Mutual funds have been growing in popularity among retail investors in India over the last few years. 2017 was one of the best years for the mutual fund industry with record inflows. Media observers and experts attribute this growth to increased awareness and maturity of the retail investors. Despite the phenomenal growth in mutual fund AUM, penetration of mutual funds in our country is still very low. The share of mutual funds in financial savings is below 3% (October 2017), whereas insurance is about 25% of savings. The maximum share of financial savings, around 40% (October 2017), is in cash and deposits.
The above figures show that risk aversion is still the pre-dominant sentiment among large sections of investor population in our country; Bank Fixed Deposits and Government Small Savings Schemes are still automatic investment choices for most investors. In fact, many investors, who have been investing in mutual funds for several years, still have most of their savings in Fixed Deposits. With FD and small savings interest rates falling over the last 2 years or so, many financial advisors are advising their clients to replace their FDs with investment in Equity Savings Mutual Funds. In this blog post, we will discuss about Equity Savings Fund and their suitability for different investment needs.
Equity Savings Fund is a relatively new category of mutual fund schemes. Equity Savings Funds were launched in late 2014 and 2015, primarily in response to the change in debt fund taxation introduced by in NDA Government’s 2014 Budget. Prior to 2014, capital gains in debt mutual funds held for more than 1 year were taxed at 10% without indexation or 20% with indexation. Debt fund capital gains taxation gave debt funds, especially low risk products like Fixed Maturity Plans, a significant tax advantage of bank FDs, especially for investors in the higher tax brackets because FD interest is taxed as per the income tax rate of the investor; indexation, on the other hand in an inflationary environment, reduced the tax outgo of debt fund investors considerably.
In the 2014 Budget, the Finance Minister, Mr. Arun Jaitley, changed the holding period for long capital gains tax for debt funds from 1 year to 3 years. Long term capital gains (investment held for more than 3 years) was to be taxed at 20% with indexation and short term capital gains (investment held for less than 3 years) was to be taxed as per the income tax rate of the investor. With this change in taxation, over a 3 year plus investment tenure debt mutual funds still enjoyed a tax advantage over FDs, but there was no tax advantage for shorter tenures. The industry response to this tax change was to come up with a tax friendly product, which retained some of the risk characteristics of debt funds. This product was Equity Savings Fund.
Equity Savings Funds are hybrid mutual fund schemes, which invest in both debt and equity securities. The main purpose of any hybrid fund is to balance the risk return characteristics of different asset classes. Risk and return are directly correlated; higher the risk, higher the return and vice versa. Equity is a risky asset class, but gives higher returns in the long term. Some investors are comfortable with the risk, while others may not be comfortable. Debt is a low risk asset class, but gives lower returns than equity. Some investors may prefer low risk, but also seek higher returns. Hybrid funds combine equity and debt assets to produce an asset type whose risk is lower than equity, but which can beat fixed income returns. There are different types of hybrid funds with different debt and equity allocations. Balanced Funds, for example, have 65% asset allocation in equity and the remaining in debt securities. You may like to read Balanced Fund Demystified
Monthly Income Plans have 5% to 25% asset allocation in equity and 75% to 95% in debt. The risk characteristics of hybrid mutual funds depend on the asset allocation. SEBI has devised a “Riskometer”which can give investors a sense of the risk in each scheme – we encourage investors to refer to the scheme “Riskometer” before investing.
Equity Savings Mutual Funds invest in debt and equity securities. The gross equity exposure of these funds is at least 65%. This ensures that, these funds enjoy equity taxation – equity is much more tax friendly than debt (we will discuss in more details later). Debt exposure will not exceed 35%. But how is this different from Balanced Funds; after all, Balanced Funds have existed in India for more than 20 years. Remember, the idea was to have a product, which is a somewhat similar to a debt fund and tax friendly at the same time. In other words, the risk profile of Equity Savings Funds has to be lower than that of Balanced Funds, while maintaining the 65% equity allocation to enjoy equity taxation. This was accomplished through hedging.
Hedging is a strategy for reducing the price risk of a security. It is achieved through derivatives. Let us understand this with the help of an example. Suppose you buy 1000 shares of a company at Rs 100 each. If the share price rises to Rs 110, you will make a profit of Rs 10,000; if the share price falls to Rs 90, you will make a loss of Rs 10,000. Now you want to hedge your risk by 50%. You sell 500 futures of the company in the derivatives (F&O) market. Futures price moves closely with the share price and converges on expiry of the futures contract every month. If futures price increases by Rs 10, you will make a loss of Rs 5,000 in futures, but you made Rs 10,000 profit in the stock and so your overall profit will be Rs 5,000. If futures price falls by Rs 10, you will make a profit of Rs 5,000 in futures and this will offset the Rs 10,000 loss you made in the stock and your loss is limited to just Rs 5,000.
