Mutual funds invest in a plethora of financial instruments like stocks, government and corporate bonds, debt instruments and gold, depending on the schemes’ mandate. Disciplined and systematic investments through mutual funds can do wonders, if planned well. However, as not all types of mutual funds may be suitable for every investor, investors should know about the different kinds of mutual funds before investing, depending upon their risk appetite, needs, goals and tenures.
Adhil Shetty, CEO, Bankbazaar.com, says, “Mutual funds have become popular among all age groups of investors. In case of confusion, it is easier to shortlist the right investment product when your financial goals are clear. One can decide between debt vs mutual funds basis the investment tenure. For short-term investment, you can go for less-risky debt funds. You might need the money; therefore, you cannot afford to take higher risks. On the other hand, if you have a long-term horizon, you might take some risk and invest in equity mutual funds for marginally higher returns. Evaluate your mutual fund options based on your investment objectives.”
Broadly, mutual funds are classified into two categories – Equity Schemes and Debt Schemes.
Equity Mutual Funds
As the name suggests, equity mutual funds or growth-oriented funds are schemes which invest your money in the shares of several companies listed on the stock exchanges. They offer investors exposure to many companies in different sectors. This strategy of allocating assets across the companies helps investors reduce risks and benefit from growing a broader spectrum of businesses.
For instance, if you have put Rs 1000 in an equity fund which invests, say, in 50 companies, you will have a proportionate ownership of all these companies in your portfolio. If a few stocks do not perform, the better-performing stocks in the portfolio would either negate or reduce the hit on your investment value. Thus, you have the advantages of diversification and getting risk-adjusted returns.
Having said that, it is essential to highlight that equity is one of the riskiest and most unpredictable asset classes in the short to medium term. But a longer investment horizon tends to reward investors with tremendous wealth, beating nearly all other investment avenues. That’s why it is prudent to avoid equity investments if your tenure is less than three years.
Data suggests that equity funds have offered a CAGR of as high as 18%-20% over the last two decades. In actual terms, a lump sum investment of Rs 1 lakh would have turned over 38 times to Rs 38.33 lakh during the same period. Similarly, a monthly investment (SIP) of Rs 10,000 — an overall deposit of Rs 2.4 lakh during the last two decades — would have become a whopping Rs 2.48 crore. However, historical trends may or may not repeat, and that’s why returns from equity schemes are not guaranteed as is in the case of traditional investment avenues.
In terms of taxation, equity schemes attract a short-term capital gain tax of 15% on the realised gains if units are sold within a year of purchase. However, if units are sold after a year, there is a 10% long-term capital gain tax applied on the gains over and above the capital gain of Rs 1 lakh.
Equity mutual funds should be the preferred choice for investors with moderate to high-risk appetites who want to benefit from stock markets but need more experience or time to track the markets actively. Equity schemes offer a reliable proxy to ride the growth story of an emerging economy.
Debt Mutual Funds
The debt category of mutual funds is relatively safer and more stable than its equity counterparts. However, in terms of long-term returns, they may come far from what equity schemes offer. But debt funds tend to perform better when compared to banks’ savings accounts or traditional investment avenues like fixed, recurring, or postal deposits.
Debt mutual funds are also diversified schemes like equity. Still, they invest mainly in a mix of debt or fixed-income securities, which include Corporate Bonds, Government Securities and Treasury Bills, among other debt papers. Thus, given the kind of instruments debt funds invest in, these are relatively less risky investments and much more predictable than equity investments. However, debt schemes need to be equipped to offer very high returns compared to equity mutual funds.
Investors with a conservative approach towards investments who prefer their invested capital’s safety (in relative terms) may choose debt mutual funds. Especially investors at the fag-end of their working life must primarily consider investments into debt funds. Such an approach helps them avoid undue risks emanating from equity which they may need to prepare for old age.
In terms of taxation, debt schemes have a tax-related tenure threshold of 3 years. If profits are realised within three years, gains are termed STCG and profits made after three years of holding units are LTCG. If you sell your units of debt funds within three years of buying them, profits thus made are added to your taxable income, and depending on your tax slab, they are taxed. For instance, if your taxable income is Rs 6,00,000 and short-term gains from debt investment are Rs 1,00,000, your total taxable income will be Rs 7,00,000. On the other hand, if your holding period is over three years, there is a flat tax rate of 20% on the capital gains after including indexation benefits.
If you know your investment goals, it is easier for you to take a better decision.