In the first part of this four-part series we had discussed about the factors affecting the popularity of Aggressive Hybrid funds and the reasons we think investors should still hold on to the category. In the second part, we will talk about another category that investors have been ignoring, i.e., Equity savings category.
With assets of over Rs 10,000 crore, the equity-savings category was designed to be an improvisation of the traditional monthly income plans (MIPs), now known as conservative hybrid funds. While both the funds seem pretty similar in payoffs, equity-savings ones are more tax-efficient, given that they enjoy equity taxation. These funds invest about one-third each in equity, debt and arbitrage, which makes them a suitable choice for conservative investors. While the debt portion helps investors get returns better than FDs, arbitrage helps in protecting from equity volatility.
Together, the equity and arbitrage elements add to over 65 per cent, which qualifies these funds for equity taxation. This category came into being in 2014 and was always flaunted as a tax-friendly option to an MIP. However, over the years, its charm seems to have fizzled out. Look at the graph 'Equity savings: AUM trend' which highlights the general lack of interest the category has been seeing.
According to D P Singh, Chief Business Officer at SBI Mutual Fund, "The expenses of equity savings kind of funds need to be rationalised. In this category, you have 60-65 per cent of the money invested in debt and arbitrage, which are today giving about 5 per cent, but the funds are charging the maximum permissible rates. It impacts the performance of the scheme."
Well, expenses are definitely a spoiler here. The graph 'Different composition, similar expenses' compares the expenses of these funds with actively managed large-cap funds. In case of regular plans, the expense ratio of the equity-savings category is fairly close to actively managed large-cap funds. Clearly, fund houses need to reduce the expense ratio as it acts as a drag on the category. Having said that, these funds aim to provide convenience and act as a one-stop regular income solution.
As far as hybrids are concerned, while dynamic asset-allocation funds have been hogging the limelight, the equity-savings category certainly has its own merits. We find this category particularly useful for the retirees who are looking for only a measured dose of equity in their portfolio.
To check how well these funds fit the bill as a regular-income solution, we ran an illustration on the category. Suppose Mr Goyal has Rs 1 crore at the age of 60 as retirement savings and he puts the entire corpus in an average equity-savings fund at the end of 2014. Further, he starts with a conservative withdrawal rate of 5 per cent in the beginning of 2016 and increases the amount withdrawn by about 5 per cent every year to keep up with inflation. However, to avoid eating into his retirement nest, he ensures that his withdrawal rate, by and large, does not exceed about 6 per cent of his capital. For simplicity's sake, we have also assumed that withdrawals are taxed at a flat 10 per cent.
The graphs 'Mr Goyal's retirement income' and 'Mr Goyal's withdrawal rate' show the outcomes. In the first graph, you can see that by investing in an average equity-savings fund, Mr Goyal would have been able to comfortably maintain the goal of getting a steady income with a constant increase. The second graph shows how the withdrawal rate would have been during this time.
Since this illustration incorporates taxation, it is relatively aggressive and even then, an average equity-savings fund would have been able to help Mr Goyal achieve his goal. If you're thinking that illustration shows only the average outcome, we did replicate a similar strategy on a few funds and they were well able to pass this test.
So, from a utility perspective, investors who don't want to assume higher risk, and want to derive a regular income from their investment can look at equity-savings funds. These are desirable funds for conservative investors seeking moderate and stable returns.