Tax on Capital protection funds

A capital protection-oriented fund is a closed-ended debt scheme of a mutual fund. The fund manager invests money in both equity and fixed income instruments in a pre-determined ratio.

Most of your money is invested in high quality fixed income instruments that are expected to mature in sync with the end of the scheme tenure.

High quality fixed income instruments include instruments with high ratings that imply low possibility of default.
This ensures that by the end of the scheme term, the money invested in these instruments grows to the original sum invested in the capital protection-oriented fund. Rest of the money is invested in equity.

To understand it better, let us take an example. Suppose `1 lakh is invested in a capital protection fund with a three-year tenure.

If the fund manager comes across instruments of high credit quality with the least possibility of default, offering 8% return per year, he would invest approximately 80% of the money into a portfolio of such instruments.

This will ensure that this money will grow to `1 lakh at the end of the tenure and you are assured of getting your money back. The remaining 20% of the money in this case is invested in equity. While fixed income instruments assure your capital back, equity brings in the much needed returns.

Put simply, the performance of the capital protection-oriented funds will depend on the fund manager’s ability to choose the right calls in equity.

A point to note is that the fund does not guarantee your capital. In extreme situations, if the issuers of the high quality fixed income instruments default, a scheme may show capital loss.

Normally, if the investor remains invested till maturity of the scheme, he is likely to get the capital back along with returns generated by equity.

Units of the capital protection oriented scheme are listed on the stock exchanges. However, they are rarely traded on the stock exchanges offering little liquidity to the investor.

Capital protection oriented funds are taxed like a debt mutual fund , where long-term capital gains are taxed at 10.3% without indexation or 20.6% with indexation, whichever is lower.

Source: Economic Times

How to earn better returns from your MF portfolio

Pick up any mutual fund portfolio of an active investor and you will usually find it beset with typical problems. These can affect the overall performance. If we can understand, identify and rectify these common blunders, we can make much better returns out of our money.

A bloated Portfolio

Many people have the habit of collecting funds. Over time, therefore, you will find such portfolios having 40-50 funds. Diversification is good, but over-diversification is not.

Firstly, a large portfolio would mean that some funds in the portfolio will always be below-average, thus dragging down your total returns. Secondly, even with all the support of the computers and specialized websites, it is not possible to effectively manage a large portfolio. This again is going to impact the performance on the whole.

One should, therefore, have a limited but power-packed portfolio. The idea is to extract maximum punch with minimum cost and effort.

Chasing the Top Performers

There is too much focus on the performance and that too usually the recent one say over 3 months to 1 year. That’s why you always find this fascination among people for fund rankings.

Of course, performance matters! But making performance (and that too short-term) as the sole selection criteria can prove counter productive.

 

Historical evidence shows that no fund can always remain the top performer. It also shows that a fund, which has been consistently amongst the top quartile say over 3-5 years, will usually continue with its’ good performance. Similarly, a consistently poor performing fund usually finds it difficult to make it to the top.

Besides this the markets, as we all know, are highly sentiment-based. Therefore, more often than not, you will find some theme or the other being market fancy. It could be infrastructure, mid-caps or technology and so-on. At any given time you will find that most of the top performers belong to the same category.

So if you chase top performers you will end with similar schemes in your portfolio. In the process, the portfolio becomes concentrated, defeating the very idea of using MFs to diversify one’s investment.

Your focus should not only be the past performance but also reputation & management of the AMC, fund’s investing style & focus, asset size, etc., besides of course, other key factors such as your investment horizon, risk appetite and other funds in your portfolio.

Mismatched and Unbalanced

It is but natural that the money you need in the short term should be in debt, while only the long term money should be in equity. Liquidity apart, your asset allocation between debt and equity should be in line with your risk appetite.

Some people of course do not do so. Some others start in planned manner. But, as equity and debt follow different paths, over time the portfolio will become mismatched and unbalanced.

As such you may either be over-exposed to equity thus increasing risk; or under-exposed thus losing out on the benefits of equity.

Or a liquidity mismatch may happen between the investment and your need. For example equity markets may be down when you need money, thus forcing you to sell at a loss.

Thus your portfolio needs timely review and correction in tune with your risk appetite & liquidity needs.

Infested with NFOs

Thousands of pages have been devoted to pointing out the myth of NAV. Yet the logic that NAV has absolutely no bearing on the future returns, simply does not register with a common investor.

