Most of us expect our investments to deliver one of two things - capital appreciation or regular income. While the mutual fund industry has plenty of products for those who prefer capital appreciation, there are hardly any viable ones for those who seek regular income.
All equity funds, given the volatile nature of stock markets target long term capital appreciation. So do a good number of the debt funds that duration calls.
But MFs have become very poor choices for investors seeking monthly or quarterly income, thanks to adverse changes to their taxation structure in recent years.
Not so long ago, MFs had Monthly Income Plans to cater to the regular income market. With 80-90 per cent of their portfolio parked in debt instruments and 10-15 per cent in equities, these plans offered monthly dividends with some regularity (but they did skip dividends if the equity market misbehaved). But the imposition of dividend distribution tax on these dividends rendered them quite inefficient. With dividend distribution tax on all debt funds hiked to an effective rate of 28.33 per cent, investors across tax brackets ended up forking out ₹28.3 out of every ₹100 they receive as dividends to the taxman. That's a burden that no debt investor can afford to bear.
Using the Growth option of MIPs or other income funds for this purpose proved to be no better. Before July 2014, investors who held Growth option units could use systematic withdrawal plans to receive regular cash flows from their funds by redeeming their units. This proved to be tax effective because the sums withdrawn after one year were taxed at 10 per cent, as long term capital gains.
This made the Growth options of MIPs and other debt funds a more tax-efficient way to earn regular income than bank or NBFC FDs, whose interest was taxed at the investor's slab rate. But post the 2014 budget that has become impossible too.
The budget brought in a minimum 3-year holding period for non-equity funds to get 'long-term' capital gains tax benefits. Therefore, investors who used systematic withdrawal plans (SWPs) to get regular cash flows from debt funds and MIPs had to pay tax at their slab rates on the returns. This ended up again chipping away at the income of investors, except for those who fell in the 10 per cent tax bracket.
With the high tax incidence closing out debt funds as an option for regular income, both investors and the MF industry have come up with other Jugaad solutions to invest in MFs and still earn monthly income.
Some investors seeking regular income, including senior citizens, have turned to the dividend options of equity funds for a regular cash flow. With the equity markets in a bull phase, equity funds have been upping their dividend payouts too. These payouts are tax-free. So far, this has been working out fine for everyone concerned.
But given that equity markets by their very nature are quite volatile and are likely to go up one year and down the next, they are far from being a reliable source for regular dividend payouts. It certainly isn't wise for investors to lean heavily on equity funds to meet their monthly living expenses.
The industry on its part has come up with complex alternatives that marry the tax advantages of equity funds with the low risk of debt funds. Equity Income funds, which park 30-35 per cent of their portfolio in stocks, 30 per cent or so in arbitrage opportunities return and the rest in actual debt securities, have been one such innovation. Thus, with 65 per cent of their portfolio parked in equities and equity derivatives, such funds are treated as equity funds for tax purposes.
But while this may be a smart way to save on taxes, the returns may not be as predictable as those from income funds or even MIPs. While the 30 per cent debt portion in these funds can no doubt pay out regular interest, profit booking on the equity portion can only happen in bull markets. Arbitrage can yield predictable returns, but returns depend on the arbitrage opportunities available in the market.
As a result, about two-thirds of the portfolio returns on such funds are subject to some form of uncertainty. This makes them not-so-ideal as regular income funds.
So what could be the alternative? The truth is that using equity oriented funds or pseudo-equity funds to try and maintain a regular dividend is a bad idea. The only kind of MFs that can truly deliver regular income to monthly income investors is a pure debt fund, or one with a marginal equity investment.
So maybe one good idea to deliver a regular income to MF investors could be a deferred Monthly Withdrawal Plan (MWP). Basically, why can't we have a debt fund with a three year lock-in period, where investors can set up a deferred monthly income? Such a fund can invest either wholly in high yielding corporate bonds (which are available aplenty today) or in 90:10 mix of bonds and large-cap stocks.
So, if I as an investor want a monthly income from August 2018, I need to buy the plan today and hold on for the next three years, without any expectation of dividends.
But at the end of three years, investors can use SWPs to redeem units each month so as to create their own monthly 'income'. Yes, the returns made on such withdrawals will be subject to long term capital gains tax at 20 per cent. But as the cost can be indexed to inflation, the investor may still end up making a decent post-tax return. Given that the stocks have a 3 year time frame to pay off, such a structure may even be better at delivering equity returns than the current MIPs.
So, any takers for the deferred MWP?