Everyone has different risk appetites. Some people can stay equanimous amidst the most chaotic markets and find undervalued gems. Some others wish to keep their finances uncomplicated, therefore, they incline towards simple debt instruments. (Also Read: All Doctors wanted to know about Public Provident Fund)
Being conservative with your investments is a choice that most investors make to get peace of mind. After all, if the goal is to let money work for you, then it should work silently. If it gives you sleepless nights and frequent heartburns, then it is not serving you. Most likely, it is the other way round.
A portfolio that is made of debt instruments – small savings, FDs, and debt mutual funds – can prove to be a drag for your financial goals. Most safe instruments do give you yields to top inflation and support a comfortable life. You need to add a small part invested in growth instruments to give a fillip to your portfolio returns. Read More: All you Wanted to Know About Mutual Fund: Concept and Types
Relatively unsafe debt instruments, like corporate deposits, can be too risky. Sometimes, even riskier than equities. Therefore, conservative investors think that they do not have too many options left and settle for lower yields and compromise on lifestyle.
So, is there any instrument that is relatively safe like good quality debt but can add a little zing to your returns?
It turns out that there is.
What are Equity Savings Funds?
The market regulator SEBI allows mutual fund houses to offer hybrid funds. As the name suggests, these funds are hybrid instruments comprising of both equity and debt. Therefore, the debt part gives stability, while equity gives the occasional booster shot to the returns.
Though launched in the early part of the last decade, hybrid funds have started to catch the fancy of the investors only recently. They are becoming popular for the balance they offer between stability & growth, and risk & reward.
There are different categories of hybrid funds – categorized according to the primary asset class they represent. These range from arbitrage to equity, and from dynamic asset allocation to multi-asset allocation funds.
Available since 2017, one of the most sought-after hybrid funds is the Equity Saving Funds. The SEBI mandate requires an Equity Savings Fund (ESFS) to invest a minimum of 65% in equity markets, and a minimum of 10% in debt markets. The 65% equity floor includes arbitrage opportunities in equity-related instruments.
The arbitrage levels are pre-defined with minimum and maximum levels of hedging set in the Scheme Information Document (SID). Every fund house can have different limits affecting their risk and returns giving investors many options.
The equity part provides the benefit of long-term compounding, while the debt part reduces the downside risks. Arbitrage opportunities help the fund manager to cap the losses on the equity portion, giving downside protection.
How does an Equity Savings Fund work?
The fund manager can exploit arbitrage opportunities arising due to price differences in cash and derivative segments of the equity markets. This makes ESFs less volatile compared to pure equity funds because their equity exposure is unhedged. The debt potion gives additional stability to the fund returns.
The hybrid nature of these funds puts them a notch below equity funds on the risk scale. While the perked-up returns put them above debt funds in the returns table. The flexibility to the fund’s manager to switch between asset classes help them contain losses. It also helps them keep the fund’s risk exposure moderate.
Equity Savings Fund is an ideal investment vehicle for anyone looking to diversify into multiple asset classes. Diversification and asset allocation require periodic review and adjustments. Most investors do not have the time and knowledge to do so. An ESFS can do it automatically for them. For conservative investors, who are wary of going all in to equities, ESFs can give the much-needed stability.
The equity and equity arbitrage parts can be allocated by the fund manager across market caps. Large-cap stocks give secular growth, while tactical investments in select mid/small-cap stocks may push it higher. The debt exposure, just like the equity part, gives enough room to invest in varied credit profiles with different maturities.
Advantages of Equity Savings Fund
Exposure to equity arbitrage and good-quality debt papers keeps the returns stable. The mandate for the fund manager is capital preservation with stability in returns.
Better Returns Than Debt Funds
Risk-averse or conservative investors can invest in these funds getting better returns than any of the debt-oriented funds or instruments. The equity part takes care of it.
As minimum equity exposure is 65%, the tax treatment is like any other equity fund. If you hold it for more than one year then long-term capital gains (LTCG) over Rs. 1 lakh are taxable at 10%. The short-term capital gains (STCG) from ESFs are taxable at 15%. Read More: Taxation of Mutual Funds In India
The arbitrage offers the biggest source of return stability. It allows the fund manager to take positions with low risks, high rewards.
the investor automatically gets the diversification benefit as the fund automatically invests in:
- Equities across market caps.
- Debt papers of different profiles and maturities.
- Arbitrage opportunities in stocks.
Lower Transaction Costs
As the churn in portfolio equities, debt instruments, and arbitrage opportunities are done at the fund level, the overall transaction costs are minimum.
Equity Savings Fund Vs. Balanced Advantage Fund
There is a First Cousin of Equity Savings fund which is having almost the same structure in the fund composition but still works differently.
Where ESFs restrict themselves on Direct equity up to 35% of the Portfolio, there BAFs can go up to 80% of Equity. On the other side, BAFs can go down in equity up to 30%.
So, in a rising market you may find ESFs down-performing BAFs, in the Falling market they may perform better.
Just like any investment avenue, ESFS also needs some consideration on your part.
Individual funds may have different risk/reward ratios depending on their portfolio composition. For example, a fund with more mid/small-cap stocks may give higher returns but would be more volatile than the one investing in the large-cap universe. Similarly, if a fund manager invests in sub-AAA debt papers, then the yields may be great, but the credit risk also increases.
Braving the Market Cycles
No fund can perform well across all market cycles. There would be some periods when the fund would give less than satisfactory returns in comparison to the broader market or benchmark. The objective should be to contain the downside while capturing the upside.
Equity Savings Funds are not guaranteed return products. Even pure debt instruments can’t offer that. So, if your distributor entices you with guaranteed returns, then it is a red flag and you must pack up and bolt.
ESFS are good instruments to invest for the period between three to five years. If you are looking to park your funds for a near-term goal, then equity savings funds might not be the right vehicle.
An ESFS should offer diversification. But if you see that the fund manager is betting too much on a particular sector or theme, then he is not doing a good job at diversification.
Though, at the fund level, the transaction costs are lower than at an individual’s level. But you can lose that advantage if you see the fund turnover ratio is too high. The ESFs would see more turnover due to the arbitrage built into their structure. But if you see the equity portfolio changing too frequently then it is a cause for concern.
The experience & track record of the fund manager and reputation of the fund house are also important considerations. Their past track record should be inspiring and consistent.
Equity savings funds are one of the more balanced instruments that are available for a conservative investor. Whether you are a retiree, nearing retirement, or conservative by nature, an ESF can give your better returns than debt funds and bank FDs. At the same time, they can be more stable in choppy markets, where you see wild swings at the drop of a hat. If you are looking for equity exposure for the short term, then also ESFs offer an ideal choice.