BackHow to migrate to mutual funds from fixed deposits
Financial advisers are telling investors to move from fixed deposits to mutual funds, a smart move but there are potholes that need to be avoided
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Bank fixed deposits (FDs) are no longer the all-seasonal investments they used to be. Thanks to demonetisation last year, banks are flush with funds, and the term deposit rates have come down in the recent past. The State Bank of India’s (SBI) 3-year term deposits now offer 6.25% on deposits of 2 to 10 years. In October 2015, a 3-year SBI term deposit used to give you 7%, which was 8.75% in October 2014. Its 465-days to less than 2-year FD now offers 6.50%, which used to be 6.95% in November 2016 and 7.25% in January 2016, as per BankBazaar.com.
Of course, inflation has dropped as well, but investors prefer to look at the nominal rather than real returns. So, if your adviser has recently asked you to switch to mutual funds, there is good reason for that. But you will still have to take care while shifting.
First, if you wish to move some of your money from FDs to mutual funds, stick to debt funds. Avoid equity and balanced funds. Second, to make the most of debt funds, you need to decide how long you want to stay invested. As debt funds invest in fixed-income scrips that mature after a specific time, it pays to map your investment horizon with that of the fund. Remember, most debt funds live on in perpetuity, but their underlying scrips mature periodically.
Most fund houses publish their debt schemes’ modified duration. This measures a fund’s sensitivity to interest rates (read more here). This mapping helps reduce volatility and also sensitises you to the tax rates. Debt funds, though more tax-efficient than bank fixed deposits, aren’t tax-free. If you redeem them before 3 years, you pay short-term capital gains tax at your income tax rate (10.3%, 20.6% or 30.9%). After 3 years, long-term capital gains tax is applicable at 20.6%, with indexation benefits. For purposes of taxation, indexation inflates the cost price—to account for inflation—thereby shrinking your taxable gains, leading to lower taxes. On the face of it, investments in debt funds are more tax efficient if held for 3 years or more. But you could look at debt funds even for time periods of less than 3 years.
FDs had been used to get regular incomes. Debt funds can also be used for that if you combine them with systematic withdrawal plans (SWPs). An SWP is an instruction to your fund house to withdraw a certain amount from your debt fund and move it to your bank account. To do this, your fund will extinguish the units equivalent to the said amount, every month.
Back of the envelope calculations show how debt fund SWPs are more tax efficient than FDs (see table).
Vidya Bala, head of mutual fund research, Fundsindia.com, warns that investors must tone down their return expectations from mutual funds. “When investors come to mutual funds from fixed deposits, they... think mutual funds give very high returns. That is possible with some set of funds, but such funds call for a much higher risk profile. Debt funds, like accrual and short-term funds, return slightly more than FDs and are more tax efficient," she said.
Amol Joshi, founder, PlanRupee Investment Services, says that short-term bond funds are the closest substitutes to FDs, especially those that invest significantly in AAA- and AA-rated securities. Broadly speaking, debt funds offer liquid, ultra short-term, short-term and long-term bond funds. Avoid liquid funds as they are meant for those who wish to invest for not more than a month or two. For investments up to a year, stick to ultra short-term funds. If you wish to invest for more than a year, go for short-term bond funds as these funds have low volatility and aim to give steady returns. This route is meant for those who usually invest in cumulative income fixed deposits.
But what if you want to earn a regular monthly income right away? Bala prefers a mix of ultra short-term and short-term bond funds. “Spilt your lump sum amount between an ultra short-term bond fund and a short-term bond fund. Start an SWP in an ultra short-term bond fund first. Don’t touch your short-term bond fund just yet. After a period, of say 2-3 years, when your short-term bond would have grown, you can start an SWP from it as well.
Ensure that your SWP withdrawal amount does not exceed the returns that your debt fund usually makes. In our example, the fund earned a return of about 8.92% and a withdrawal of Rs5,000 every month, roughly translates to a return in hand of 6%. This means your fund grows even after your withdrawals. If you withdraw more than how much the fund grows “you will, unknowingly, eat into your principal," says Bala. It’s best to work out with your adviser to ensure you have a steady income, and at the same time, allow your fund to grow.
In the past 1-2 years, some distributors have sold balanced funds in the grab of giving regular income investors. Rough industry estimates say that the average assets under management (AUM) of dividend plans in balanced funds, in the March-June 2017 quarter, grew to Rs39,684 crore, compared to Rs29,206 crore in the January-March 2017 quarter. That’s a growth of 36%. The average AUM of growth plans of balanced funds for March-June 2017 quarter grew to Rs52,051 crore, up from Rs40,701 crore in the previous quarter, a jump of 28%. More authentic data would be available with a registrar and transfer agent (RTA) of mutual funds such as Computer Age Management Services Pvt. Ltd. We reached out to it but did not get a reply till going to print.
“Many banks are misselling balanced funds, especially their dividend plans, to investors who want to migrate from FDs. This is wrong, as dividends are not assured," said the head of marketing of a large fund house, on condition of anonymity. “It’s a dangerous move as the risk profile of a balanced fund, which is almost like an equity fund.... If markets go down, these investors are facing disaster," said Deepak Chhabria, chief executive officer and director, Axiom Financial Services Ltd, a Bengaluru-based distributor of financial products.
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