What is the Difference Between Equity and Debt Funds? Legal Aspects Explained

In today’s financial world, mutual funds have emerged as one of the most preferred investment options among Indians. Mutual funds pool money from investors and invest in diversified asset classes like stocks, bonds, and other securities. Two of the most common categories of mutual funds are equity funds and debt funds.

While investors often choose between the two based on returns and risks, there are also crucial legal aspects that govern the operation, regulation, and taxation of these funds in India.

In this article, we will understand the difference between equity and debt funds, legal frameworks, investor protections, and tax implications, making it easier for you to make an informed investment decision.

What are Equity Funds?

Equity funds primarily invest in shares of listed companies. Their main objective is to generate higher returns by participating in the company’s growth and profits. Equity funds are market-linked instruments, meaning their returns depend on the stock market’s performance.

Types of equity funds include:

• Large-cap funds
• Mid-cap funds
• Small-cap funds
• Multi-cap funds
• Sectoral/thematic funds

They are ideal for investors with a higher risk appetite and a long-term investment horizon.

What are Debt Funds?

Debt funds invest in fixed-income securities like government bonds, corporate bonds, debentures, treasury bills, and commercial papers. The objective is to provide regular income and preserve capital.

Types of debt funds include:

• Liquid funds
• Short-term funds
• Corporate bond funds
• Gilt funds
• Fixed maturity plans (FMPs)

Debt funds are suited for conservative investors who prefer stable returns with lower risk exposure.

Key Differences Between Equity and Debt Funds

Legal Framework Governing Equity and Debt Funds in India

Mutual funds in India, including equity and debt funds, are governed by a comprehensive regulatory framework to ensure transparency, investor protection, and smooth functioning of the market.

SEBI (Mutual Funds) Regulations, 1996

The Securities and Exchange Board of India (SEBI) regulates mutual funds through the SEBI (Mutual Funds) Regulations, 1996. These regulations:

• Define mutual funds.
• Specify registration procedures.
• Regulate investment norms, disclosures, and operational procedures.
  

Fund Houses (Asset Management ompanies or AMCs) must be registered with SEBI to launch and manage mutual fund schemes.

Investment Restrictions

• Equity funds must invest at least 65% of their corpus in equity and equity-related instruments to qualify as an equity-oriented fund.
• Debt funds are subject to restrictions on investment concentration, maturity profiles, and credit ratings.

These restrictions aim to minimise risks and protect investors’ interests.

Disclosure Requirements

Mutual funds must disclose their Net Asset Value (NAV) on a daily basis (for most funds) and provide detailed information about the portfolio, fund manager, risks, and performance.

Compliance and Audit

• Regular audits and compliance checks are mandated by SEBI.
• An independent trustee oversees the functioning of the fund to protect investors’ interests.

Legal Protections for Investors

Investing in mutual funds is relatively safer compared to unregulated schemes because of the robust legal protections in place:

SEBI Investor Protection Measures

• Grievance Redressal: Investors can lodge complaints through SEBI’s SCORES portal.
• Mandatory Risk-O-Meter: Every fund must display a Risk-O-Meter indicating the level of risk.
• Fair Valuation Norms: Funds must follow SEBI’s valuation norms ensuring fair pricing of securities.

KYC Norms

Investors must comply with Know Your Customer (KYC) norms before investing. This helps in verifying the identity and tracking the source of funds, thereby preventing money laundering activities.

AMFI Code of Conduct

The Association of Mutual Funds in India (AMFI) has laid down a code of conduct for mutual fund distributors, ensuring that they act in the best interests of investors.

Role of Trustees

Trustees appointed under the Trust Deed act as watchdogs over the Asset Management Companies (AMCs) to ensure they work in accordance with SEBI regulations and in the investors’ best interests.

Legal Distinction in Risk Factors

1. Equity Funds

• Market Risk: Prices of stocks fluctuate due to company-specific or macroeconomic reasons.
• Liquidity Risk: Risk that the fund may not be able to sell investments when needed.
• Regulatory Risk: Sudden regulatory changes can impact equity markets.

2. Debt Funds

• Credit Risk: Risk of default by the issuer of the bond.
• Interest Rate Risk: Bond prices fall when interest rates rise.
• Reinvestment Risk: Risk of returns falling if interest rates decline.

SEBI mandates mutual funds to disclose risk factors comprehensively in the Scheme Information Document (SID) and Key Information Memorandum (KIM).

Compliance Obligations for Fund Managers

Asset Management Companies (AMCs) managing mutual funds must comply with several obligations:

• Periodic Reporting to SEBI.
• Adherence to Scheme Objectives as specified in the offer document.
• Avoidance of Mis-selling: Fund managers and distributors must avoid making misleading claims about returns.

Violation of SEBI norms can result in penalties, suspension of licenses, and other legal action.

Conclusion

While both equity funds and debt funds offer unique advantages, they cater to different types of investors based on risk appetite, investment horizon, and return expectations.

However, beyond financial considerations, understanding the legal aspects is equally crucial. SEBI’s strict regulations, tax laws, and investor protection frameworks ensure that investors’ interests are safeguarded while investing in mutual funds.

Before making an investment, one must carefully read the scheme documents, understand the associated risks, and if required, consult a financial advisor or legal expert.