Study of basic Relationships of Equity Funds and Debt Funds

Study of basic Relationships of Equity Funds and Debt Funds




Equity Funds

Equity funds are considered to be the more risky funds as compared to other fund types, but they also provide higher returns than other funds. It is advisable that an investor looking to invest in an equity fund should invest for long term i.e. for 3 years or more. There are different types of equity funds each falling into different risk bracket. In the order of decreasing risk level, there are following types of equity funds:

  1. Aggressive Growth Funds: In Aggressive Growth Funds, fund manager aspire for maximum capital appreciation and invest in less researched shares of speculative character. Because of these speculative investments Aggressive Growth Funds become more volatile and consequently, are inclined to higher risk than other equity funds.
  2. Growth Funds Growth Funds also invest for capital appreciation (with time horizon of 3 to 5 years) but they are different from Aggressive Growth Funds in the sense that they invest in companies that are expected to outperform the market in the future. Without thoroughly adopting speculative strategies, Growth Funds invest in those companies that are expected to post above average earnings in the future.
  3. Speciality Funds: Speciality funds have stated criteria for investment and their portfolio comprises of only those companies that meet their criteria. Criteria for some speciality funds could be to invest/not to invest in particular regions/companies. Speciality funds are concentrated and consequently, are comparatively riskier than diversified funds. These are following types of speciality funds:

a) Sector Funds: Equity funds that invest in a particular sector/industry of the market are known as Sector Funds. The exposure of these funds is limited to a particular sector (say Information Technology, Auto, Banking, Pharmaceuticals or Fast Moving Consumer Goods) which is why they are more risky than equity funds that invest in multiple sectors.

b) Foreign Securities Funds: Foreign Securities Equity Funds have the option to invest in one or more foreign companies. Foreign securities funds unprotected to international diversification and hence they are less risky than sector funds. However, foreign securities funds are exposed to foreign exchange rate risk and country risk.

c) Mid-Cap or Small-Cap Funds: Funds that invest in companies having lower market capitalization than large capitalization companies are called Mid-Cap or Small-Cap Funds. Market capitalization of Mid-Cap companies is less than that of big, blue chip companies (less than Rs. 2500 crores but more than Rs. 500 crores) and Small-Cap companies have market capitalization of less than Rs. 500 crores. Market Capitalization of a company can be calculated by multiplying the market price of the company’s proportion by the total number of its noticeable shares in the market. The shares of Mid-Cap or Small-Cap Companies are not as liquid as of Large-Cap Companies which gives rise to volatility in proportion prices of these companies and consequently, investment gets risky.

  1. Diversified Equity Funds Except for a small portion of investment in liquid money market, diversified equity funds invest mainly in equities without any concentration on a particular sector(s). These funds are well diversified and reduce sector-specific or company-specific risk. However, like all other funds diversified equity funds too are exposed to equity market risk. One noticeable kind of diversified equity fund in India is Equity connected Savings Schemes (ELSS). As per the mandate, a minimum of 90% of investments by ELSS should be in equities at all times. ELSS investors are eligible to claim deduction from taxable income (up to Rs 1 lakh) at the time of filing the income tax return. ELSS usually has a lock-in period and in case of any redemption by the investor before the expiry of the lock-in period makes him liable to pay income tax on such income(s) for which he may have received any tax exemption(s) in the past.
  2. Equity Index Funds Equity Index Funds have the objective to match the performance of a specific stock market index. The portfolio of these funds comprises of the same companies that form the index and is constituted in the same proportion as the index. Equity index funds that follow general indices (like S&P CNX Nifty, Sensex) are less risky than equity index funds that follow thin sectoral indices (like BSEBANKEX or CNX Bank Index etc). thin indices are less diversified and consequently, are more risky.
  3. Value Funds Value Funds invest in those companies that have sound fundamentals and whose proportion prices are currently under-valued. The portfolio of these funds comprises of shares that are trading at a low Price to Earning Ratio (Market Price per proportion / Earning per proportion) and a low Market to Book Value (basic Value) Ratio. Value Funds may select companies from diversified sectors and are exposed to lower risk level as compared to growth funds or speciality funds. Value stocks are generally from cyclical industries (such as cement, steel, sugar etc.), which make them volatile in the short-term. consequently, it is advisable to invest in Value funds with a long-term time horizon as risk in the long term, to a large extent, is reduced.
  4. Equity Income and Debt provide Funds: The objective of Equity Income or Dividend provide Equity Funds is to generate high recurring income and steady capital appreciation for investors by investing in those companies which issue high dividends (such as strength or Utility companies whose proportion prices fluctuate comparatively lesser than other companies’ proportion prices). Equity Income or Dividend provide Equity Funds are generally exposed to the lowest risk level as compared to other equity funds.

DEBT FUNDS

Funds that invest in medium to long-term debt instruments issued by private companies, edges, financial institutions, governments and other entities belonging to various sectors (like infrastructure companies etc.) are known as Debt / Income Funds. Debt funds are low risk profile funds that seek to generate fixed current income (and not capital appreciation) to investors. In order to ensure regular income to investors, debt (or income) funds spread large fraction of their surplus to investors. Although debt securities are generally less risky than equities, they are unprotected to credit risk (risk of default) by the issuer at the time of interest or principal payment. To minimize the risk of default, debt funds usually invest in securities from issuers who are rated by credit rating agencies and are considered to be of “Investment Grade”. Debt funds that target high returns are more risky. Based on different investment objectives, there can be following types of debt funds:

1) Diversified Debt Funds: Debt funds that invest in all securities issued by entities belonging to all sectors of the market are known as diversified debt funds. The best characterize of diversified debt funds is that investments are properly diversified into all sectors, which results in risk reduction.

