Equity savings funds invest more than 65 percent of their corpus in equity and are thereby treated at par with equity funds for taxation
"Extremes are easy. Strive for balance". This quote by Colin Wright holds true in many facets of life. In life, balance is not only essential for happiness and well being, but also for productivity and success. We try to strike the right work life balance, balance between personal and social life or for that matter, balance between physical and emotional health. Ascertaining how far to move in one direction is never an easy decision to make for most of us. Starting from a point which is comfortable, we slowly change things in a particular direction, but are never quite sure as to how far we should go without tipping over the edge.
The pursuit for balance holds true even in financial planning. Individual investors are in a quandary when it comes to allocating their investments across asset classes. Pursuit for higher returns draws investors to equity, but higher returns at times are accompanied by higher risk. Investors seeking comfort in lower risk of debt investments may end up falling short of their capital appreciation goals. Striking the right balance between asset classes is easier said than done for individual investors. Not to mention the fact that asset class diversification is not a one-time exercise, but requires periodic monitoring.
Use of hybrid funds which invest in debt and equity is a smarter way of diversification. Traditionally, there have been two types of hybrid funds viz. balanced funds, which are equity oriented; monthly income plans (MIPs), which are debt oriented;
One of the latest entrants in hybrid funds category is equity savings fund. Budget 2014 increased the minimum holding period for non-equity funds to qualify for long term capital gain taxation from 12 months to 36 months, thereby reducing the attractiveness of debt funds. As the old adage goes, necessity is the mother of all inventions. What was widely viewed as an unsavory change for debt funds, led to the creation of a new product viz. equity savings fund.
Equity savings funds try to balance risk and returns by investing in equity, debt and derivatives. Use of derivatives reduces net equity exposure (around 20-40 percent, although it may vary from fund to fund) and consequently protects investors from volatility of returns. Further, since equity savings funds have gross equity exposure (without considering derivatives) of more than 65 percent, they are treated at par with equity funds for taxation.
Equity portion of the portfolio provides potential for higher returns, whereas the debt component provides stability to returns. Use of derivatives to manage net equity exposure, allows the fund to be nimble and make the most of market conditions, especially in volatile markets. Thus, equity savings funds perform a balancing act between risk and return.
From a risk return perspective, equity savings funds are a notch below balanced funds (More than 65 percent exposure to equity) and a notch above Monthly Income Plan (MIP) funds, which generally have an allocation of 15-35 percent in equity. Equity savings funds provide better stability and downside protection as compared to pure equity funds. Assuming 35 percent unhedged equity allocation and 7 percent returns on debt component, this strategy yields positive returns (1.1 percent),even if the equity returns are negative (-10 percent).
Equity Savings funds are suitable for conservative investors, who seek moderate exposure to equity. Investors with a short time frame (1-3 years), like those approaching retirement could invest in equity savings funds to achieve their wealth creation goals, without running the risk of volatility in equity markets eroding their capital. Such Investors could also use Systematic Investment Plan (SIP) to invest into such funds at periodic intervals, without having to worry about timing the market. Subsequently, post retirement, use of Systematic Withdrawal Plan (SWP) to withdraw pre-determined amount at periodic interval can create a reliable pension stream.
Another noteworthy feature of equity savings fund happens to be its tax efficiency. Equity savings funds invest more than 65 percent of their corpus in equity and are thereby treated at par with equity funds for taxation. Consequently, if they are sold within a year, short-term capital gains would be taxed at 15 percent.
If they are sold after a year, they qualify for long-term capital gains tax, which is nil for such funds. This provision makes them more attractive than debt funds where short term capital gains are taxed at slab rates and long term gains are taxed at 20 percent with indexation. Further, the minimum holding period for debt funds to be categorized as long term capital assets is 3 years vis-à-vis 1 year for equity savings funds.
Dividends declared by equity savings funds are exempt from Dividend Distribution Tax (DDT), whereas dividends from debt funds are subject to DDT (25 percent+Surcharge+Cess for individuals, 30 percent+Surcharge+ Cess for domestic companies).
Like any other financial product, suitability of equity savings fund for any given investor would depend on various factors like investment horizon, risk appetite, investment goals etc. Although, capital appreciation potential of these funds is lower than pure equity funds, equity savings funds score over equity funds and balanced funds in terms of lower market risk and are more tax efficient than pure debt funds.
In essence, what was perceived as an unfavorable tax amendment for conservative investors has eventually led to a novel offering in asset management industry, which strikes the sweet spot between attractive returns and risk mitigation.
"The opinions expressed in this article are those of the author alone and not of HDFC AMC, and should not be regarded as investment advice. Investors should obtain their own independent advice before taking a decision to invest in any securities."
Disclaimer by HDFC AMC: "The opinions expressed in this article are those of the author alone and not of HDFC AMC, and should not be regarded as investment advice. Investors should obtain their own independent advice before taking a decision to invest in any securities."
Author is Senior Vice President & Head - Products, HDFC Asset Management Co. Ltd.Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol are their own and not that of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.