Mutual fund investment offers you 3 categories to invest in: Equity Funds, Debt Funds and Hybrid Funds. Although each mutual fund has its benefits, the difference between them is mainly based on the risk-return they provide and the tax treatment.
These funds also include some subcategories which we will discuss below.
Equity mutual funds are the investment schemes that mainly put your money into the stocks of different companies which lead them to generate higher returns. The fund’s portfolio invests 65% of its assets in equity and equity-related instruments.
Compared to debt funds and hybrid funds, equity funds are highly risky and that’s the reason they offer higher returns.
Equity funds are classified based on market capitalisation: they are classified into Small-cap equity funds, mid-cap equity funds, large-cap equity funds and multi-cap equity funds.
Debt funds mainly invest in debt and money market instruments. The instruments include treasury bills, commercial bills, certificates of deposits whereas debt market instruments involve government bonds, non-convertible debentures etc.
Many people invest in debt mutual funds because they are receiving income in the form of interest payments. The main difference between equity mutual funds and debt mutual funds is that debt funds are considerably less risky as compared to equity funds.
Mutual funds that are a mix of equity and debt instruments are known as hybrid mutual funds. Hybrid mutual funds are designed in such a way that it balances out the market risks. Here, the fund risk mainly depends on the investment stance and asset allocation into equity and debt.
All mutual funds are subjected to market risks, however, the degree of risks vary for each category depending upon the investment style, portfolio construction and more. Here is the difference between equity mutual funds and hybrid mutual funds:
By placing the assets in small-cap, mid-cap and large-cap companies, equity mutual funds. If we see the historical equity returns, then you will get to know that these funds have given clear records of giving inflation-beating returns.
If you are an investor, who is willing to place the riskier returns and gain higher returns, then equity mutual funds are a great source of investment options.
Hybrid mutual funds, on the other hand, have the potential to beat the stock market trading returns from the debt funds. Unlike equity mutual funds, these funds give no guarantee of steady returns as the NAV of hybrid funds is directed by the performance of the securities in which are invested.
Debt oriented market funds provide the stability of the income because of the presence of the equity component in the portfolio.
Equity funds are considered the riskiest mutual funds because they are directly dependent on the stock market positions. On the off chance, you invest in a diversified equity fund, the risk factor is balanced.
Debt funds are considered less risky than equity mutual funds. This is because debt funds are based on interest payments which help in mitigating portfolio risk.
Hybrid funds are considered low-risk funds but they are not entirely risk-free.
When it comes to taxation, there are only two categories to determine the taxation on dividends and capital gains.
In the case of dividends; it is tax-free in the hands of the investors in the case of equity funds, debt funds and balanced funds.
However, the rate of dividend distribution tax (DDT) differs. While equity fund dividends attract DDT of 10%, the debt fund dividends attract DDT at a much higher 25%. Now let us focus on how capital gains are taxed in each of these cases.
The Income Tax Act only recognizes two categories of funds viz. equity funds and debt funds.
As long as the equity exposure of the fund is more than 65%, it is classified as an equity fund for tax purposes. So equity diversified funds, sectoral funds, index funds, balanced funds with more than 65% in equities, and arbitrage funds will all be categorized as equity funds.
The dividends in all these cases will attract a DDT of 10%. The capital gains shall be STCG if held for less than 1 year and taxed at 15%.
If held for more than 1 year it will be LTCG. Effective Union Budget 2018, LTCG on equity funds will be taxed at 10% above Rs.1 lakh in a year without the benefit of indexation.
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Source: SEBI study dated January 25, 2023 on “Analysis of Profit and Loss of Individual Traders dealing in equity Futures and Options (F&O) Segment”, wherein Aggregate Level findings are based on annual Profit/Loss incurred by individual traders in equity F&O during FY 2021-22.