Debt tax tweak breathes life into equity savings scheme

Post the change in debt fund taxation in March, a lesser-known hybrid fund has emerged as one of the alternatives for fixed-income investors.

Equity savings schemes, the smallest hybrid fund category in terms of assets, have raked in around Rs 6,000 crore this financial year (FY24) so far compared to Rs 1,100-crore outflow in FY23.

The inflows along with a strong performance led to a 50 per cent surge in assets under management (AUM) to Rs 24,100 crore during April-November, shows data from the Association of Mutual Funds in India (Amfi).

Equity savings funds aim to strike the right balance between returns, risk and tax efficiency.

They invest in a mix of equity, arbitrage and debt, allowing them to offer returns that are higher than most fixed income products while keeping volatility lower.

According to regulations, these schemes have to maintain a minimum 65 per cent allocation in equity and arbitrage and 10 per cent in debt.

Equity savings funds are gaining traction among investors as they offer an opportunity to earn from the upside of equities and at the same time get stability from fixed income allocation, said Abhishek Tiwari, executive director (ED) & chief business officer, PGIM India Mutual Fund.

Also, since the equity and arbitrage portion accounts for over 65 per cent of the portfolio, these schemes qualify for equity taxation.

Equity funds enjoy a favourable tax treatment gain of up to Rs 1 lakh is tax free if the investment is held for more than one year. Profit above Rs 1 lakh is taxed at 10 per cent.

If the investment duration is less than a year, the rate of taxation is 15 per cent.

Whereas, in case of debt funds, gains are taxed at the investor s income tax slab rate.

Until FY23, debt funds enjoyed a concessional tax rate of 20 per cent along with indexation benefits for long-term investments (over three years).

Post the change in debt fund taxation, investors in the higher tax brackets were on the lookout for debt fund alternatives, which enjoy equity taxation.

As a result, categories such as arbitrage and equity savings have gained popularity, said Arun Kumar, vice-president and head of research, FundsIndia.

Strong performance of equity savings schemes as a result of the sharp rally in equity markets could have also played a role, Kumar added.

In the last one year, equity savings schemes have delivered anywhere between 18 per cent and 9 per cent returns.

According to fund managers, the divergence in returns is largely due to variation in pure equity allocation.

Fund managers have the flexibility to invest anywhere between 0 and 65 per cent in pure equity.

However, most schemes maintain the investment in the range of 20-40 per cent.

According to Mansi Sajeja, co-fund manager of SBI Equity Savings Scheme, the fund has generated higher returns in the last one year, owing to 38-40 per cent equity allocation.

SBI Equity Savings Fund has maintained an active equity at 38-40 per cent.

Within the active equity component, the fund is market cap agnostic and has a core portfolio of bottom-up picks, contributing significantly to the fund alpha,  she said.

Sajeja added that arbitrage allocation has ranged around 26-28 per cent of the AUM on an average.

Though the scheme is being seen as an alternative to debt funds, they carry higher risks and are not suitable for short-term investments, said experts.

It is suitable for investors who have a flexible timeframe of 3-5 years and can withstand slightly higher temporary declines compared to pure debt funds.

The broad post-tax return expectation can be 1-2 per cent higher than pure debt funds over a 3-5 year timeframe, said Kumar.

Investors should have an investment horizon of at least two years or above while investing in this category, said Tiwari.