Understanding equity and debt fund is no rocket science

Mutual funds have become a popular investment haven, largely because of the convenience and returns offered by mutual funds.

You can start investing in mutual funds with as low as Rs 500 every month. Moreover, you get a wider choice of asset classes like equity, debt, gold, to park your short term and long term funds.

However, due to the underlying sophistication, a retail investor may find it difficult to make a wise selection. Understanding equity and debt fund is no rocket science. You can make an informed decision by getting hold of the basic concepts.

How do equity and debt funds work?

Equity fund is a high risk-high return mutual fund scheme which pools in money from a large number of investors and invests it in stocks of various companies. The type of company chosen depends on the investment objective of the scheme.

Primarily, there are companies of small/mid/large capitalisation. A pure large-cap/mid-cap/small-cap fund will invest in stocks of the given capitalisation.

Conversely, a multi-cap fund will invest in stocks of companies across capitalisation. These funds enable wealth creation via dividend generation and appreciation in the fund value over the long run.

Debt funds are low risk-low return schemes which invest in fixed-interest generating securities like bonds, debenture, treasury bills and the likes. Based on the investment duration, these are subdivided as short-term funds, liquid funds, dynamic bond funds, GILT funds, credit risk funds, etc.

These funds aim at preservation of capital along with generation of regular income. They achieve this by adjusting the portfolio as per the interest rate volatility and credit rating of the underlying security. These funds may be suitable for short to medium term investment horizons.

Which mutual fund is right for me?

Choosing the right mutual fund is the first step toward goal accomplishment; this underscores the point that goal orientation is very crucial while investing in equity and debt fund.

Equity funds are meant for investors who have a relatively higher risk appetite. It means that they can cope with extreme fluctuations in the fund value and thus, would expect a higher return to compensate for the high risk taken.

From this standpoint, you need to understand that investing in equity funds entails prioritising wealth accumulation over the safety of capital. Moreover, it would be best if you were prepared to stay invested for at least 5 years or more. It is because the short term fluctuations smoothen over the long run to give you average returns of around 12%. This may be good enough to beat the adverse effects of inflation and taxation.

On the contrary, debt funds are meant for the conservative investor who possesses a relatively low-risk appetite. Accordingly, the investor may receive regular income on account of fixed-interest earned by the debt fund.

Here, the motive is to preserve capital and earn returns higher than conventional avenues like fixed deposits. However, debt funds also face moderate fluctuations in the fund value. Moreover, these funds do not guarantee assured returns, and fund performance may vary from one period to another. On average, debt funds are known to generate returns in the range of 7%-9%.

Things to consider while fund selection

As a prudent investor, you need to keep a few things in mind while shortlisting a fund. Be it equity fund or debt fund, depending only on plain-vanilla returns may be inadequate.

Try to look for other quantitative and qualitative aspects of the fund. Begin with examining the fund history. The fund must have a track record of at least say 5 years to indicate its resilience across market cycles.

Then you may compare its Sharpe ratio to analyse its risk-adjusted return. The higher the Sharpe ratio, the better. Finally, you may settle for a fund which has a lower cost of investment by way of a low expense ratio.