Debt Mutual Funds vs Equity Mutual Funds: Which is Better For You?


A Mutual fund is an organised institution that collects money from members of the public to invest across the broad stock market, in the hope of gaining profit for the fund managers and the investing public. The two most popular types of mutual funds are Debt Mutual Funds and Equity Mutual Funds. Today we’ll look at which gives you a better bang for your buck.

The main differences between debt mutual funds and equity mutual funds are… The nature of the investment, the taxation of profits, Risk factors associated with the investment, and most importantly… Your return on investment.

Investors are always confused when choosing between debt and equity mutual funds. To find out which is best for you, take these factors into consideration when reading this article:

  • Your Age: Depending on your age and how long you have before retirement, you can explore riskier investment options if you choose to do so.
  • Your Risk Tolerance: Risk is everything when you put your money into someone else’s hands, find out how much you are willing to risk and what reward you want from it.
  • Your Financial Competence: Warren Buffett believes that you should only invest in things you understand. The simpler the investment, the more you will understand, hence you are not surprised by unforeseen hiccups.

You might be thinking ‘all funds are the same’… Or ‘they all make the same amount of money’… The sad truth, a lot of people have lost money in mutual funds. To make money, you need to understand your exposure to the market, risk associated with the type of fund, and exit points if things go south.

What is an Equity Mutual Fund?

An equity mutual fund, also known as a ‘stock fund’ is the type of fund that only invests in company shares. They evaluate industries, companies, and emerging markets to find solid companies to invest your money in.

Equity mutual funds are categorised according to fund size, investment style, industry of the funds holdings, and part of the world they invest in.

What is a Debt Mutual Fund?

Debt mutual funds are a type of fixed income fund for shareholders. They invest in debt securities such as Government and Treasury bonds, ranging from very short term expiry bonds to very long term, some reaching over 15 years.

By floating debt through Government & Treasury bonds, they are able to provide a fixed payout every month/quarter for shareholders of the fund.

Debt vs Equity Funds 900x900

Which Mutual Fund is Better: Debt vs Equity?

Ask which fund is better depends on your goals, so taking the characteristics of each fund into account, we will look at the main positives & negatives of each investment. Hopefully this will help you decide which is better suited to your current circumstance.

Nature of the Investment

By the nature of the investment I mean what the fund is involved with.

Debt Mutual Funds: As briefly described above, debt funds invest in the bond market to give shareholders a fixed income. Most funds only deal with treasury or government bonds, which being lower yield investments are among the safest that can be made.

Very few debt funds actually strive into the corporate & municipal bond market, making it hard to grow your investment quickly. However if you risk sensitive you can gain yourself a reasonable fixed income, as well as the possibility of your shares increasing in value over time.

Equity Mutual Funds: As you might guess, these funds exclusively invest in equity. To become categorised as an equity fund, they have to have over 65% of their portfolio in company stocks.

This style of investing is risky, but high yielding. Not only do some funds offer shareholders distribution payments from collected dividends, your shares in the fund are more likely to appreciate over time. For a young person looking to start investing, these types of investments are perfect to grow your portfolio.

Taxation on Profits

Taxation of profits might differ depending on which country you live in, however I will go over the U.K tax and U.S tax.

U.S Tax on Profits

Debt Mutual Funds: Shares in debt funds held for more that 36 months are taxed at 20% with indexation. Shorter term gains are not classified as capital gains, the income will be added to your general annual income and taxed at the tax band rate you fall under.

Equity Mutual Funds: Stock funds, as they are trading company shares, as taxed as capital gains. For most people this will mean any gain made on your shares in an equity fund will be taxed at 15%, however short term gains are taxed as ordinary income, these are shares owned for less than 3 years.

U.K Tax on Profits

Debt Mutual Funds: Any fixed income from you gain from owning shares in a mutual fund will be taxed at the dividend rate, which is split into the tax bands – 7.5%, 32.5%, 38.1%, depending on your level of income. Upon sale of the shares in the fund you will need to pay capital gains tax at the rate of 10% or 20%, again depending on your level of income.

Equity Mutual Funds: Similar to debt funds, any dividend payment will be taxed at the appropriate rate as stated above. As well as sale of shares at the above rates also.

In the U.K you have certain allowances. Per tax year, everyone have a £2,000 allowance for dividends, meaning any dividend you receive up to £2,000 is tax free. Also if the profit gained from the sale of your shares is less than £12,500 you will have a capital gains exemption, so no tax will be payable.

