Equity savings funds: Safe but not a perfect substitute for debt funds

While they could offer higher returns over three-five years, they would also be more volatile

The loss of indexation benefit for debt mutual funds has left investors scrambling for alternative products that offer favourable tax treatment. Equity-savings funds have emerged as a sought-after choice for many investors.

Investment approach

Equity-savings funds belong to the hybrid category. According to the Securities and Exchange Board of India’s (Sebi) definition, they must have at least 65 per cent of their portfolio in equity and equity-related instruments and a minimum of 10 per cent in debt instruments. “Most funds in this category have equity exposure between 20 and 40 per cent. Then they use arbitrage to reach the 65 per cent mark. The remaining is invested in debt,” says Arun Kumar, head of research, Fundsindia.com.

Equity-like taxation

These funds are taxed on a par with equity funds: 10 per cent on long-term capital gains and 15 per cent on short-term capital gains. “The capital gains of these funds are treated as long-term after the holding period of only one year,” says Bharat Phatak, director, Scripbox.

While the debt component is likely to offer a return in line with the yield to maturity (YTM) of that portion of the portfolio, the arbitrage component is likely to offer returns similar to liquid funds. The rest of the returns are determined by the equity component.

Says Sonam Srivastava, founder, Wright Research, a Sebi-registered investment advisor: “By combining equity, debt and arbitrage, these funds are able to generate a slightly better return than a simple bond fund.”

These funds rank low on the risk spectrum among hybrid funds. “The lowest are arbitrage funds. Equity-savings funds rank above them,” says Vidya Bala, co-founder, Primeinvestor.in.

More volatile than debt funds

With an equity exposure of 20-40 per cent, these funds tend to be more volatile than debt funds. “The intermittent, temporary declines an equity-savings fund witnesses will be higher than in debt mutual funds. The exact extent of the decline will depend on the fund’s equity exposure,” says Kumar.

These funds could deliver losses. “If you check out the one-year returns of these funds rolled over a three-year period, the returns would be negative 10 per cent of the times,” says Bala.

Adds Phatak: “If the equity market is down by, say, 20 per cent in a year, the fund will deliver nil or slightly negative return. Unless the investor has understood this aspect before investing, he may carry the wrong expectations and exit these funds at the wrong moment—before the market has recovered.”

Many investors have an equity-heavy portfolio and are looking to diversify their risk. “These funds won’t perform that task very well,” says Bala.

Srivastava points out that when the equity market recovers, equity-savings funds would underperform equity funds.

Meet these preconditions

Investors considering these funds must have a sufficient investment horizon. Says Bala: “Enter with a two-three-year horizon. The chances of getting a negative return get reduced with such a timeframe.”

Kumar too suggests a similar horizon with an added caveat. “If towards the end of this holding period the equity market tanks, you must have the leeway to extend the holding period by another couple of years.”

Only investors with the risk appetite to stomach interim volatility should opt for these funds.

Checks you should run

First, check the equity exposure. “The equity exposure could range between 16 to 45 per cent. A fund with a higher net equity exposure will exhibit greater volatility,” says Bala.

The portfolio’s debt portion shouldn’t carry too much credit risk. The modified duration of the debt portion should be less than three years.

The equity component should be tilted towards large-cap stocks. Select a fund with a lower expense ratio.

Bala suggests selecting a fund that has done a good job of containing downside risk.

According to Phatak, “Investors should look at the maximum drawdown and days to recovery over the past period. This will help in keeping short-term expectations realistic and ensure that investors choose the right investment horizon.”

Not a perfect replacement

Equity-savings funds are not a perfect substitute for debt funds as they are likely to be more volatile. According to Bala, investors with large portfolios, who are in a higher income-tax bracket, may take limited exposure to these funds in lieu of debt funds, without substituting the latter entirely. She adds that investors who have just started building their portfolios should stick to pure equity and debt funds. “They will be better off having a clean portfolio consisting of a combination of equity and debt, rather than trying to maximise tax efficiency,” she says.

According to Srivastava, conservative investors who want to achieve a financial goal in the next three to five years may opt for these funds.