Hybrid funds offer investment choices to investors who want to earn more than what they get from their fixed income investments and at the same time not take risks associated with equity funds. Depending on their risk tolerance and investment objectives, investors can choose between equity oriented hybrid funds and debt oriented hybrid funds. Equity oriented hybrid funds, also popularly known as Balanced Funds, invest 65% or more in equity securities and 35% or less in fixed income securities. These funds enjoy equity taxation. More conservative investors can choose debt oriented hybrid funds, usually 70 – 75% in fixed income securities and the balance in equity securities. These funds are subject to debt taxation. We will discuss mutual fund taxation in more details later, but suffices to say at this stage that, equity and equity oriented mutual fund schemes enjoy substantial tax advantages over debt and debt oriented schemes. Over the past one year we have seen a number of New Fund Offers of hybrid mutual fund schemes where the risk return characteristics are similar to debt oriented hybrid funds, but the scheme is designed to enjoy equity taxation. The popular nomenclature of these schemes is equity savings funds. DSP Black Rock has launched DSP Black Rock Equity Savings Fund, a hybrid mutual fund scheme, which can deliver higher than fixed income returns while taking risks much lesser than equity and at the same time enjoy the benefits of equity taxation.
Equity as an asset class outperforms fixed income in the long term but it is risky
We have discussed a number of times in our blog that equity outperforms fixed income in the long term. The chart below shows the 1 year rolling returns of Nifty over the last 10 years.
Source: National Stock Exchange
You can see in the chart above that over the last 10 years, Nifty gave more than 10% annual returns a majority of the times. In many years the annual Nifty returns were higher than 20%. However, it is also apparent from the chart above that the Nifty had been extremely volatile in the last 10 years. The last 10 years also saw three bear markets, in 2008, 2011 and 2015 – 16.
Let us now see the yields of the 10 year Government of India Bonds from 2006 to 2016 (please see the chart below).
You can see that see that the 10 year Government Bond yield was on an average around 8% over the last 10 years. Let us take 10 year yields as the average risk free return for the investor. You may have got a little more or less than the 10 year yields, depending on which fixed income scheme you invested, but it is generally accepted that the 10 year yield is the risk free rate.
You can see from the two charts above that equity and fixed income outperformed each other in different time periods. If you have high risk appetite and long investment horizon, then equity is the best asset class to invest in. On the other hand, if you cannot afford to take risks then fixed income is suitable for you. However, for a large number of investors who are somewhere between these two extreme risk profiles, a portfolio comprising of both equity and fixed income can provide moderate growth, which is higher than fixed income, while limiting potential losses. If we think of investment risk profile as spectrum with equity investment at one extreme (aggressive) and risk free debt investment at the other extreme (conservative), equity savings funds are towards the conservative side of the risk profile spectrum.
Combination of equity and fixed income can give capital appreciation and income
Equity as an asset class serves the objective of generating capital appreciation in the long term. Fixed Income generates stable income for the investor. A combination of equity and fixed income can serve both the purposes. The chart below shows the benchmark returns of equity funds, low risk debt funds and hybrid funds over the last 10 years. We are taking Nifty as the benchmark for equity (though the actual benchmark may differ from fund to fund), CRISIL Short Term Bond Index as the benchmark for debt or income funds with low interest rate risk and CRISIL MIP Blended Index as the benchmark for conservative hybrid funds.
Source: DSP Black Rock
You can see that, while Nifty (shown in blue bars) gave the highest returns in most years, it also suffered losses in 2008, 2011 and also last year. The CRISIL short term bond index (shown in red bars) gave lower returns than Nifty but gave positive returns every year. You can also note the returns of the CRISIL short term bond index are more stable within a range. Now look at the CRISIL MIP Blended Index (shown in green bars). This index gave double digit returns in 4 out of the last 10 years. The highest return was 17% in 2014, but the more interesting observations are downside performance of the index. While Nifty made over a 50% loss in 2008, the CRISIL MIP Blended Index was almost flat, making only a 2% loss. In the 2 other years when Nifty made losses, namely 2011 and last year, the CRISIL MIP blended index gave positive returns. Over the last 10 years, we can see that the CRISIL MIP blended index gave fairly stable returns, while in the good years, e.g. 2007, 2009, 2012 and 2014, it would have also generated good capital appreciation. The risk return characteristics of Equity Savings Funds are similar to the CRISIL MIP Blended Index.
Advantages of Equity Savings Fund
- Equity Savings Funds invest in a portfolio of arbitrage positions, equity securities and fixed income securities
- The arbitrage component of the portfolio aims to generate arbitrage profits arising out of pricing mismatches in the market. Arbitrage strategies offer the investors to earn short term returns by taking minimal or no risks. In fact, in volatile market conditions arbitrage funds can provide comparable or even higher returns than low risk liquid funds. To know more about arbitrage strategies in mutual funds, see our article, Arbitrage Mutual Funds: A good short term investment option in volatile markets
- The pure (un-hedged) equity component of the portfolio is aimed at generating capital appreciation for the investor
- The debt component of the portfolio is aimed at generating stable returns and minimizing the risk / volatility in the portfolio
- We can see that two out of the three components of the portfolio lowers the portfolio risk. Therefore, these funds are suitable for investors with moderate to conservative risk profiles. However, investors should note three important points. Firstly, mutual funds are subject to market risks and therefore there are no risk free investments in mutual funds. Secondly, Equity Savings Funds have an equity component, which makes them riskier than pure debt funds. Thirdly, risk is not binary, in other words, an investment is not either risk free or very risky. There are different gradations of risk. Therefore, if investors understand their risk tolerance and the risk / return characteristics of the investments, they can make suitable investment decisions.
