Three tax-efficient mutual funds for safe, short-term investors

Investors seeking stability with a touch of growth have typically turned to conservative hybrid funds . These funds combine debt investments (for safety) with a small portion of equity (for growth) to create a balanced, low-risk portfolio. However, their structure works like a double-edged sword. Although its debt features provide stability to your investments, the gains from these funds are now taxed as per your income tax slab rate. Which means it is not very tax-efficient for those who fall under the highest 30 percent tax bracket.

This is where three equity savings funds come to the rescue. Equity savings funds offered by ICICI Prudential , Franklin India and PGIM India have embraced a more tax-efficient model, making them an attractive option for conservative investors looking for stability, tax efficiency and low volatility.

These three tax-efficient equity savings funds are slightly different to the other equity savings funds widely available in the market. While these three funds also invest in equity, debt and arbitrage strategies, they limit their net equity exposure to just 15-16 per cent, compared to the category average of 30 per cent. That said, they continue to keep their gross equity exposure above 65 per cent with the help of arbitrage positions. This structure helps them get the added benefit of equity-like tax treatment.

So, if you stay invested in any of these three funds for over a year, gains only above Rs 1.25 lakh will be taxed at 12.5 per cent. If you withdraw within a year, the tax rate on gains is 20 per cent. In short, they are more tax-efficient than conservative hybrid funds, especially for investors in the highest 30 per cent tax bracket.

Stability

Since these three funds have almost halved their net equity exposure to 15-16 per cent, they have become more stable. Their standard deviation, a measure of an investment's volatility, has come down by four percentage points.

Performance

The trade-off for added stability is slightly lower returns than conservative hybrid funds, primarily because conservative hybrid funds have higher net equity allocation on average, around 20 per cent.

However, when considering post-tax returns, particularly for those in the highest tax bracket (30 per cent tax rate), the performance of the three equity savings funds looks more favourable. Two of the three equity savings funds - Franklin India Equity Savings and ICICI Prudential Equity Savings - have delivered 1-1.17 percentage points higher returns than the conservative hybrids ever since they reduced their equity exposure, while the third fund delivered lower returns, but by just 0.1 per cent.

The final word

The three tax-efficient equity savings funds fill a niche between traditional equity savings funds and conservative hybrid funds by offering safer returns with equity taxation benefits.

That said, these funds may not be suitable for retirees or those seeking regular income. Why? Retirees and regular income seekers should have at least one-third of their money in equity to ensure they don't run out of money later, whereas these three funds only allocate 15-16 per cent to equity.

Also read: Long-duration funds are top-performing debt funds right now. Time to invest?