2) High provide Debt Funds: As we now understand thatrisk of default is present in all debt funds, and consequently, debt funds generally try to minimize the risk of default by investing in securities issued by only those borrowers who are considered to be of “investment grade”. But, High provide Debt Funds adopt a different strategy and prefer securities issued by those issuers who are considered to be of “below investment grade”. The motive behind adopting this sort of risky strategy is to earn higher interest returns from these issuers. These funds are more volatile and bear higher default risk, although they may earn at times higher returns for investors.

3) Assured Return Funds: Although it is not necessary that a fund will meet its objectives or provide assured returns to investors, but there can be funds that come with a lock-in period and offer assurance of annual returns to investors during the lock-in period. Any shortfall in returns is suffered by the sponsors or the Asset Management Companies (AMCs). These funds are generally debt funds and provide investors with a low-risk investment opportunity. However, the security of investments depends upon the net worth of the guarantor (whose name is stated in improvement on the offer document). To safeguard the interests of investors, SEBI permits only those funds to offer assured return schemes whose sponsors have adequate net-worth to guarantee returns in the future. In the past, UTI had offered assured return schemes (i.e. Monthly Income Plans of UTI) that assured stated returns to investors in the future. UTI was not able to fulfill its promises and faced large shortfalls in returns. ultimately, government had to intervene and took over UTI’s payment obligations on itself. Currently, no AMC in India offers assured return schemes to investors, though possible.

4) Fixed Term Plan Series: Fixed Term Plan Series usually are closed-end schemes having short-term maturity period (of less than one year) that offer a series of plans and issue units to investors at regular intervals. Unlike closed-end funds, fixed term plans are not listed on the exchanges. Fixed term plan series usually invest in debt / income schemes and target short-term investors. The objective of fixed term plan schemes is to gratify investors by generating some expected returns in a short period.

examination OF DEBT AND EQUITY FUND

Debt Funds

– They must be repaid or refinanced.

– Requires regular interest payments. Company must generate cash flow to pay.

– Collateral assets must usually be obtainable.

– Debt providers are conservative. They cannot proportion any upside or profits. consequently, they want to eliminate all possible loss or downside risks.

– Interest payments are tax deductible.

– Debt has little or no impact on control of the company.

  • Debt allows leverage of company profits.

Equity Funds

– They can usually be kept permanently.

– No payment requirements. May receive dividends, but only out of retained earnings.

– No collateral required.

– Equity providers are aggressive. They can accept downside risks because they fully proportion the upside in addition.

– Dividend payments are not tax deductible.

– Equity requires shared control of the company and may impose restrictions.

  • Shareholders proportion the company profits.

Importance of using Debt Funds:

  • Debt is not an ownership interest in the business. Creditors generally do not have voting strength.

– The payment of interest on debt is considered a cost of doing business and is fully tax deductible.

Importance of using EquityFunds:

  • Unlike obligation of debt, your business will not have any contractual obligation to pay for equity dividend
  • Equity financing also allows your business to acquire funds without incurring debt, or without having to repay a specific amount of money at a particular time.

Equity financing also allows your business to acquire funds without incurring debt, or without having to repay a specific amount of money at a particular time. Recent deals by equity funds are much larger than in the past. And debt funds are now doing larger “club” deals. Both types of funds have more money under management than ever before. More cash is chasing deals, causing overlap where both types of funds vie over the same company.

Although these funds do not represent long-term threats to each other, secured lenders must recognize that equity and debt funds have marked different characteristics, goals and behaviors. The most basic difference in equity funds seeks to buy all of the equity of companies debt funds are not constrained to controlling equity investments. Highlighted below are other major differences between the both types of funds.

Whether investing in debt or equity, debt funds typically need a much more rapid exit strategy than equity funds. Debt funds generally seek a quick flip of their investments. However, some debt fund investments are “loan to own” that is, they buy debt at a thorough discount with an eye towards converting that debt to equity, then magnetizing that equity (by a recapitalization, refinancing, sale, merger or other disposition) in a short time period. This is a function of, among other things, the liquidity and leverage differences between the two types of funds. The time-keep up differences directly affect the exit strategy, risk tolerance and desired rate of return of the two types of funds.

consequently, Investing money for short-term has generally been an issue. As it is the interest rates / returns are quite low. On top of this, there could be taxation issues, which will further reduce the effective returns. Equity funds may not be a prudent option for short-term. consequently, we need to consider mainly the interest-based investment options. In the equity funds, higher the risk you take, the higher the returns you can get. Since there’s a known cash flow associated with debt, the risk is less. But the returns are also less. When compared with equity funds, the risk for the latter may be more. This is because there’s a steady cash flow associated with debt funds. In fact, the interest which the debt fund promises to pay (known as ‘coupon’ in financial parlance) is one of the basic attributes of a debt fund.

However, debt fund shares a very basic relationship with interest rates. To understand this relationship and how that can be used in present day context to make money, you must understand the basics of debt.




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