Equity, Debt, and Hybrid funds: which one suits you the most?

What are Mutual Funds?

It’s better to first know the basics of Mutual Funds before thinking about different types of funds.

A mutual fund collects money from a large number of investors and uses it to purchase various financial instruments such as stocks, bonds, or a combination of both. A professional fund manager is in charge of managing the mutual fund and trying to maximise returns for the investors. The objective of a mutual fund is to gain more investors while at the same time lowering the risk through diversification which means that the money is not dependent on one single company or sector.

Equity funds: for wealth creation

Equity funds mainly invest in the shares or stocks of a company. Therefore, when you invest in equity funds, you are, in effect, becoming a shareholder of several companies.

How do they work?
The fund manager selects the companies in which to invest and tries to buy the stocks at a low price and sell them at a high price. As a result, your money grows along with their growth.

Who should invest?
Equity funds are the right investment option for those who:

• Want to build long-term wealth
• Are able to endure short-term losses in the market
• Have an investment horizon of at least 5 years

Types of Equity funds

• Large-cap funds: Concentrate on well-established, stable companies (low risk, stable returns)
• Mid-cap funds: Concentrate on medium-sized companies that are experiencing growth (average risk, high return possibility)
• Small-cap funds: Concentrate on smaller companies that have higher growth potential (high risk, high reward)
• Sectoral/Thematic funds: Focus on certain industries such as technology, energy or healthcare
• Index funds: Follow the performance of a stock market index such as Nifty 50 or Nifty Auto (cheaper, less risky than active equity funds)

Pros:

• Possible high returns over a long period
• Can help to beat inflation over the long-term
• Appropriate for long-term goals such as retirement, buying a house, or children’s education

Cons:

• High risk in the short-term due to stock market volatility
• Returns are not predictable in the short-term

Debt funds: for steady and safe returns

Debt funds purchase fixed-income instruments or securities such as treasury bonds, corporate bonds, treasury bills, government securities and other debt securities. They do not buy the shares of any company; instead, they lend money to a company or to the government and earn interest on it.

How do they work?

The fund manager buys debt instruments that provide a good interest income and that are at a very low risk of non-payment. Debt funds, which demand fixed returns, are less affected by stock market ups and downs.

Who should invest?
Debt funds are best suited for people who:

• Prefer the safety of their capital to high returns
• Need short-to-medium term investments (from a few months to 3 years)
• Are risk-averse or want to park their money temporarily

Types of Debt funds:

• Liquid funds: For parking money for a few days to a month
• Short-term funds: For investments up to 3 years
• Corporate bond funds: For higher returns but with slightly more risk
• Gilt funds: Invest in government securities only (very low risk)

Pros:

• Comparatively more secure than equity funds
• Steady and predictable returns are possible
• Perfect for Emergency and short, term goals

Cons:

• Returns are not as high as those of equity funds
• The returns may vary with the changes of interest rates
• Not good for long, term wealth creation

Hybrid funds: the balanced approach

Hybrid funds are a combination of equity and debt investments. They offer a compromise between the two, wherein some of your funds are invested in stocks for higher returns, and the rest in debt securities to maintain stability.

Which funds suit you most?

Choose Equity funds if:

• You are able to take big risks and you are willing to accept big losses
• You are looking for annual returns around 15% for example
• You do not need the money for 5 years or more
• You are aware of the fact that the stock market can be unstable and you are not bothered by price fluctuations

Choose Debt funds if:

• You are not prepared to take much risk
• You need steady and regular income
• Your investment horizon is short-to-medium term
• You prefer safer investment options to stocks

Choose Hybrid funds if:

• You would like to have both growth and safety
• You have moderate risk tolerance
• You want diversification without having to buy different funds

Making the right choice

The decision of what type of funds to select that suits a person depends on that person's financial goals, risk appetite, time horizon, and knowledge of the markets. A mix of these fund categories can be a good way of balancing risk with potential reward.

If you are not sure where to invest, a financial advisor will be able to help you draft a personalised investment plan that meets your goals.