I have around ₹5 lakh lying idle in my savings account. I am looking for a better parking option (any instrument, not just mutual funds) which
- is safe as saving account/fixed deposit
- is liquid (I am open to lock it for one to two years)
- should earn better than FD
- the earnings are tax free.
I have been considering Equity Income Schemes lately. But I need expert advice.
- Philip
You are unlikely to find another investment that is as safe as a saving account and fixed deposit. You will have to compromise a little on safety if you want to park money for a short-term in other reasonably safe avenues, including mutual funds.
Since you have a holding period of more than a year, you can consider investing in arbitrage funds for a slightly better tax-free returns. These funds are treated as equity funds for the purpose of taxation and returns on investments in them held over a year are tax free. However, these fund don't invest directly in equity. They try to look for the arbitrage opportunities between the cash and derivative segments in the stock market. They have given a return of around 7.20-8.69 per cent in the last year. See their performance: Click Here
Equity Income Schemes are new products that invest in a mix of debt, equity and arbitrage. These schemes don't have a long history and it would be better to wait for sometime to see their performance before committing any money.
Here is a primer on Equity Income Schemes. It also discusses arbitrage funds.
Equity income funds: lower risk with lower taxation
Driven by India's tax rules, balanced funds have become too equity-heavy and risky. Now, there's a new type of balanced fund that combines tax efficiency with a more conservative, safer exposure to equities.
This new animal in the zoo of Indian mutual funds goes under the rather odd name of 'Equity Income Fund'. Experienced investors would find the name a little puzzling, because all hybrid funds--like balanced funds or MIPs--have both equity and income parts and could justifiably be called by this name.
High Risk, Low Taxation
Let's see what's new about these so-called equity income funds, and how they deliver lower risk while having the same lower tax liability as regular balanced funds or equity funds. Experienced investors know that under our tax laws, capital gains from equity investments are zero if you stay invested for more than one year. To qualify as an equity investments, a mutual fund must invest more than 65 per cent of its assets in equity. If the equity exposure drops below this level, then the risk will be lower, but investors will have a heavier tax liability, as for any income fund.
Low Risk, Low Taxation
That's where the new equity income fund come in and deliver lower equity exposure, combined with the lower taxation of equity funds. They do this by utilising equity derivatives in such a way that the returns are predictable and safe, while the investment is still classified as equity for tax purposes. Therefore, if one creates a balanced fund where some of the equity exposure is in the form of arbitrage trades, then one gets the very useful combination of lower risk and lower tax.
How Arbitrage Works Here
The idea is quite simple. The fund manager looks for opportunities where there is a price gap between a stock price and its futures price. For example, let's say the market price of a stock is ₹100, and the price of its futures a month hence is ₹101. Then, the fund manager could buy the stock and simultaneously sell the derivative. Effectively, this is a predictable and safe gain of one per cent over the month. However, it is an equity trade, and therefore a fund composed of such investments would get classified as an equity fund, and its investors would pay no long-term capital gains tax. In principle, this kind of an investment does not have the safety level of the kind of investments that short-term debt mutual funds make, and definitely not of bank fixed deposits. However, in practice, they offer a much higher post-tax return in exchange for a small technical increase in risk.
The Proof of The Pudding
There are now ten such funds, as you can see in the accompanying table. It's still early days--they haven't even completed one year yet--and their returns are a modest 8.66 per cent. However, the interesting part is how they contained the recent slip in the equity markets. The median of the worst one-week performance since launch is -2.38 per cent. The median of the worst one-month performance is -2.21 per cent. Compare these numbers with the worst one-week and the worst one-month performance of balanced funds. The median of the worst one-week performance of balanced funds is -5.88 per cent and that of the worst one-month performance is -5.41 per cent.
Loophole
Of course, investors should be aware that by investing in these funds, they are exploiting what is basically a loophole in the tax rules. It may continue like this for years, or the tax authorities may close it at any point--that risk is always there.
This article was originally published on October 08, 2015.
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