Rising participation of retail investors in India along with rising stock markets have been an amazing combination for the investors who have started investing in past two to three years. After the COVID lows, we have seen a few hiccups but overall the market has been on upward journey. At such times, people often tend to forget about the risks involved in the nature of volatility of stock markets. An investor should always focus on having a balanced portfolio that has all types of assets viz. equity, debt, gold in it.
The tide was completely against investing in fixed income products like fixed deposits or debt mutual funds as everyone was interested in returns delivered by stock market. However, when the hiccups started to flow in, the investor tried to find ways to stabilize their portfolios but the FDs still didn’t offer good returns.
In this post, we are going to discuss a category of mutual funds that may offers better than fixed deposit returns with lower volatility than equity oriented mutual funds.
Equity Savings Funds: Equity Savings Funds are Hybrid Mutual Fund schemes which invest in equity, debt and hedging strategies (using derivatives). As per the SEBI Circular overall equity allocation (including hedged and un-hedged exposures) should be minimum 65% of total assets and minimum of 10% of total assets in debt and / or money market instruments. These schemes are also required to mention their minimum hedged and un-hedged exposures in their Scheme Information Document.
Let us take a deep dive into the asset allocation strategy of these schemes:
Debt: Debt exposure of Equity Savings Funds can range from 10 to 35% of total assets. The debt allocations of these scheme works as a fixed income portfolio generating regular income in form of interest by reducing volatility of portfolio.
Equity (Hedged): Hedging is an investment strategy to reduce portfolio risk, by taking an opposite positions on the same underlying assets in different market segments. This is done by buying the stock in cash segment of the market & selling the stock in futures market. Usually the stock price in futures market trades at a premium due to time value. The stock prices & futures price becomes same on the day of expiry. This ensure the difference between cash price and futures price at the time of entering the trade is booked as profits.
Eg: Stock price of Infosys in cash market is Rs. 1,500 & in futures market is Rs. 1,530. A fund manager can sell the stock in futures market and buy it in cash market and wait till the expiry. Let us see how the outcome works.
Infosys stock closes at Rs. 1,450 on the expiry day: Fund will have a loss of Rs. 50 in cash market & profit of Rs. 80 in futures market. Hence the net profit will be Rs. 30.
Infosys stock closes at Rs. 1,550 on the expiry day: Fund will have a profit of Rs. 50 in cash market & loss of Rs. 20 in futures market. Hence the net profit will be Rs. 30.
Infosys stock closes at Rs. 1,500 on the expiry day: Fund will have no profit & no loss in cash market but a profit of Rs. 30 in futures market. Hence net profit will be Rs. 30.
This ensures that no matter where the market goes, the fund will book a profit on the difference between both prices at the end. This again is a fixed income portion.
Equity (Un-hedged): The entire equity exposure of an Equity Savings Fund is not hedged; a portion of the equity exposure is un-hedged or active with the objective of getting capital appreciation for the investor.
The total equity exposure (hedged as well as un-hedged) is to be kept at minimum 65% of fund to ensure it classifies as equity fund.
Tax treatment on Equity savings funds: Being a fund with minimum 65% exposure to equity oriented instruments, the gains are taxed as equity oriented mutual funds in following manner:
Short-term capital gains: If you redeem your investments within 1 year, then the gains will be taxed as short term capital gains at a tax rate of 15%
Long-term capital gains: If you redeem your investments after 1 year, then the gains will be taxed as long term capital gains at a tax rate of 10%. However, there is an exemption of Rs. 1,00,000 per annum on long term capital gains from equity oriented mutual funds. Hence the tax rate of 10% will apply on gains above Rs. 1,00,000
Ideal investment horizon:
Considering the un-hedged equity portion of equity savings funds, Investors should invest for a minimum horizon of 2-3 years.
Who should consider invest in equity savings funds:
- Investors with an objective of generating higher returns than a fixed deposit.
- Investors who are just starting out their journey of investing in equities
- Investors with short term goals of 3-5 years.
Important Tip: Since equity savings funds have a lower equity exposure, an investor should check for the expense ratio charged by the funds, a higher expense ratio will lead to lower returns & hence investor should avoid a fund if it is charging very high expense for management. One can always approach an advisor to check if a particular scheme is suitable for his risk appetite before taking a call on whether to invest or not.
CA Rohit J. Gyanchandani is Managing Director, Nandi Nivesh Private Limited, A Pune based Wealth Management Company.