In his first Union Budget Finance Minister Arun Jaitley in July'14, made debt funds at par with all debt products available in the market. The tax advantage which debt funds enjoyed over other financial products was removed by the FM, which eventually impacted inflows into debt funds. A year later, fund houses have found a unique way to give investors returns with less risk, but with tax advantage of equity funds. These are called Equity Savings Funds.
In the past few months, many fund houses like Tata Asset Management Company, Axis AMC, Reliance AMC, SBI AMC and DSP BlackRock AMC have come out with a product category known as Equity Savings Funds. Several other fund houses are also planning to launch new schemes under this category.
Debt funds, particularly Fixed Maturity Plans (FMPs) were the worst hit, after the Finance Minister announced plans to hike the tax rate of long-term capital gains from 10% to 20% on transfer of mutual fund units and increase the holding period for such funds from 12 months to 36 months for this purpose. Until then, debt funds had enjoyed tax arbitrage as investors investing in debt mutual funds had to pay capital gains tax at 10.3% (without indexation) or 20.6% (with indexation). At that time, the net out go was significantly reduced for investors who used indexation benefits as it allowed them to adjust their total gains for inflation.
An investor in a simple fixed deposit is typically charged tax deducted at source based on his income tax slab. Such idea of giving tax advantage to debt funds was meant to promote retail investors' interest in such schemes. But there were some loopholes and debt funds evolved as a perfect place for fund houses to sell to corporates who wanted to park their idle cash at low rates.
But everything changed post Union Budget 2014 as there was complete parity among all debt products available in the markets. However, in the last few months some equity products have evolved and investors get returns in line with debt products, but with the tax efficiency of equity-oriented funds.
What Are Equity Savings Funds
Typically, most Equity Saver Funds are open-ended equity schemes that attempt to generate capital appreciation and income distribution, by investing in multiple asset classes - equity, hedged equity (arbitrage opportunities) and debt. In the global market, research shows that the bulk of any portfolio's performance can be explained by its asset allocation. Though such kind of asset allocation in India is a new concept, there is no major history to prove its returns records.
Equity Savings Funds rely on asset allocation across multiple asset classes in order to seek reasonable returns while bringing down risks for investors. For example, the recently launched Axis Equity Saver Fund will invest in different investment avenues like equity, arbitrage and debt within a common fund. Such combined portfolios have lower risks compared to pure equity products. Therefore, they allow investors to plan for their long-term goals without getting affected by short-term fluctuations in the market.
Axis Equity Saver Fund seeks to invest around 25% to 40% in equity (there is no bias in stock picking), another 25% to 30% in fixed income for regular income and lower risks, and the remaining portion to be hedged in arbitrage opportunities. Although other funds also follow the same procedure, there could be a minor difference depending upon their in-house capabilities.
Tata Regular Saving Equity Fund was structured by changing some of the fundamental attributes of Tata Monthly Income Funds. In Tata Regular Saving Equity Fund, the strategy will be 0% to 35% allocation to net long equity, managed strategically as per Tata Red Line Strategy. The fund will maintain 65% to 90% exposure to equity and equity-related instruments including derivatives.
Debt and money market instruments (including margin for derivatives) will have an indicative allocation of 10% to 35% under normal circumstances. Unlike others, Tata Regular Saving Equity Fund has introduced an exclusive feature known as Tata Red Line Strategy to strategically manage equity allocation.
It is a known fact that equities are volatile in nature. But a long holding period helps neutralize volatility in equities. However, equity investing experience can further be improved by strategic equity re-balancing.
Most investors understand the general volatile nature of equity. However, there is a need to manage allocation to equity to safeguard against major market downturns like the Tech Bubble of 2000, Global Financial Crisis of 2008 and the European Crisis of 2010.
Tata Red Line Strategy uses trailing PE of CNX Nifty to strategically manage allocation to equity by cutting equity allocation during hyped valuation periods and reinvesting at long-term average valuations or lower. The strategy is termed as the Red Line Strategy as it draws a Red Line in terms of valuations beyond which it does not pay to remain invested in the markets.
Such funds offer a superior risk-return mix for long-term investors in a tax efficient structure. To give a small example, all gains on any debt investment with period of more than one year and less than three years are taxable.
Assume that a person has invested Rs. 10 lakh at a 9% rate of return (which is Rs. 90,000). In such a scenario, the investor's capital gain of Rs. 90,000 will be taxable. If that investor is in the highest tax bracket (over 30%), then the tax payable will be around Rs. 30,000 which will give post-tax returns of over 6%. However, if you invest in such equity-oriented funds, there will be no tax payable and the investor can earn the entire 9% returns on his investment.
In such funds it has been observed that asset allocation portfolios are able to bring down risks and generate reasonable outcomes for investors across markets and time periods. In the Indian context, where high volatility of equities deters investors, asset allocation strategies are likely to help investors experience the power of long-term investments and achieve their financial goals through the mutual funds route.
However, investors should realize that although such funds use equity, arbitrage and fixed income funds give an equity tax advantage. They are low in risk since their assets lie in arbitrage opportunities and fixed income securities.
There are some risks in both equity and in debt. Equity funds will invest across market capitalization (it can have large-cap, mid-cap and even small-cap). The stock selection strategy in many funds would be a blend of top-down and bottom-up approach without any sector or market capitalization bias.
All companies selected will be analyzed taking into account financial ratios like return on capital employed, returns on capital, price to earnings and debt equity ratios. It would also look for business fundamentals like nature and stability of business, prospects of future growth and scalability, financial discipline and returns, valuations in relation to broad market and expected growth in earnings, the company's financial strength and track record. While in debt if fund managers go on investing in longer duration papers and taking credit call, it can have a negative impact on returns of funds.
These funds lack track record. The entire category of 'equity saver funds' is new in the Indian context. So, there is hardly any history of how such funds perform in bull and bear markets. Many participants believe that at a time when there is a general consensus of recovery in the economy, a high equity exposure would give added alpha to the fund.
But how the fund will perform in a downturn or in continuously falling markets remains to be seen. One is also not sure how it will fare if and when arbitrage opportunities dry up in the equity markets.
IN A NUTSHELL
As said earlier, such funds are a new concept in India and it will take some time for investors to adapt to the new changes. Though there are more advantages for such funds like low risks and tax advantages, it also has its share of disadvantages.
No one knows how they will perform in rising market conditions and what will happen if there are no arbitrage opportunities. There are also chances that the government might give such funds the status of debt funds and the complete tax advantage would be wiped off.
This category of funds is for investors who already have investments in diversified equity funds and are looking to park some short-term money to save tax. But investors who are about to start their investment journey should look at monthly income plans (MIPs) or balanced funds which can also provide same tax efficiency with history of performance behind them.
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