Article

Retiring easy - Equity funds versus debt funds

01 Nov 2019

Retirement planning is undoubtedly a key aspect of your long term financial plan. But you have a choice of different types of mutual funds. You have equity funds, debt funds and balanced funds; not to mention the sub-categories in each of them. How do you plan your retirement; via debt funds, equity funds or a mix of the two? Let us start by looking at the best mutual funds in these categories to get a quick idea. We focus only on Growth Options of Regular Plans (ranked on 5-year returns).

Top Equity Funds

1-Year Returns (%)

3-Year Returns (%)

5-Year Returns (%)

Mirae Large cap (G)

12.531%

11.466%

12.697%

JM Core 11 Fund (G)

19.239%

9.781%

12.672%

Axis Blue-chip Fund (G)

24.495%

15.548%

12.397%

Top G-Sec Funds

1-Year Returns (%)

3-Year Returns (%)

5-Year Returns (%)

Nippon Gilt Fund (G)

15.699%

8.318%

10.516%

SBI Magnum Gilt (G)

15.217%

7.911%

10.328%

Birla G-Sec Fund (G)

14.928%

7.732%

10.281%

Data Source: Morningstar

How equity and debt funds compare on returns?

In the case of equity and debt funds, the short period returns over 1 year can be quite misleading. For example, G-Sec funds have done extremely well over the last one year due to bond yields falling from 8.3% to 6.5% during this period. That has translated into windfall capital gains for government securities funds. However, if you look at the two types of mutual funds, the return differential over a five year period is just over 200 bps. These are returns in pre-tax terms and we shall look at the post tax returns subsequently.

How equity and debt funds compare on the risk aspect?

Now is the time to be a little more nuanced in our approach to the type of mutual funds to be selected. Over the last five years, the top equity funds have earned CAGR that is over 200 bps more than debt funds. The normal argument is that equity funds are prima facie more risky than debt funds as debt funds are more stable and hence more predictable. There are 3 aspects to understand about risk here.

Firstly, if you consider equity funds for more than five years, the probability of negative returns is almost negligible. This substantially tones down the risk. Secondly, in the longer time frame of 15-20 years (normal for retirement planning), the biggest risk is “not taking adequate risk”. Thirdly, debt funds are not entirely risk free. While G-Sec funds may be free of default risk, they are vulnerable to interest rate risk and inflation risk. Also if you go lower in the credit ranking for higher returns, then risk also proportionately increases. We have seen enough number of debt fund defaults in the last one year to appreciate this point.

How do equity and debt funds compare on tax efficiency?

A couple of years back, the answer would have clearly favoured equity funds. However, post April 2018, equity fund profits are subject to 10% tax on LTCG above Rs.1 lakh. Let us see how equity and debt funds compare for retirement planning in the new scenario. We shall assume that investor has allocated a fixed lump sum of Rs.10 lakh in Mirae Large Cap Equity Fund and Rs.10 lakh in Nippon Gilt Fund. We assume that the 5-year CAGR for both the funds have sustained over a 10 year period also. Here is how these two top mutual funds actually perform in post tax terms.

Equity Fund

Amount

Debt Fund

Amount

Initial Investment

Rs.10,00,000

Initial Investment

Rs.10,00,000

Invested in

Oct-09

Invested in

Oct-09

Redeemed in

Sep-19

Redeemed in

Sep-19

10-Year CAGR

12.697%

10-Year CAGR

10.516%

Value in Sep-19 (A)

Rs.33,04,635

Value in Sep-19 (Y)

Rs.27,18,013

Capital Gains

Rs.23,04,635

Capital Gains

Rs.17,18,013

Exempt capital gains

Rs.1,00,000

Index ratio (2019/2009)

280/137

Taxable capital gains

Rs.22,04,635

Indexed cost of purchase

Rs.20,43,796

Tax at 10% (B)

Rs.2,20,464

Indexed capital gains

Rs.6,74,217

Post tax value (A-B)

Rs.30,84,171

LTCG tax at 20% (Z)

Rs.1,34,843

 

 

Post Tax Value (Y-Z)

Rs.25,83,170

Clearly, the equity fund still outperforms the debt fund in post tax terms. However, the effective tax on the debt fund (post indexation) is less than 8% as against nearly 10% for equity fund. That is something to keep in mind when comparing the two types of mutual funds over a longer term retirement plan.

Summing it together: How to balance equity and debt funds?

Clearly, both equity funds and debt funds have managed to give above average returns, even in post tax terms. How to balance the two types of mutual funds in your retirement plan? There are two important factors here. Firstly, if you are starting early, then you can allow equity funds to predominate in the retirement plan mix and every five years, you can tweak the equity mix lower and the debt mix higher.

The more important aspect is of liquidity. Your retirement plan has a milestone and you must avoid getting married to price risk close to your retirement. Plan a phased shift to debt funds or liquid funds, at least 2 years prior to your retirement milestones. This will ensure a smooth and hassle-free retirement for you. Between the aggression of equity and the stability of debt, the retirement truth lies somewhere in between!