Risk Factors of Investment

As you can probably tell, debt mutual funds are the safer investment.

Debt Mutual Fund: There is virtually zero risk when investing in a debt fund. Because most funds prioritise government and treasury bonds, and those types of debt never default, your fixed income will almost never be in jeopardy.

Debt mutual funds have virtually no risk, but bond prices are sensitive to interest rate changes, so that is something to keep an eye on. Even so, loaning the government money, it is the most secure loan agreement ever.

It may not seem like it, but the U.S government has the best credit rating available.

Equity Mutual Funds: Equity funds invest in company shares. We all know how volatile and unpredictable the stock market can be, so your money is always at risk. But, you are investing in a fund with expert managers, and top notch analysts, so you would think they know what they’re doing.

The average return from equity funds are positive, however major market corrections such as in 2008, or the ‘.com bubble’ can cause significant losses. However, diversifying with equity funds can be a good idea. After all, equity funds generally follow some sort of index, most of which have grown massively in the last century.

The simple fact is: With debt funds, you don’t need to worry about broad market corrections, bear market turns, or industry collapses. The bond market is very stable and your fixed income is safe.

If you invest in equity funds, you need to watch the market, check what the fund is invested in, and make decisions about where you want your money. Even though it is safer than investing in individual stocks, equity funds still carry the risk of market fluctuation.

Also, don’t forget… Equity Funds can go to Zero!

Long story short, equity funds carry higher risk than debt funds.

Returns on Investment

Debt Mutual Funds: As mentioned, debt funds offer investors a regular fixed income which is distributed monthly, or quarterly. Since debt funds generally hold government and treasury bonds, the risk is low… Meaning the returns are nothing to write home about.

During a volatile market, bonds or debt funds are a great investment as they do not react to short term market shifts. Therefore securing your income.

If you invest in a debt fund however, you not only have the ability to draw regular income, you can also accrue wealth through asset appreciation. If the fund performs well, your share value will increase.

The average 1 year return for the top 10 debt mutual funds in the U.S for 2019 was 5.95%.

Equity Mutual Funds: Investing in company shares, some of which offer dividend payments can yield some high returns. The S&P 500 posted a 31.1% annual gain for the year 2019, with an average return of 15.2% over the last 10 years.

With equity funds following indexes such as the S&P 500, it comes at no surprise that the average equity fund return over the last 10 years was 15.6%.

You also have to take into consideration, when the market is experiencing depression or high volatility, equity funds can weather the storm, and usually come out unscathed.

Summary

Debt Mutual FundsEquity Mutual Funds
NatureInvestment Grade Government & Treasury bondsCompany Shares
Tax ImpactDefined as ordinary income if held for less than 3 years, assessed for CGT if more than 3 years.Short term gain assessed as ordinary income, over 3 years taxed at 15%.
RiskLow Risk (Virtually Zero)Medium to High Risk
ReturnLow ReturnHigh Return

Now it’s time for you to make the decision of which one you like the most.

Plan A or Plan B

Who Should Invest in an Equity Mutual Fund?

Because of the risk associated with stock market investments you need to assess your current situation before diving into equity funds.

The ideal candidate to invest in an equity fund is…

  • A young person.
  • With excess disposable income.
  • Who is financially literate and understands market jargon.
  • A person is not risk sensitive.

I know not a lot of people fit all of these categorises, but you should be able to at least tick off 1.

Someone who is close to retirement should handle their investments with a lot more care than someone who has just started earning money.

For example, if a 30 person loses $1,000 on an equity fund investment, they have another 30 years to replace that money in their retirement savings.

However if a 60 year old person losses $1,000 it would be very hard to recoup that money if they are retired, or close to retiring.

What I’m trying to get at, is you need to not only assess how much money you are willing to lose, you need to figure out how long it would take you to recoup that money if you lost it all. A person who likes to take risks, may not always be the most financially literate, or have the most excess income.

Equity funds are a great way to build your retirement savings, however when you reach a certain age, you might want to think about reducing the amount of money invested in such a risky environment, and focus on low risk fixed income funds.

Who Should Invest in a Debt Mutual Fund?

When people reach retirement age, or close to it, they might want to start thinking about moving their savings into debt mutual funds.

With such a low risk investment, it means you are safe from market corrections while also yielding a fixed income.

Because the stock market is so risky, you don’t want to have your entire retirement savings in stock and shares. A good portfolio distribution would be around 20% stocks, and 80% bonds or debt funds, this will keep your money safe and growing at the same time.

