Do equity savings funds make sense after the tax hit on debt mutual funds?

Equity Savings Funds derive their returns from three different sources ― stock arbitrage, equities and debt.

With the changes in the taxation of debt fund units purchased after April 1, investors with low-risk appetite are looking for alternate investment options where they can reduce their overall tax liability.

Following the changes to the Finance Act, gains from investments in mutual funds, where not more than 35 percent is invested in domestic equities, are now taxed at a maximum marginal rate. Further, debt mutual funds no longer enjoy the benefits of long-term capital gains (LTCG) and indexation for fresh investments starting April 1.

One category that is expected to benefit is hybrid funds, which offer a balanced approach to risk and reward by investing in both equity and debt, among other asset classes.

While Dynamic Asset Allocation/Balanced Advantage and Multi Asset Allocation stand to gain from the taxation change, another category, which had largely gone under the radar ― Equity Savings Fund ― can also return to the limelight, experts say.

Eyeing a bigger pie now

These funds enjoy the benefit of equity taxation even while taking a conservative exposure to equities. It is different from other hybrid categories because it derives its returns from three different sources ― stock arbitrage, equities and debt ― and enjoys equity taxation.

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Overall, equity savings funds have the smallest assets under management (AUM) at Rs 16,399 crore among all the hybrid schemes. In comparison, Dynamic Asset Allocation/Balanced Advantage Funds had assets of Rs 1.97 trillion as of April end.

“Equity savings fund is the least volatile category, which carries equity taxation, that is, LTCG at 10 percent and STCG at 15 percent, among all the hybrid funds. These schemes invest 30-40 percent in equities, 25-35 percent in equity arbitrage and the rest 25-35 percent in debt. Whereas Balance Advantage and Aggressive Hybrid funds maintain the average equity allocation of 35 percent and 75 percent, respectively,” said Vinayak Magotra, Founding Team, Investment Product, Centricity Wealthtech.

ICICI Prudential Equity Savings is the biggest scheme in this category with assets of around Rs 4,600 crore. Apart from stock arbitrage, equities and debt, the scheme also writes covered call options in order to generate returns.

Limited traction

As per Nitin Rao, Head – Products and Proposition at Epsilon Money Mart, there are various factors which may have made equity savings funds to be less attractive to investors. “Its suitability towards short-term needs, not a perfect substitute to debt or conservative funds while comparing volatility, and lack of awareness about its taxation and diversification benefits are some of the factors,” he said.

Mainly, two types of risks are involved here. These are ― fluctuations in interest rates and changes in stock prices.

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“The NAVs (net asset value) may fall in case of a fall in stock prices according to the equity proportion, and similarly, in the case of increased interest rates too,” said Magotra of Centricity Wealthtech.

Appeal of such funds

Equity savings funds can be appealing to investors who are looking for relatively stable returns with low exposure to equity and the benefit of equity taxation.

“Investors who have a conservative approach and are looking to get 2-3 percent higher returns than fixed deposits can consider this asset class. Investors who are worried about a full-equity portfolio’s volatility and want a small allocation to stocks can consider equity savings funds,” said Magotra.

Keep in mind that while equity savings funds are not as safe as debt funds due to the exposure to stocks, they are considered less risky than pure equity funds.

The arbitrage portion of an equity savings fund is similar to a Balanced Advantage Fund as it involves buying and selling shares simultaneously in the futures market, reducing exposure to equity risks.

For tax purposes, the arbitrage portion is treated as equity, but its characteristics are more like fixed income.

How to select?

As per Chintan Haria, Head – Investment Strategy, ICICI Prudential Mutual Fund, factors such as net equity level, credit quality of debt component and duration risk could be looked at when selecting a hybrid fund.

“The portfolio’s net equity level and the duration-credit quality composition of its debt component together can help ascertain the risk profile of equity savings funds,” says Haria.

Investors should also understand their investment horizon, risk appetite, fund performance, expense ratio and taxation benefits.

Apart from these factors, those looking for a diversified portfolio with moderate growth along with a safety cushion can go for the equity savings category.

“The factors to look at while choosing any hybrid funds depend on the type of asset blend, equity exposure, capital safety, and asset allocation. To understand the risk profile of equity saving fund, one should understand the asset mix a scheme holds,” said Rao.

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Also, analysing the historical performance of equity savings funds can help investors understand the risk-return trade-off. While past performance does not guarantee future results, it can provide insight into how the fund performs in different market conditions.

Return expectations

One can expect moderate growth by investing in equity savings funds. This category is for investors who need equity exposure but with hedging benefit and do not have a specified time horizon.

“Due to low equity exposure, the fund seems suitable for short- to medium-term goals, where the investment horizon is between two-four years. We can expect the average annual returns to be 2-3 percent more than fixed deposits post-tax,” said Magotra.

Data from ACE MF shows that as a category, equity savings funds have delivered an average return of 12 percent on a three-year basis and 7.11 percent on a five-year basis.

What should investors do?

There is a clear advantage to being in this category from the taxation perspective. However, experts warn that investors should not compare this to debt funds.

“This is fundamentally different from what people would want to invest, especially when it comes to debt. These funds have lesser risk compared to other hybrid funds. So, for that kind of investor only, we can suggest this. Investors who want a slight bit of equity allocation, maybe 35 percent, and they want a bit of debt allocation and favourable taxation, this is not a bad category to be in,” said Suresh Sadagopan, Managing Director and Principal Officer, Ladder7 Wealth Planners.

However, some experts warn that this may not be suitable for retail investors given its complex construction.

“These funds keep the equity component at around 65 percent to make it taxable like equity funds and at the same time give only debt fund kind of returns. Not many may understand how they do that,” says Melvin Joseph, a SEBI-registered investment adviser and founder of Finvin Financial Planners. His mantra: “I will not recommend a product to a client if the client doesn’t understand that product.”