For The Long Haul

Equity Funds

If you are not a professional in the stock markets, why not just trust them?

For investors, last year's Budget was quite disappointing. It didn't hold any tangible benefits and there were quite a few items that featured in the list of cutbacks and losses. Investors discovered that, after the Budget, income taxes were higher, interest rates were lower and the tax edge on several savings schemes had been blunted. Many tax exemptions and rebates had been done away with.

The biggest change that affected mutual fund returns was the finance minister's decision to revert to the taxation of dividends in the hands of the investor. Earlier, income funds only paid a dividend distribution tax of 10 per cent and dividends from equity funds were totally tax-free.

 

Getting tax-free dividends was one of the main reasons why inflows into debt funds had surged significantly in the past three years. This arbitrage opportunity was now lost. Suppose you belong to the highest tax bracket of 30 per cent and had invested in an income fund, your dividend will now be added to your taxable income and taxed at the same rate.

Equity funds and schemes of the UTI, which were earlier tax-free, now attract 10 per cent dividend tax. Capital gains tax is to be levied as earlier. If the units are redeemed within a year, short-term capital gains tax will be applicable. If they are redeemed after a year, either a 10 per cent long-term capital gains tax without indexation benefit, or a 20 per cent tax after indexation benefit will be applicable.

With the change in dividend tax rules, investing directly in stocks has also become a less attractive option. If one were to invest directly in stocks, dividend income earned from investments will be taxed at higher rates of 20 or 30 per cent (excluding surcharge). So, unless you want to speculate or bet on individual stocks, you're better off taking shelter in an equity mutual fund for the sheer tax advantage it offers.

There are other benefits that come from investing in mutual funds. Mutual funds offer you instant diversification and professional management. The idea of diversification is to ensure that, at any given point of time if one part of your portfolio is hit by some negative factor, it will be offset by another part of the portfolio which may remain unaffected, or indeed react positively to the changes.

Thus overall returns from the portfolio are insulated. A diversified equity fund fills up its portfolio with stocks from various sectors, reducing the overall risk. But before committing yourself to diversified equity funds, there are a few things you need to keep in mind.

For one, take a close look at the track record of the fund. Stick only to those that have already proved themselves in the market. Though past performance is no guarantee of how a fund will perform in future, it's a good idea to consider only funds that have delivered consistent returns over a period of time.

"Investors should first look at the consistency of returns before investing in these funds," says Vetri Subramaniam, chief investment officer, Kotak Mahindra Mutual Fund.

Your next step should be to evaluate the fund's portfolio. Choose a fund that's well-diversified across sectors and companies. Too much of a fund's money clustered around just a few sectors can significantly increase the risk of that fund. Returns, too, can be uncomfortably volatile.

There's also a need to take a closer look at the quality of stocks invested in by the fund. Says Chandresh Nigam, fund manager at Zurich India Mutual Fund: "It's important that the fund invests in good quality stocks with good growth prospects. We, at Zurich invest in fundamentally-sound companies with some kind of competitive advantage and a sustainable business."

The ability of the fund manager to pick sectors that outperform the market, and stocks that outperform in that sector, plays a crucial role in ensuring that the fund delivers consistent returns. It also makes sense to diversify across fund houses because we find that each of them has distinct styles. Even among actively managed funds, there are some who follow "value investing", while others like to put their money in growth stocks. Value investing aims at investing in stocks with the potential for long-term growth rather than in the current market favourites.

The growth style of investing picks out companies clocking strong growth rates, above-average earnings and have the potential to be even more valuable in future. It makes sense to diversify within value and growth investment styles. This is because one style typically outperforms the other in any given year.

Mutual funds also offer you the convenience of investing regular sums of money through their systematic investment plans (SIPS). Since the amount invested per month is constant, you end up buying more units when the price is low and fewer units when the price is high, thereby making the volatility in the market work for you.

The best way to optimise returns from equities is to stay invested for a longer period. The longer you stay invested in equities, the greater becomes the predictability of returns. In other words, the risk associated with investing in equities reduces over a longer holding period.

Given the decline in interest rates and the ceiling on investment in tax-free bonds, the relative attractiveness of equity funds has definitely increased. Investors with a higher risk tolerance, and in the higher tax bracket should now seriously consider investing in an equity fund to capitalise on the tax arbitrage opportunity.