Get best of equity, debt features in one product

When we call a person two-faced, it's an insult. But for some cleverly designed investment products, being two-faced is a compliment. These products may have debt/fixed income allocation, but they are taxed not like debt. If you invest in such products, you can get the stability benefit of debt, but with equity-like taxation or even zero tax depending on the structure. DNA Money talked to wealth managers to highlight these 'two-faced' products that truly give you dual advantages. Read on know about them.       

Equity savings funds

Equity savings funds have characteristics similar to hybrid aggressive funds. They offer equity tax treatment despite having partial debt allocation in their portfolios. Equity savings funds attempt to balance risk and returns by investing in equity, debt and equity derivatives.

"Derivatives lessen net equity exposure to about 20-40% and lessen volatility of returns. Further, since these funds have gross equity exposure of more than 65%, they are treated on par with equity funds for taxation purposes," says Rajesh Cheruvu, chief investment officer, WGC Wealth Management. 

From a risk-return perspective, equity savings funds fall in between hybrid aggressive funds (with more than 65 % exposure to equity) and a notch above hybrid conservative funds (with 5-25% in equity). The average three-year return of equity savings funds is 8.7%. "Equity savings funds are suitable for conservative investors, seeking moderate to low exposure to equity. Investors with a short time frame of investments could use this. Also, investors use these funds for a Systematic Transfer Plan to invest into equity funds in lieu of SIP from bank accounts," said Cheruvu. 

Capital appreciation potential of these funds is lesser than pure play equity funds, but they score over equity and balanced funds in terms of lower risk and over pure debt funds in terms of better tax efficiency.

Advantage arbitrage

Products with equity-like taxation have been a favourite of investors in all seasons due to their tax-friendly nature and the comparatively lower risk profile due to the fixed income component. For a scheme to qualify for equity taxation it must have a minimum portfolio allocation of 65% to equity asset class. Aggressive hybrid funds, earlier known as balanced funds, have a 65% component of equity and a 35% component of debt instruments. They have equity taxation. Such portfolios provide stability through the fixed income part and the growth part through equity. 

Joseph Thomas, head research, Emkay Wealth says arbitrage funds too provide equity-like taxation and they are a good substitute for liquid funds, and they generally provide efficient returns in relation to comparable funds. "They invest in arbitrage opportunities and do not take a directional view on the markets, making them relatively safer investment avenue," adds Thomas.

Arbitrage funds work best for those in the highest income tax slab. Imagine an investment of Rs 1 crore each in fixed deposits, bond/debt funds, and arbitrage funds. Assume fixed deposits and bond/debt funds give 7.5% pre-tax return in one year while arbitrage funds give 6.5% only. Due to the tax benefit enjoyed by arbitrage funds, their post-tax return would be higher than FD and bond/debt funds even though the others delivered a higher pre-tax return.

Experts feel investors should consider the risk profile of the product and not be merely swayed by taxation. "The taxation may be equity-like, but it is very important that you look at the risk profile of the products before investing. For example, very high portfolio duration of the fixed income component of balanced funds in a rising interest rate scenario could depress overall returns," says Thomas.

Zero tax in debt Ulip

Investments in debt fund option in Unit-linked Insurance Plans (Ulips) can ensure zero tax for investors even though they get the protection of debt. 

Sampath Reddy, chief investment officer, Bajaj Allianz Life Insurance says: "Since Ulips are a long-term investment/ savings product, they enjoy various tax advantages, including that maturity proceeds are exempt from tax under section 10(10)D of the Income Tax Act, 1961 (provided the annual premium is at least 10 times the sum assured) and also any fund switches are exempt from capital gains tax incidence (which may help investors to plan their asset allocation in a more tax-efficient manner)."

However, for long-term wealth creation, it is advisable for investors to do a higher allocation to equities, especially if the investment horizon is long term (10 years and above). The taxation benefit can be taken later by moving equity money into debt at a later stage (near maturity). "As the policy approaches maturity, preservation of capital / stable returns takes precedence and the investor can consider gradually shifting asset allocation towards fixed income. On maturity of the policy or unfortunate death of the life insured, the policy market value/sum assured is exempt from tax," says Reddy.

Investors must know how Ulip's bond fund duration may be dynamically managed. It will depend on the fund manager's interest rate outlook. 

Dynamic delight

Investors who want exposure to a mix of debt and equity and yet get tax benefits akin to equity scheme, can also consider dynamic equity asset allocation funds. "From a tax point-of-view, they are taxed just like equity-based schemes. One major difference between traditional balanced fund (which are also taxed like equity schemes) and these schemes is that there are no predetermined caps on asset allocation between equity and debt," says Rajiv Ranjan Singh, CEO - stock broking, Karvy. 

Fund managers, depending on their analysis, can change the allocation dynamically. For instance, when they feel that the interest rate cycle is about to turn, they can increase or decrease allocation to debt accordingly. Normally, fund managers use in-house models to determine their asset-allocation strategy. Whenever equity allocation falls, the fund manager ensures that equity component and arbitrage component t is maintained above 65%, says Singh.

Abhinav Angirish, founder, InvestOnline.in points out that a dynamic equity fund investor is taxed as per equity standards if at the time of exiting from the scheme, the fund on an average in the last one year invested 65% of the corpus of the fund in equities. "If the equity corpus couldn't be maintained than the investor will be taxed as per debt fund," he says. 

The same treatment is done with dividend distribution. "If the fund invested 65% allocation in equity on a median in last one year than the tax on dividend shall be about 11.648% as per the equity norms. The 65% of equity take along the debt portion with itself, which would be liable for 29.12% Dividend Distribution Tax, had it been a debt-oriented fund," says Angirish.

Dynamic equity asset allocation funds are riskier compared to a traditional balanced fund, due to issues related to market timing. However, the advantage of these funds is that they rebalance across assets and can lower volatility.

BEST OF BOTH WORLDS

• For a MF to qualify for equity taxation it must have a minimum portfolio allocation of 65% to equity asset class 
   
• Look at product’s risk profile too, and not only taxation. Very high portfolio duration of fixed income component in a rising interest rate scenario could depress overall returns