What every investor can expect from their equity saving funds

After spending more than 20 months in a rangebound manner, key equity indices are rallying strongly from April this year. At new highs, retail investors, especially the conservative ones, find it challenging to enter the market and allocate across assets and get the timing right. The recent rate pauses by the Reserve Bank of India (RBI) and the Federal Reserve suggest that interest rates may be peaking. Adding to all these, recent taxation changes in debt funds have made asset allocation even more complex for retail investors.

In this regard, equity savings funds from the hybrid category may be considered by investors with a modest risk appetite looking for downside protection, but not superior returns. Apart from equity and debt, these funds use equity arbitrage via derivatives to reduce risks and potentially generate better inflation adjusted returns. One key advantage that these funds offer is the equity taxation, as their gross equity exposure (including arbitrage) is above 65% of the portfolio at all times Here is more on how equity savings funds could be a hybrid category that is a useful addition to portfolios of conservative investors. Of course, some risks also need to be considered before taking a final call.

Derivatives investments

Equity savings products are managed very conservatively with an attempt to lower the volatility while participating in equities. The fund portfolio essentially consists of:

Equity: Usually the equity allocation on a net basis (adjusted for arbitrage or hedged portion) varies between 20% and 40% of the portfolio. The focus is primarily on market leaders or large caps with some allocations to the larger mid caps, given the overall focus to reduce volatility. In line with risk management practice, the aim is to diversify the portfolio with participation across sectors.

Arbitrage/derivatives: Fund houses hedge the equity part of the portfolio by using derivatives. This hedging strategy helps to add equity exposure to the portfolio without increasing the equity risk. The combined exposure of equity and the arbitrage portion is always maintained equal or above 65% of the portfolio to avail of the tax benefits.

Fixed income: The residual allocation up to 35% is invested in debt securities. The debt portfolio is focused on generating accrual returns by investing in high grade/quality instruments with moderate duration profile. Usually, the duration is of 1-3 years so that there is no additional duration risk in the portfolio, while the credit risk is managed by selecting high grade instruments of well-established issuers.

Edging inflation

As per category average returns over the past one, three and five-year periods, the equity savings funds can give double-digit returns in some years but can generate a little more than inflation over the longer term (see chart). But the returns in general would depend on market conditions, availability of arbitrage opportunities, prevalent interest rates and so on.

Taxation

Thus, with a combination of equity, arbitrage and debt, the equity savings funds attempt to generate better inflation-adjusted returns along with lower than equity volatility. Most conservative non-equity offerings are taxed at the slab applicable to the investor starting from the current fiscal, while a conservative product like equity savings is eligible for equity taxation which as per current tax laws would entail a long term capital gain tax of 10% (for units held for more than one year from the date of investment; excluding surcharge and cess).

Risks

The pure equity portion is also subject to market conditions and can fluctuate, as can the debt portion in case of interest rate changes by RBI in response to inflation data. There may be scenarios where equity savings funds can give negative returns in some years or over shorter terms as markets turn volatile. The idea is risk and downside protection and slightly better than debt fund returns. Investors must not expect equity-like returns from these funds.

Equity savings products seek to provide a simple but efficient solution for investors looking at potentially better inflation-adjusted returns along with lower volatility and taxation benefit. These products may be considered by investors with moderate risk appetite and a time horizon of three year or higher.

Sailesh Raj Bhan is chief investment officer-equity investments, Nippon India Mutual Fund