When selecting an equity savings fund, check its net equity exposure

Conservative investors keen to reduce volatility should choose a scheme with 15% net equity exposure

Many conservative investors would like to earn slightly more than fixed-income returns. To achieve this, some opt for low-rated bonds, while others explore equities. Equity Savings Funds (ESFs), which have total assets under management of Rs 19,311 crore, offer a mix of both equity and debt in a tax-efficient way.

How do they work?

An ESF allocates between 15 and 35 per cent of the fund to stocks, known as “net equity exposure”. The fund manager then engages in cash-future arbitrage trades so that the gross exposure to equity and equity-related instruments reaches at least 65 per cent of the fund’s corpus. The remainder is invested in bonds.

“Investment by ESFs into various segments helps to maximise returns with much lower equity-market volatility, thus creating a healthy balance between risk and reward,” says Sailesh Jain, fund manager, Tata Mutual Fund.

For the one-year and three-year periods ending on September 6, ESFs have yielded category average returns of 9.3 per cent and 10.9 per cent, respectively.

Providing stability

Since these funds are pitched to relatively low-risk investors, fund managers primarily invest the equity portion in large-cap stocks, which are less volatile. According to Value Research, as of July 31, 2023, more than 80 per cent of the equity allocation of these schemes was in large-cap stocks.

Additionally, for their fixed-income allocation, most schemes opt for high-quality bonds with low duration. “Most funds in this category maintain good credit quality portfolios (predominantly AAA and equivalent) and have low modified duration, thereby keeping both credit risk and interest-rate risk low,” says Anil Rego, founder and chief executive officer (CEO), Right Horizons.

The tax attraction

Since these funds maintain a minimum gross equity allocation (net equity exposure + arbitrage) of at least 65 per cent, they are considered as equity funds for tax purposes. Long-term capital gains from units held for more than one year are taxed at 10 per cent if such gains exceed ₹1 lakh in a year. Short-term capital gains are taxed at 15 per cent. By contrast, debt funds’ capital gains are now taxed at the individual’s slab rate. This has made ESFs attractive for conservative investors in the higher income tax slabs.

Returns during bull phase

Investors may wonder if it is prudent to invest in these funds when the equity market is in a bullish phase. Experts say such funds may have limited upside but are likely to protect the downside well.

“In a bullish market, the upside may be limited due to the small equity exposure. But unlike other equity-oriented funds, drawdowns may be limited in a bearish market,” says Sirshendu Basu, head, products, Bandhan Asset Management Company.

Be prepared for some volatility

While not as volatile as pure equity funds, ESFs can in some years yield less than fixed-income returns. For instance, in the 2022 calendar year, the category offered an average return of only 4.22 per cent. “While the risks associated with equities and debt will affect ESFs, the impact is generally lower since these funds are well diversified among various instruments,” says Jain.

Experts recommend a minimum time horizon of two years when investing in ESFs. “The ideal time horizon to achieve decent returns would be between two and five years,” says Basu. Rego adds that investors may invest 10-25 per cent of their portfolios in this category.

For conservative investors

ESFs are most suitable for investors with a moderate risk appetite. According to Basu, these funds, with their limited equity exposure, are suited for conservative investors.

Adds Jain, “Those averse to any equity exposure or with a time horizon of less than one year should avoid these funds.”

These schemes don’t offer linear returns like fixed deposits. During periods of low returns, it is advisable to stay invested. Investors should also scrutinise the net equity exposure of individual schemes. If you wish to mitigate risk further, consider schemes with around 15 per cent net equity exposure, as these are likely to be less volatile than funds with around 35 per cent equity exposure. Choose a scheme with a strong track record and stable fund management.