In this example, our hedge ratio was 50%, but if you want you can hedge 100%. If you hedged 100%, there would be no profit or loss. Equity Savings Funds also hedge a certain portion (usually 50 to 60%) of their gross equity exposure, to reduce the risk for the investor. Thus Equity Savings Funds are able to enjoy equity taxation, but the equity risk is reduced by around 50% due to hedging. The un-hedged equity allocation, also known as the active equity allocation, is exposed to risk but also gets returns for investors over a sufficiently long investment horizon.
In a perfect market, hedging reduces the risk exactly in proportion of the hedge ratio. However, the market is not perfect. There are inefficiencies in the market which can allow investors to make risk free profits. Futures usually trade at premium or sometimes at a discount to the spot price (price of the share in cash market). Suppose in the above example, the futures price was Rs 101 when the share price was Rs 100; you sold 500 futures. On expiry of the futures contract, the futures price will converge with the stock price. So if the share price rises to Rs 110 by expiry, you will make a profit of Rs 10,000 in the stock and a loss of Rs 4,500 in the futures. So your net profit will be Rs 5,500 (in the earlier example, the profit was Rs 5,000).
Similarly, if the share price falls to Rs 90 by expiry, you will make a loss of Rs 10,000 in the stock and the profit of Rs 5,500 in futures. So your net loss will be Rs 4,500 (in the earlier example, your loss was Rs 5,000). So in this example, irrespective of whether the price went up or down, you made an extra Rs 500 in your combined position. This profit is known as Arbitrage.
Please note we have ignored transaction costs like brokerage, Securities Transaction Tax etc. in the Arbitrage example. Transaction costs reduce Arbitrage profits, but equity savings fund managers have the ability to identify arbitrage opportunities, which can yield reasonable returns even after factoring transaction costs. Liquidity is another important consideration for fund managers in Arbitrage and fund managers try to ensure high liquidity in the hedged portion of Equity Savings Fund’s portfolios. Historically, arbitrage opportunities yielded 6 – 8% average annualized returns, similar to what money market mutual funds like liquid funds yield. Arbitrage profits on the hedged positions enable Equity Savings Mutual Funds to generate additional returns to investors without any risk– Arbitrage, by definition, is risk free profits. The hedged equity portion of Equity Savings Mutual Funds is usually around one third of the total portfolio; however, it can vary within 30 – 40% range at the fund manager’s discretion.
The un-hedged equity exposure of Equity Savings Funds, also known as an active equity exposure or net equity exposure, is subject to stock market risks generates capital appreciation for the investors. The active equity exposure is in a diversified portfolio of stocks across different sectors and market cap segments. Some equity savings funds employ a predominantly large cap strategy, which limits risk, while others employ a multi-cap strategy, which increases risks but generates higher returns. Investors can chose a large cap oriented or multi-cap oriented Equity Savings Fund based on their risk preferences. The active equity exposure of Equity Savings Funds can help investors and inflation over a sufficiently long investment horizon. If you are looking to get higher than FD interest rates, then the active equity exposure will help you get the additional returns. The un-hedged equity portion is usually around one third of an Equity Savings Fund portfolio.
As discussed earlier, the debt or fixed income exposure is below 35%, so that Equity Savings Funds enjoy equity taxation. The fixed income or debt portion of the portfolio has much lower risks than the active equity portion of the portfolio, but slightly higher risk than the hedged equity portion. This is because the debt portion is exposed to interest rate and credit risk. The degree of interest rate and credit risk varies from one Equity Savings Fund to another. In most cases these risks are moderate, but in Advisorkhoj, we ask investors to do their own homework before investing.
Investors should look at the modified duration and the credit rating profile of the debt portion of Equity Savings Mutual Funds. If the modified duration of Equity Savings Mutual Fund is low (2 – 3 years or less) then the interest rate sensitivity is limited. Since, risk moderation is an important investment objective for investing in Equity Savings Mutual Funds, an accrual based fixed income strategy is best suited for investor needs and for this fund managers should invest in low duration bonds. But some fund managers may want to take duration calls to benefit from interest rate changes which increase the risk. Investors should therefore, look at the modified duration to decide, whether they are comfortable with the interest rate risk of the fund.
We in Advisorkhoj, urge investors to invest in high credit quality funds because credit risk can yield higher returns, it is unpredictable. Therefore, in our view, you should invest in funds which have a high percentage, 85% or higher, in Sovereign / AAA / AA rated bonds or NCDs or commercial papers. You can find the modified duration and credit profile of a fund in the monthly factsheet available on the AMC websites.