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Beginner's Corner

Retiring easy - Equity funds versus debt funds

01 Nov 2019

Retirement planning is undoubtedly a key aspect of your long term financial plan. But you have a choice of different types of mutual funds. You have equity funds, debt funds and balanced funds; not to mention the sub-categories in each of them. How do you plan your retirement; via debt funds, equity funds or a mix of the two? Let us start by looking at the best mutual funds in these categories to get a quick idea. We focus only on Growth Options of Regular Plans (ranked on 5-year returns).

Top Equity Funds

1-Year Returns (%)

3-Year Returns (%)

5-Year Returns (%)

Mirae Large cap (G)

12.531%

11.466%

12.697%

JM Core 11 Fund (G)

19.239%

9.781%

12.672%

Axis Blue-chip Fund (G)

24.495%

15.548%

12.397%

Top G-Sec Funds

1-Year Returns (%)

3-Year Returns (%)

5-Year Returns (%)

Nippon Gilt Fund (G)

15.699%

8.318%

10.516%

SBI Magnum Gilt (G)

15.217%

7.911%

10.328%

Birla G-Sec Fund (G)

14.928%

7.732%

10.281%

Data Source: Morningstar

How equity and debt funds compare on returns?

In the case of equity and debt funds, the short period returns over 1 year can be quite misleading. For example, G-Sec funds have done extremely well over the last one year due to bond yields falling from 8.3% to 6.5% during this period. That has translated into windfall capital gains for government securities funds. However, if you look at the two types of mutual funds, the return differential over a five year period is just over 200 bps. These are returns in pre-tax terms and we shall look at the post tax returns subsequently.

How equity and debt funds compare on the risk aspect?

Now is the time to be a little more nuanced in our approach to the type of mutual funds to be selected. Over the last five years, the top equity funds have earned CAGR that is over 200 bps more than debt funds. The normal argument is that equity funds are prima facie more risky than debt funds as debt funds are more stable and hence more predictable. There are 3 aspects to understand about risk here.

Firstly, if you consider equity funds for more than five years, the probability of negative returns is almost negligible. This substantially tones down the risk. Secondly, in the longer time frame of 15-20 years (normal for retirement planning), the biggest risk is “not taking adequate risk”. Thirdly, debt funds are not entirely risk free. While G-Sec funds may be free of default risk, they are vulnerable to interest rate risk and inflation risk. Also if you go lower in the credit ranking for higher returns, then risk also proportionately increases. We have seen enough number of debt fund defaults in the last one year to appreciate this point.

How do equity and debt funds compare on tax efficiency?

A couple of years back, the answer would have clearly favoured equity funds. However, post April 2018, equity fund profits are subject to 10% tax on LTCG above Rs.1 lakh. Let us see how equity and debt funds compare for retirement planning in the new scenario. We shall assume that investor has allocated a fixed lump sum of Rs.10 lakh in Mirae Large Cap Equity Fund and Rs.10 lakh in Nippon Gilt Fund. We assume that the 5-year CAGR for both the funds have sustained over a 10 year period also. Here is how these two top mutual funds actually perform in post tax terms.

Equity Fund

Amount

Debt Fund

Amount

Initial Investment

Rs.10,00,000

Initial Investment

Rs.10,00,000

Invested in

Oct-09

Invested in

Oct-09

Redeemed in

Sep-19

Redeemed in

Sep-19

10-Year CAGR

12.697%

10-Year CAGR

10.516%

Value in Sep-19 (A)

Rs.33,04,635

Value in Sep-19 (Y)

Rs.27,18,013

Capital Gains

Rs.23,04,635

Capital Gains

Rs.17,18,013

Exempt capital gains

Rs.1,00,000

Index ratio (2019/2009)

280/137

Taxable capital gains

Rs.22,04,635

Indexed cost of purchase

Rs.20,43,796

Tax at 10% (B)

Rs.2,20,464

Indexed capital gains

Rs.6,74,217

Post tax value (A-B)

Rs.30,84,171

LTCG tax at 20% (Z)

Rs.1,34,843

 

 

Post Tax Value (Y-Z)

Rs.25,83,170

Clearly, the equity fund still outperforms the debt fund in post tax terms. However, the effective tax on the debt fund (post indexation) is less than 8% as against nearly 10% for equity fund. That is something to keep in mind when comparing the two types of mutual funds over a longer term retirement plan.

Summing it together: How to balance equity and debt funds?

Clearly, both equity funds and debt funds have managed to give above average returns, even in post tax terms. How to balance the two types of mutual funds in your retirement plan? There are two important factors here. Firstly, if you are starting early, then you can allow equity funds to predominate in the retirement plan mix and every five years, you can tweak the equity mix lower and the debt mix higher.

The more important aspect is of liquidity. Your retirement plan has a milestone and you must avoid getting married to price risk close to your retirement. Plan a phased shift to debt funds or liquid funds, at least 2 years prior to your retirement milestones. This will ensure a smooth and hassle-free retirement for you. Between the aggression of equity and the stability of debt, the retirement truth lies somewhere in between!