Debt and Equity Mutual Funds

We saw in Bonds, how the government and corporates issue bonds to borrow money. Now these borrowings run in crores. You and I don’t have crores to lend.

But, you and I and lakhs of other people can pool in money to lend and earn interest on our lending. This is what gives it the name “Mutual Funds”. Money from several investors mutually invested.

Because you are lending the money, you are investing in Debt.

There is another way for companies to raise money. Instead of borrowing money from you that they have to return with interest, they let you invest in their company and enjoy profit sharing. This investment is made by buying some shares for the company. What you get in return is a part of ownership — equity.

Think of it like this. If you are partner in a company, you share their good times and bad times with them. Good times will give you profit share while in bad times you may make some losses. There is no guarantee of investment return. But there is also a scope for earning greater profits that are not limited to interest rates only.

Because you invest the money for ownership, you are investing in Equity.

(Equity and stock investment deserves a detailed post which I will write soon)

For now , the mutual fund that invest in debt instruments (like bond) is called Debt Mutual Fund and the one that invests in Equity is called Equity Mutual fund. There are hybrid funds also, that invest in both Equity and Debt.

The person managing the mutual fund, managing everyone’s money, deciding where to invest, when to invest etc is a Mutual Fund Manager.

What is NAV

My mother has an agent who visit her every few months and sell some mutual fund, some ULIP to her by explaining her some funda on NAV. So basically, my mother is his way to fulfill quarterly targets! She can’t send him back empty handed you know. Also she gets to know more about NAV! (I know that’s your parents too, so stop smiling).

So let us also know more about NAV!

Say ten of us want to invest our money, Rs 10,000 each. Our mutual fund becomes:

Rs 10000X10 = Rs 100000

Now fund manager invests this in debt or equity. Say each unit of investment is Rs 10. Meaning, each one of us gets 1000 units. (These 1000 units at Rs 10 per unit is worth our initial investment of Rs 10,000 each).

Total units in the fund are 10,000.

Now when the value of this investment goes up to Rs 1.4 lakh (due to market movement, change in prices of underlying bonds and shares), and if no new person has invested in the fund and nobody exited, the units are still 10000. This causes the per unit value of Rs 10 to increase to Rs 14. (Rs 1.4 lakh/10000).

Rs 14 is the NAV. Net Asset Value (per unit).

Similarly, with same units in the fund if the fund value reduces, so will the NAV.

Because the debt instrument (example bonds) and equity instruments (example stocks/shares) are traded in the market, the movement in their prices cause the rise or fall in fund value. This along with other factors.(we we will skip for now to keep it simple)

Do subscriptions and withdrawal affect NAV?

Continuing with our example, now I have decided to withdraw Rs 5000 from my share. At the NAV of 14, the fund manager will sell my 5000/14 = 357.142 units and give me Rs 5000.

A few things happened here,

  • The total units in fund reduced to 10000–357.142 = 9642.858
  • The AUM also reduced to 140000–5000 = 1,35,000

The NAV still remains 135000/9642.858 = 13.9999 ~ 14

Instead of the withdrawal, if someone new had come and invested Rs 10000, let’s see what would happen :

  • He will get 10000/14 = 714.285 units
  • Total units will increase to 10714.285
  • The AUM will increase to 1.50 lakh

The NAV still remains 14.

The subscriptions and withdrawals alone does not affect the NAV.

Should I invest in Mutual Fund or Fixed Deposit

While fixed deposit and debt mutual funds can be compared to each other since both lend money and earn interest (both are debt instruments), one should never compare fixed deposit against equity mutual fund.

The comparison of instruments to invest in comes after a) why you want to invest (your goals) and b) in what proportion of risk that is debt and equity (asset allocation).

If you are confused between debt OR equity, you should go two steps back and work on goals and allocation first.

Now, let’s look at the differences between Debt Mutual fund and fixed deposit :

  • Returns : FD returns are 6–8% while debt Mutual fund give you between 7–8%. Some give slightly more also, but there are other variables at play there.
  • Risk : FD has no risk. Your money is with the bank. MF has low risk. See mutual funds that invest in Government bonds will suffer if government defaults (extremely unlikely). Or you can chose a mutual fund that invests in ‘investment grade’ bonds only (the rating of bonds is mentioned in mutual fund prospectus). The probability of these corporates to default on payments is again very low.
  • Cost : FD has no management cost involved while MFs have expense ratio (percentage of fund’s asset used for administrative and operating expenses). Regular MFs have more expense ratio than direct MFs.
  • Withdrawal : FD comes with a penalty for early withdrawals. MFs may or may not have exit loads. These are more prevalent in equity funds.
  • Method of Investment : FD is a lump-sum investment while you can invest in MF with lump-sum or SIP.
  • Taxes : The returns from FD is interest income while return from MF is capital gain. And that makes all the difference to post tax returns. Meaning, the return from FD is considered as income and taxed as per your income slab (returns below Rs 40,000 per year is tax exempted, revised in 2019). Plus you are taxed whether or not the FD matures in that financial year. Mutual Funds returns on other hand, are only taxed when you withdraw and actually book some gains. If you withdraw after 3 years, the tax is further reduced due to indexation (too technical for this intro post).

I personally prefer liquid and short term funds over FD. All these factors together may mean that FD is a better option for you. May be not. FD is the safest investment product but this comes at a cost of lower returns.

This is my agreement with my mother — If FD gives you good night sleep, by all means stay invested with what you have. But if it makes sense for you to take a little risk for better return, diversify your new investments into Mutual funds too.

And it makes sense for her. She has FD and the dear NAV to back her up!

Again, none of this is an investment advice. I write what I read for my personal finance.(I realise this should go as permanent disclaimer somewhere on the blog)

Originally published at She Talk Cents.

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