Types of Fund in India – Debt, Equity or Balanced
Mr.Palekar asked me “What types of fund should I choose?”
Unfortunately I was not able to give him a clear-cut answer. So I just said “You can consider a mix of equity, debt and balanced funds” which is like saying “Buy Low and Sell High” – obvious but not useful.
The lesson here is the fact that every individual like Mr.Palekar needs a solution that is suited or tailored to their personal needs. So there is no formula or one-size fit all approach.
Choice of Funds – A Customized Balanced Diet!
Whether to go for debt funds, equity funds, hybrid funds, thematic funds, etc is like asking a dietician whether you should consume carbohydrates, proteins, vitamins, etc.
You can’t choose one over the other at the same time you can’t have everything, but its all about having a balanced portfolio (like a balanced diet). In some cases a lot of customization has to be done to build a customized portfolio (like a customized balanced diet).
Why Mutual Funds?
Before getting into types of fund, lets understand “why choose mutual funds?”
Mr. Palekar actually burnt his fingers in the stock market after following his friend’s tips and advice. However, his friend Asrani somehow used to claim that he made several thousand rupees every month. Soon Palekar realizes that Sensex and stocks are not his cup of tea.
(Some of the names resemble the story of a 70’s movie – if you can guess it please comment below)
During a vacation he meets Mr.Wilfred Singh, a Financial Adviser guides Palekar on investment/financial planning. After a long and detailed discussion, Wilfred Singh tells Palekar that running away from equities/stocks is not the answer, and reiterated that one must rather invest in mutual funds, which can provide decent returns with moderate risk.
Types of fund – Debt, Equity and Balanced Funds
Wilfred in his typical style smokes a cigar and tells Palekar “Be the change you want to see in this world”….. Realizing Palekar’s dilemma Wilfred explains types of fund in India in simple language.
When investors like you invest in a debt fund, the Fund Manager would in turn invest the proceeds in several fixed income securities or bonds. Bonds are instruments which companies issue to investors to raise funds, where investors get an interest periodically for parking their funds for a fixed tenure.
So here Palekar can invest in the fund which will invest in a diversified set of bonds rather than investing in individual company’s deposits/bonds.
This is a fund which will invest in stocks or shares of various companies on behalf of several investors like you who invested in the equity fund. Some funds invest in blue chip or large cap companies which some invest in a mix of mix and small sized companies, and there are several variations too.
These funds invest in a mix of debt and equity securities or instruments. So the fund manager in this case would divide the investible corpus (money collected) between debt and equity in a certain ratio like 60:40 (debt:equity). So assuming a 60:40 (Debt:Equity) ratio where Rs.1 crore is collected Rs.60 lakh would be used to invest in debt and Rs.40 lakh would be used to invest in stocks. This is only an illustration, but this is variable depending on the investment objectives, investing style of the manger, market situation and other factors.
To get an easy and quick snapshot see the table below:-
|Parameter||Debt Fund||Balanced Fund||Equity Fund|
|Portfolio Mix||Debt||Debt & Equity||Equity|
|Returns*||Low (4-10% p.a.)||Medium (10-15% p.a)||High (15-25% p.a.)|
|Suggested Investment horizon#||Flexible**||Medium-Long (1-2 years)||Long Term (2-3 years)|
*These are just indicative pre-tax returns in a normal market. Actual returns can vary.
** The investor can hold their investment for a tenure ranging from a couple of days to several years.
# This is highly subjective and can vary from individual to individual and also depends on the choice of product or instrument
How a debt fund works?
Debt fund is almost similar to other fixed income instruments like bonds, however, since it holds multiple bonds and debt instruments its overall performance will be the aggregate performance of all securities in its portfolio.
A retired Chief Engineer Mr. Chintamani invests in Pumkin Debt Fund which invests in a mix of Govt. of India securities, corporate bonds (issued by companies) and other short term securities.
The average return earned by the fund was 8% p.a. for the past two years. The distribution of returns to investors in this case are quite different. The investor can earn dividend declared by the fund or benefit from price appreciation of each unit (increase in NAV).
