Get dual benefits using systematic transfer plans

You may have heard the concept of Systematic Transfer Plan (STP) in connection with mutual funds. Have you ever wondered what this product is all about. An STP is not a product. It is a combination of a liquid (debt) fund and a Systematic Investment Plan (SIP) in an equity fund. Let us understand the idea of an STP with an example.

Sharad Patel sold the land he owned in his ancestral village to a large corporate for setting up a factory and received Rs 10 lakh as compensation. He has been advised to invest the sum for his long-term goals. But he is not too sure how to go about it. The current equity market conditions are volatile, so Patel is skeptical about opting for putting the entire money into equity funds. His concern is that markets may fall further after he invests in equity funds. That is when his financial advisor suggested the idea of a STP. What Patel needs to do is to invest this Rs 10 lakh in a liquid fund and then sweep a certain sum out of the liquid fund and into an equity fund over the next three years. His idle money will continue to earn about 5.5 to 6% in the liquid fund, while he will get the benefit of rupee cost averaging (RCA) in his gradual investment in the equity funds.

Converting lumpsum to SIP

A lumpsum amount can be converted into an SIP through the process of STP. Essentially, what you do in an STP is that the entire corpus is invested into a debt fund or a liquid fund and each month a fixed sum can be swept into an equity fund. Liquid funds are preferred as there is no exit load, so your movement of funds can happen at zero cost. As far as your equity fund is concerned, you are still doing an SIP and getting the benefit of rupee cost averaging. The idle money is better off than sitting in a savings account waiting for an appropriate opportunity.

In the above case, Patel can choose to allocate Rs 10 lakh to a liquid fund and sweep Rs 25,000 each month for a period of say four years. His idle money earns higher returns and the rupee cost averaging reduces his average cost of holding the equity fund.

Does STP work better or lumpsum

Generally, the STP should outperform the lumpsum investment because the idle money is earning higher rate of return and the effective cost of the SIP is likely to be lower. Here are some key reasons an STP can really add value:

It is difficult and practically impossible to time tops and bottoms of the market. An STP overcomes the problem by adopting a rule-based approach. When the Net Asset Value (NAV) goes up, you gain on your corpus and when the NAV goes down you get more units.

Over a longer period of time, the STP will work exactly like an SIP and ensure that the average cost of your holdings come down so as to enhance your returns.

STPs typically give you a dual benefit. Firstly, liquid funds earn higher return on idle funds than bank savings accounts. The STP into equities gives you the advantage of rupee cost averaging. This will be more obvious in the midst of volatile markets.

A lumpsum investment becomes a one-time commitment and if the price goes down subsequently then you are stuck with Mark-to-Market losses. The calibrated approach of an STP solves that problem and reduces the burden of decision making.

The active bias is avoided in an STP. When it comes to lumpsum investing, your returns will depend on how well you time the market. That is a function of the level of the Nifty, P/E ratio, price of entry, choice of fund etc. In an STP, you can also change your fund choice if you are not happy with the performance.

Tax benefits of STPs

An important consideration is the tax implication. Remember, when you invest in a liquid fund and sweep funds into an equity fund, then each sweep will be treated as redemption of the liquid fund. The real benefit arises in tax treatment.

Since you are doing STP on a growth plan, you only pay tax on the return component, while the principal component does not attract any tax. You can also time the STP in such a way as to enter around March and exit in early April after three years. This way, you get the benefit of double indexation also. Since, liquid funds do not charge exit loads, sweeping money out of the liquid fund into equity funds does not entail any cost.

The writer is head of research and ARQ, Angel Broking