Mutual funds give better returns over a period than the average inflation rate and equity funds are best suited for investors inclined to benefit from the highs and lows of the shares market.(Bloomberg)
Mutual funds give better returns over a period than the average inflation rate and equity funds are best suited for investors inclined to benefit from the highs and lows of the shares market.(Bloomberg)

Personal finance: It’s good to go into debt (funds)

By Abeer Ray
UPDATED ON JAN 04, 2021 01:01 PM IST

If you’ve been reading this space, you’d know about the fundamental questions you need to ask yourself before investing (short goal, long goal, risk appetite, age of retirement; and then, revisit them at a later stage) and the different kinds of mutual funds there are. Today, we’ll talk a bit about asset allocation, or to put it differently, why debt funds could be an important element in your investment portfolio.

As we mentioned last week, mutual funds give better returns over a period than the average inflation rate and equity funds are best suited for investors inclined to benefit from the highs and lows of the shares market. However, is it wise to opt for equity funds alone? Returns on equity stocks may leave you inclined to say, why not. But there is always the risk of loss of capital. The wisdom of the herd derives from stock market crashes and therefore, preaches reliance on fixed-income assets like fixed deposits, government bonds, etc.

Domestic equity indices tanked hard in September 2020 after their US counterpart received a hit following the poor performance of the American economy. Amidst the fear of resurging coronavirus cases in the European countries, Indian investors witnessed a slump in both the indices as the country’s domestic economy mirrored the sentiments of its western counterpart. A debt allocation would have perhaps saved from such unforeseen losses.

The underlying instruments of most debt funds sold in the market are fixed income deposits and money market instruments. Manish Kothari, co-founder and CEO, ZFunds, an online mutual fund platform in India said, “It is true that currently, debt instruments are earning interest rates that are lower than inflation, but they can provide a safe investment option with a fairly stable income. Equities can turn volatile as we have seen many times in the past and sometimes for very long periods too. In order to make your portfolio less correlated to stock market falls, a portion of one’s assets should be invested in debt instruments.”

What’s more, if you break a debt fund (for an emergency, or to meet a short-term goal), you would not need to sell your higher returning but more volatile equity asset and incur a loss. “It is recommended to add some fixed income instruments like fixed deposits, Post Office Schemes, government schemes, etc. offering guaranteed returns and debt mutual funds,” Raj Khosla, founder and managing director, MyMoneyMantra, an online comparison portal for loans and credit cards, said.

Here’s what to look for when you’re picking out a debt fund: Consistent performance, corpus size (the total amount of money invested by all investors in a debt fund; a big corpus fund indicates greater stability), risk factors involved like credit and interest rate risks, growth in returns over time and expense ratio (fund’s operational expenses divided by its average assets; the lesser the better).

There’s also hybrid fund, which invests in both equity and debt instruments — the high-risk factor synonymous with equity is balanced with stable returns from fixed interest-bearing instruments. Depending on your risk appetite, one can choose between aggressive hybrid funds (up to 75 per cent exposure to equity and 25 per cent exposure to debt) and conservative hybrid funds (roughly 70 per cent exposure to debt and 30 per cent to equity).

How does one decide which sort of hybrid fund to invest in? According to Kothari, it comes down to two things: risk appetite and time horizon. For investors looking for a regular stable income in their portfolio, a conservative hybrid fund is surely suitable. However, for investors who can afford the ups and downs, an aggressive fund could generate higher returns. If the investment horizon is short, a conservative fund would score over an aggressive hybrid fund, because the latter can see lower returns or even losses in the short to medium term, as they invest predominantly in equities. For longer time horizons of say five years or more, aggressive hybrid funds can provide much higher inflation-beating returns.

At any rate, staying invested in debt and hybrid funds for long periods (10-15 year cycle) is the key to earning returns that not only beat inflation rates but also help meet financial goals. New first-time investors investing for say five years can earn returns good enough to buy a car. The risk of volatility is low since a part of the investment is debt funds.

Personal Finance is a weekly feature that aims to provide our readers pertinent and helpful financial information.

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