- Finally, Equity Savings Funds enjoy a big tax advantage. Let us briefly recap mutual fund taxation to understand this point. Short term capital gains in equity or equity oriented funds (funds with minimum 65% equity investment) are taxed at 15%, while long term capital gains are tax free. What are short term and long term capital gains? Equity and equity oriented funds investments held for a period of less than 1 year are subjected to short term capital gain, whereas investments held for a period of more than one year are treated as long term capital gains. Further dividends paid by equity and equity oriented funds are totally tax free. What about debt or debt oriented funds? Short term capital gains in debt or debt oriented funds (funds with less than 65% equity investment) are added to the income of the investor and taxed as per his or her tax rate. Long term capital gains are taxed at 20% after allowing for indexation benefits. What is indexation benefit? The cost of acquisition of the investment is allowed to be indexed as per the cost of inflation index values in the year of purchase and the year of sale / redemption. For example, if you purchased units of a debt fund for
र1 lakh and the cost of inflation index is higher by 15% in the year of redemption than the year of purchase, the indexed cost of acquisition of the units will be र1.15 lakhs. Long term capital gains will be calculated on the basis of sale value and the indexed cost of acquisition. Note that the indexation benefit is not allowed for bank fixed deposits and many other fixed income investments. Therefore, debt mutual funds are more tax efficient than fixed deposits, but that is another topic of discussion. As far as equity and debt mutual funds are concerned, it is clear from the above discussion that, profits made in investments in equity or equity oriented funds, held for a period of more than one year, are more tax efficient than debt or debt oriented funds. Though risk return characteristics of Equity Savings Funds are similar to hybrid debt oriented funds, from a taxation viewpoint, these funds are treated as equity funds, because the arbitrage component of the fund portfolio is treated as an equity investment, even though the arbitrage component is theoretically risk free.
DSP Black Rock Equity Savings Fund can fulfil investment goals of moderate risk investors
- The scheme will aim to capture the growth potential of Indian equities by investing in diversified portfolio of stocks across different market capitalization segments and industry sectors. The fund managers will follow a combination of top down and bottoms up approach to selecting stocks in the portfolio. The Indian equity market is down by 15% from its all time high and there are pockets of deep value within sectors and individual stocks, which the fund managers can leverage to give good returns to investors. The equity allocation will be 20 – 40% of the portfolio value.
- For the arbitrage portion of the portfolio, the fund managers will take completely hedged positions minimizing risks for the investors. The fund managers will aim to exploit the market inefficiencies and capture the spread between spot (cash) and derivatives (F&O) markets. A prudent arbitrage strategy can ensure capital safety, returns and liquidity for the investors. The arbitrage portion of the portfolio will be 25 – 55%. The un-hedged equity and arbitrage positions will ensure equity taxation for the investors.
- 25 to 35% of the portfolio will be allocated to fixed income investments. The fund will invest in debt and money market securities, with the objective of lowering volatility and ensuring stable returns. The fund will take exposure to securities across the maturity spectrum and manage duration actively. For investors who are less familiar with bond investments, duration is directly related to interest rate risks. The DSP Black Rock Equity Savings Fund will aim to generate good returns in different interest rate scenarios.
- DSP Black Rock is one the most well known asset management companies in India. Their mutual fund schemes across product categories have been strong performers, with strong long term track record.
Suitability of DSP Black Rock Equity Savings Fund
DSP Black Rock Equity Savings Fund can be good investment for the following investors:-
- Investors who want stability of fixed income and also the capital appreciation of equities. As such, this can be a good investment option for retired investors who want regular income and also some capital appreciation to beat inflation in the long term
- Investors in the higher tax brackets, who want higher than fixed income post tax returns with moderate levels of risk
- First time investors who may find volatility associated with equity investments stressful
Key Features of DSP Black Rock Equity Savings Fund NFO
- Open ended equity oriented hybrid scheme
- NFO Period: March 8 2016 to March 22, 2016
- The scheme will aim to generate income investing in fixed income and arbitrage strategies. In addition the scheme will also aim to generate capital appreciation by investing in equity securities.
- Fund Managers: Vinit Sambre and Marzban Irani
- Benchmark Index: 30% Nifty 500 + 70% CRISIL Liquid Fund Index
- Minimum Investment:
- Additional Features: Investors can also invest through Systematic Investment Plan (minimum instalment amount
Investors should consult with their financial advisors if DSP Black Rock Equity Savings Fund is suitable for their investment needs. Mutual fund investments are subject to market risks read all scheme related documents carefully