If you followed the advice of just about every financial advisor in the last 50 years, you spent your 20s, 30s, and 40s accruing high gains from stock market investments through your pension account. That is very good!

But now, you are closing in on retirement, and the last thing you need is the risk of an equity investment.

Bonds and debt funds, allow you to keep building on your savings, while drawing regular income from the account. Too many people have lost proportions of their retirement because of bad investments. If you have reached your retirement goal, and have enough saved up, why not just take the easy road.

People who should invest in a debt fund are as follows:

  • Older people, people close to retirement age.
  • People with a high amount of savings.
  • High income taxpayers.
  • People who want to avoid risk.

Which Fund Type Performed Better Over the Last 10 years?

10 years is a long time for your money to be tied up in an investment, but it might be worth it.

Let’s have a look at the top equity & debt mutual funds of the last 30 years and see which yielded the highest return. Spoiler alert!! The equity funds won. But that’s not the full story.

We’ll be looking at the Fidelity Magellan Large Growth Equity Fund (FMAGX), and the iShares 1-3 Year Treasury Bond Fund (SHY). Let’s see how they differ, and which is best for you.

Fidelity Magellan Large Growth Equity Fund

  • Fund Inception: 05/02/1963
  • Expense Ratio: 0.77%
  • Portfolio Net Assets: $20,304 Million
  • Average Annual 10 Year Return: 14.01%

Hypothetical growth of $10,000 invested in the fund 10 years ago:

  • Year 1: $10,000
  • Year 2: $11,401
  • Year 3: $12,998
  • Year 4: $14,819
  • Year 5: $16,895
  • Year 6: $19,262
  • Year 7: $21,961
  • Year 8: $25,038
  • Year 9: $28,545
  • Year 10: $32,545

iShares 1-3 Year Treasury Bond Fund

  • Fund Inception: 07/22/2002
  • Expense Ratio: 0.15%
  • Portfolio Net Assets: $21,873 Million
  • Average Annual 10 Year Return: 1.2%

Hypothetical growth of $10,000 invested in fund 10 years ago:

  • Year 1: $10,000
  • Year 2: $10,120
  • Year 3: $10,241
  • Year 4: $10,364
  • Year 5: $10,488
  • Year 6: $10,614
  • Year 7: $10,741
  • Year 8: $10,870
  • Year 9: $11,001
  • Year 10: $11,133

As you can clearly see, over a 10 year period you money would be better suited in the equity fund. The equity fund has over 10 times the return of the debt fund over the last 10 years.

But you must understand that this might not always be the case. Some years, equity funds can lose money. This is why older more risk adverse people prefer debt funds.

What Other Options Are Out There?

As with everything in life, there are other options. Some include individual stocks, retirement accounts such as IRA’s or 401(K)’s, or even a broad index investment. The possibilities are endless.

If you want to get more of an idea how to build your savings I suggest sitting down with a bank statement, crossing off things you don’t need, then going to see a financial advisor to evaluate your options.

Going in alone can be scary if you are unprepared, so it’s not a bad idea to talk to someone about it first.

How to Get Started

Getting started is easy, you can do it one way, or the other!

The First Way:

This is the easiest way to go about it, and sometimes the cheapest.

Go directly to the company that manages the fund and buy shares direct. Normally you will pay a small admin fee, but you get the best service and a real time buy price, no spread.

The Second Way:

Open an account with eToro, M1 Finance, or Trading 212.

These commission free online brokers don’t charge you anything to get in the game, but once your account is open you are on your own. No financial advice, and no person on the end of the phone.

Although the customer service is great, they are not allowed to give you financial advice, meaning you’ll have to do all the research yourself… But at least it’s free!

The Final Way:

Open a workplace pension scheme with your employer, or a personal pension with a provider.

This can be a fuss to set up, but once it’s done you can sit back, deposit money, and have someone else do all the work (for a minor fee). All of this can be done online, either through a brokerage such as M1 Finance, or a pension provider like Nest Pensions.

Be Safe!

The final point I want to make is to be careful and invest wisely. A lot of money has been lost in the stock market over the years, and I don’t want you to be one.

Chris Race

I am an accountant from the U.K. specialising in Management Accounting, Personal & Business Tax, Financial Analysis, and Wealth Management. My passion for learning is what lead me to creating this blog. Stock market investing has always been a interest of mine, and since I was 18 years old... This interest has become a source of income for me and my family.

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