The biggest drawback for Chintamani was in the returns – the fund declared a paltry sum of Rs.1 per unit as dividend (The NAV was Rs.12 per unit at the time of purchase). The NAV now is down to Rs.11.5.
So basically the actual return is 1/12 or 8.33% (dividend yield). This is just the beginning, but if we estimate the post-tax returns assuming a tax rate of 30.9%., the effective after tax return is just 5.76%. This is almost equal to or less than the post tax return on bank fixed deposits.
Advantages of Debt Fund
- Low Risk: Safety of Principal or preservation of capital.
- Returns are assured to an extent assuming that the investments are of good credit quality (preferably rated by credit rating agencies such as CRISIL, ICRA, etc.)
Disadvantages of Debt Fund
- Low Returns (tax and inflation will erode your returns)
- Unlike fixed deposits or bonds the cash flows are not certain (because interest rate is only indicative) and dividend declaration is at the discretion of the fund
- Risk can come in to play if the fund invests in debt securities of small or unrated companies.
- Does not help in building wealth
When to Choose Debt Fund?
The only reason to choose this types of fund (debt funds) is to have full safety of capital, while being happy with low returns. In some cases the post tax returns from debt funds are better than bank fixed deposits. [Consult a tax expert for more on this]. You can choose debt funds in the one or more of the following circumstances:-
- As a short term parking space for funds when you are not sure where to invest
- For long term investment assuming you have plenty of cash regularly and lesser avenues to deploy
- When you get high returns on equity, property, etc and want to reallocate it to safer avenues
- When safety or preservation of your capital is more important than returns.
Learn more about debt funds and the debt market in our blog – what is debt market?
How equity and balanced funds work?
An equity fund will build a diversified portfolio (varies from fund to fund) of stocks and earns returns from dividends and price appreciation. To cash in on the price appreciation, the fund sells some stocks to book profits. When a fund declares a dividend of Rs.1 per unit your dividend will be an amount equivalent to Rs.1 X no. of units held by you.
Eg. If you hold 100 units you get Rs.100 as dividend. Price appreciation is the difference between the current (sale) price/unit and the purchase price per unit. The equity investment portion of balanced funds also have similar features but the choice of stocks and %age of amount allocated towards equity could be lesser.
The balanced fund has a mix of equity and debt components. The percentage of equity exposure in the fund could be as low as 30% or as high as 70%, depending on the fund’s mandate.
The debt component is almost similar to debt funds in terms of features with slight variations. The equity component would generally be focused on blue chip or large cap companies, though some fund may take exposure to mid cap stocks as well.
Advantages of Equity (applicable for both equity and balanced funds):
- Potential to earn dividends
- Potential to gain from capital appreciation (gain in stock prices)
- Helps in long term wealth creation
- Easy to buy or sell
Disadvantages of Equity:
- risk of poor returns
- Risk of losing principal or capital
- Suited for long term
Choosing a Balanced Fund
Balanced fund tries to mix and match the features of debt funds and equity funds so that investor gets the benefit of both in one package. A balanced fund can be also be a good choice assuming it has exposure to large cap stocks and good exposure to debt securities.
In reality most balanced funds also have high equity exposure due to favorable tax regulations for funds having more than 65% equity exposure. So the quality of equity exposure in such cases becomes critical.
Those who are more aggressive can avoid a pure debt fund and instead go for balanced and equity funds, while highly conservative investors can pick balanced and debt funds. This helps in avoiding extremes provided these investors are happy with the risk-return tradeoff.
To conclude I would advise that extremes are not good for investing as well as for diet. Have a healthy mix of types of fund in your portfolio. For instance debt provides paltry returns while the so called multibagger (mid cap) funds offer excellent returns. While debt alteast protects your capital, the mid cap fund can hurt your capital too.
In case of equity, try to stick to the regular run-of-the-mill blue chip fund or index fund which should do the trick. In case of debt funds you can pick up a debt fund with good ratings or stick to a bank fixed deposit.
Maintaining a simple portfolio with high quality instruments is far better than having dozen different items of which half are risky. One must not avoid equity or risky assets altogether, but at the same time going overboard on equities can be foolish too. Remember that investing with a balanced view is as important as sticking to a balanced diet.