We have seen that, Equity Savings Mutual Funds usually invest a third in debt securities for income, third in hedged equity earning arbitrage profits and a third in un-hedged / active equity for capital appreciation. Approximate, two thirds of the portfolio of an Equity Savings Fund is therefore, low to moderately low risk - only one third has high risk. The risk profile of these funds is therefore similar, though slightly higher than, aggressive debt oriented hybrid funds (e.g. Monthly Income Plans).
However, in quite a few mutual fund research websites, these funds are clubbed together in the same category as aggressive hybrid funds like balanced funds due to their gross equity exposure. This categorization leads to wrong comparisons. Equity Savings Funds simply, cannot be compared with Balanced Funds – if at all, they are more similar to aggressive Monthly Income Plans (MIP). Therefore, in Advisorkhoj research, we have a separate category for Equity Savings Mutual Funds.
This was the topic of our blog, but we are addressing it towards the fag end of our post. The reason is that, investors should understand the risk characteristics of a financial product before making investment decisions. By now, it should be clear to you that Equity Savings Funds cannot be compared to Fixed Deposits because around a third of the scheme portfolio is subject to equity market risk. In fact, no mutual fund product can be compared to Fixed Deposit because mutual funds are subject to market risks (debt or equity markets), whereas Fixed Deposits are risk free.
However, let us discuss this point from the perspective of investment need, rather than the risk characteristics. Why do you invest in Fixed Deposit? If you need an assured amount, principal + interest, at the end of the investment term for a specific financial goal, then there is no alternative to FDs. But very often, we invest in FDs because we have surplus funds and we do not want to take risks. The problem with that approach is that, FD returns on a post-tax inflation adjusted basis is often negative, in other words, we are not creating wealth but diminishing it, in terms of purchasing power.
Consider an FD which pays 6.25% interest rate to an investor in the 30% tax bracket. The post-tax return to the investor is 4.35% (after tax including 4% Cess); the inflation rate currently is over 5%. Clearly, the real return (inflation adjusted return) is negative. To beat inflation, you need the higher asset yields of equity. At the same time, you may not have the risk appetite associated with equity investments. This is where Equity Savings Funds can offer investment solutions. On an average, over time, Equity Savings Mutual Funds can give inflation beating returns to investors, while limiting downside risks.
Consider this scenario, where an Equity Savings Fund has one third is fixed income yielding 7 - 8% returns, one third in hedged equity / arbitrage yielding 6 – 7% returns and one third in active equity. Even if the market falls 13 to 15% (assuming the equity portion of the fund falls in line with market), the fund will not give negative returns. One the other hand, if market rises 15 to 20%, the fund will give double digit returns (assuming that the equity portion of the fund rises in line with market). Purely from a risk return trade-off perspective, therefore, Equity Savings Mutual Funds are good investment options for investors with moderately low to moderate risk capacities.
Tax Advantage and Conclusion
In this blog post, we discussed about Equity Savings Mutual Funds, how they work, their risk return characteristics and their investment suitability. These mutual fund schemes are good moderate or moderately low risk investments. The major advantage of these funds is that they enjoy equity taxation. Equity fund taxation has been changed in this year’s budget. Short term capital gains (investments held for less than 1 year) in equity and equity oriented mutual funds are taxed at 15% plus Cess (4%). Long term capital gains (investments held for less than 1 year) from April 1, 2018 onwards will be tax exempt up to Rs 1 lakh; above Rs 1 lakh, long term capital gains (LTCG) will be taxed at 10% plus Cess. Even after the re-introduction of long term capital gains tax for equity, equity savings funds will continue to enjoy significant tax benefits compared to FDs.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.
Dwaipayan leads content production and mutual fund research in Advisorkhoj.com. He is actively involved in business development strategy, driving revenue growth and profitability, delivering superior customer satisfaction and talent development in Advisorkhoj. An alumnus of IIM Ahmedabad, Dwaipayan is a Finance and Consulting professional, with nearly 17 years of management and consulting experience in financial services domain across several geographies. In his previous corporate role, Dwaipayan was the Chief Financial Officer of American Express Global Business Services in India. He also co-founded a boutique consulting start-up to advice companies on business restructuring initiatives like private equity funding, mergers & acquisitions, divestitures, outsourcing and organizational restructuring. Dwaipayan has a strong track record of driving superior financial performance and developing talent in the organizations he has been involved with. He can be followed on his Twitter handle @DBadvisorkhoj.
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