.
Equity mutual funds invest in stocks of proven companies or future market leaders, both capable of beating inflation on a long-term basis. While on an average, debt funds have given returns to the tune of 8-9 percent, equity mutual funds have given 14 to 16 percent
Investors have a wide range of choices when it comes to investing in equity mutual funds. For instance, large cap mutual funds invest in stocks of blue chip companies which can provide stable returns. Then there are mid cap and small cap funds which invest in future market leaders; while they carry high risk, they also provide exceedingly high returns over a long term.
Apart from large cap, mid caps and small caps, there are ‘multi cap funds’ that invest in a blend of stocks that embrace these three types of equity mutual funds. These types of funds help you reap the stability of large cap funds with the substantial returns of small and mid-caps.
There is a variant of equity mutual funds that gives you the dual advantage of tax saving benefits and wealth creation – ELSS (Equity Linked Savings Scheme). Though it has a lock-in period of 3 years, the investor can be exempted of a maximum of Rs 1.5 lakh as taxes in a financial year. In fact, it has the shortest lock-in period compared to other tax saving instruments. Not to mention, ELSS mutual funds help you amass a substantial amount of corpus on a long-term basis.
Equity-oriented balanced funds with a minimum of 65 percent invested in equities are ideal for those who do not want to go into pure equity funds; can contend with slightly low returns but would like to have controlled risk, These funds are treated like conventional equity mutual funds as far as tax calculation is concerned. Equity mutual funds are tax-free if the investment is held for more than one year.
Thus, investing in a debt fund or an equity fund depends on your risk appetite and the time-frame of your goals. If you have to save for marriage or have a big ticket purchase in the next 2 or 3 years, invest in a debt fund, because it is less volatile and your money grows at a rate better than a savings bank account. If your financial goal has a time period of 3 to 5 years, opt for balanced funds. If your goal is beyond 5 then invest in long term equity mutual funds, like large caps, mid caps, small caps or multi-caps.
Make sure you steer clear of bias, promotional tactics by various brands and just focus on your financial goals and the performance of the fund over the years, and investing style before zeroing on a mutual fund.
Get in touch with your financial planner and create a solid portfolio to realize your various financial goals.