For long-term wealth creation, ULIPs and Mutual funds have long been the favourite options among the investors. Mutual funds let you invest in market-linked securities like fixed-income instruments, stocks and more. Unit Linked Insurance Plans (ULIPs) also offer exposure to market-linked funds, including equity, hybrid and debt options. So, what sets these two apart? Although they may seem similar, there are several key differences between them. This article explores the key differences in detail.
Mutual funds versus ULIPs – Understanding the risk and return potential
Risk
Risk cannot be classified in simple terms as high or low. It is also important to understand the nuances of risk when comparing ULIPs and mutual funds.
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Mutual Funds: The risk profile of a mutual fund largely depends on its investment strategy. The Securities and Exchange Board of India (SEBI) classifies mutual funds into three broad categories – equity, debt and hybrid- with each presenting a different level of risk, as discussed below:
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Equity funds mainly invest in stocks and are considered high-risk
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Debt funds focus on fixed-income securities such as bonds, Treasury bills and more, making them relatively low-risk
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Hybrid funds combine equity and debt in varying proportions, offering medium risk
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Mutual fund houses are required to use a riskometer to indicate the amount of risk they carry and ensure transparency. The meter represents the level of risk associated with a fund, ranging from high to low, and helps you assess whether a particular fund aligns with your risk tolerance.
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Equity funds carry higher risk due to market fluctuations
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Debt funds are relatively safer and stable
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Hybrid funds offer a middle ground with balanced risk
However, unlike mutual funds, ULIPs offer flexibility in risk management, allowing investors to switch between funds. For instance, when markets decline, ULIP holders can switch their investments from equity funds to debt funds. This strategic move helps preserve capital by reducing exposure to volatile equity markets. Once the market stabilizes or begins to recover, switching back to equity funds can lead to quicker rebounds in investment value compared to mutual funds. This is because the switching mechanism in ULIPs allows for a more agile response without triggering capital gains taxes or exit loads.
This switching facility in the ULIPs enables you to actively manage your portfolio, adjust risk levels, and ensure that your financial goals are met.
In this sense, ULIPs offer a more dynamic approach to risk management. They are adaptable to changing market conditions and allow you to factor in your personal risk tolerance at any given point in time.
Returns
Both mutual funds and ULIPs offer market-linked returns, and their performance depends on the type of fund chosen. However, there are some distinctions here, too.
However, mutual fund returns are not guaranteed. If the market performs badly, you may lose capital. Moreover, there is no assurance of recovering from your losses within a specific timeframe. Mutual fund investors must essentially ride out market volatility and may need to adopt a long-term strategy to recover from downturns, especially in the case of equity or hybrid schemes.
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ULIPs: ULIPs also generate market-linked returns, but they also offer an additional advantage. In addition to market-linked returns, ULIP plans include a life cover element that provides a guaranteed sum assured in case of the policyholder’s demise. Regardless of market conditions, the plan’s beneficiary receives a payout, which ensures their financial security. This feature makes ULIPs distinct from mutual funds.
Additionally, the option to switch between funds in ULIPs not only enhances your returns but also gives you greater control over your investments. Unlike mutual funds, where you must first redeem your units and then reinvest them in a new scheme, ULIPs allow you to switch between equity, debt, and hybrid funds without exiting the policy. You can use this to protect your capital against market downturns and boost your funds to recover faster once the market recovers.
Additional advantages
One indirect way to enhance your overall returns is through tax savings. The less tax you pay, the more money you have to save, invest or use for other financial goals.
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Mutual funds: For the most part, mutual funds do not offer tax benefits. Moreover, the gains are taxed as per the prevailing capital gain tax laws.
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ULIPS: ULIPs qualify for tax benefits under certain sections of the Income Tax Act, 1961. The premium paid towards a ULIP is eligible for a deduction under Section 80C, up to a limit of ₹1.5 lakh per annum. Additionally, the maturity proceeds of a ULIP may also be tax-free under Section 10(10D), provided certain conditions are met.
To sum it up
While mutual funds and ULIPs may appear similar, their differences can lead to very different outcomes. Understanding these nuances is important to ensuring that your choice aligns with your financial goals.