Hence one can see thousands of crores flow into NFOs especially in a bull market, while the existing funds get practically nothing. In fact, it’s the opposite. People switch out of existing schemes to invest in NFOs under the false impression that Rs.10 NAV fund is cheaper.

As such a typical portfolio would be infested with NFOs. Higher costs in NFOs vis-à-vis existing funds will eat into the returns. Also as the so-called low NAV is why you invested in the NFO, it is quite likely that the fund’s style and focus does not fit with your needs. This also is going to hamper your returns.

Too Much Churning

Call it impatience or a false sense of being proactive or the instant-culture – we simply cannot wait and watch our portfolio grow. We always feel that we need to do something regularly.

Therefore, as soon as a fund shows good appreciation, we are quick to book profits. Or if a fund does not move for some time, we are equally prompt to dump it. This, for one, is adding to the costs in terms of capital gains taxes, entry loads, exit loads, STT, etc. But more importantly, we may be getting out too soon and thus missing out on future performance.

For example, I know investors who want to exit from some funds whose focus is on smaller or mid-sized companies. Now these are the funds, which usually will take time to show returns. It’s quite logical. A Bharti or a Suzlon or an Infosys did not become big in one day. Similarly, who knows how many such future stars are there in these funds? If we wait for 3-5 years, many such budding companies will blossom into beautiful flowers and give us super-normal returns. The question is – are we willing to wait for it?

Building and maintaining a well-diversified and balanced portfolio is no rocket science. All it needs is common sense and discipline to act prudently, promptly and purposefully.

Source: moneycontrol.com

Minimising capital gains tax

If you switch from dividend option to growth in a mutual fund during the year, it could attract tax.

Many retail investors are looking to take advantage of the soaring indices by selling their stocks and mutual funds (MFs). Besides booking profits, they can adjust such profits against any loss-making investments, thereby minimising the tax on capital gain.

Investors need to keep a few details in mind. Any Long-Term Capital Gain (LTCG) arising out of sale effected on or after October 1, 2004, on shares and equity-oriented MFs are exempt from tax. This provided, the transaction was on a recognised stock exchange in India and the investor has borne the Securities Transaction Tax (STT) on the sale.

CAPITAL GAINS & LOSSES

The Income Tax Act says capital losses can only be set off against capital gains – other incomes like salary or business income cannot be used. Long- Term Capital Loss (LTCL) can only be set off against taxable LTCG. However, Short-Term Capital Loss (STCL) can be set off against both Short-Term Capital Gain (STCG) and taxable LTCG.

STT is not required to be paid on the following transactions taken place on or after october 1, 2004:

  • Asset other than equities and equity-based MF schemes
  • Sale of equity shares which has not taken place on a recognised stock exchange in India.
  • Redemptions, share buy-backs by the companies.

On such assets, LTCG will be taxed at 10 per cent without indexation or at 20 per cent with indexation, whichever is lower. STCG is considered as normal income of the assessee, added to the income and taxed at the slab rate applicable.

SET-OFF ISSUES

Both LTCG and LTCL are tax-free. So any LTCL incurred from October 1, 2004, arising out of sale of equity shares or equity MFs cannot be set off against any LTCG, even the one arising out of, say, housing property. But it is possible to save tax on LTCGs by using Sec 54EC, 54F, 54 and carrying forward the losses.

Take the case of an individual who has earned taxable LTCG and has invested the gains immediately thereafter in infrastructure bonds, to bring his capital gains tax to nil. The question arises, if during the same financial year, he incurs a LTCL, can he offset the loss against the gains, in spite of having invested in the bonds under section 54EC? Also, can he carry forward the loss?

The answers to these questions lie in the fact that sections 54/54EC/54F are exemptions and not deductions. In other words, if an income is eligible for exemption, it is not to be included in the computation of income. On the other hand, deductions (Secs. 80C, 80G, 80D, 80U) are to be claimed after having aggregated the incomes from different sources.

After having claimed the exemption under section 54/54EC/54F, an income ceases to be taxable. As such, the full amount of capital loss can be carried forward. So, if the assessee earns LTCG later in the same financial year, he can invest in bonds within six months, claim exemption under section 54EC and carry forward the loss.

SWITCHING OPTIONS

If an investor is contemplating a switch from dividend to growth or vice versa within a MF, he could attract capital gains tax liability. One should take care to see that the investment has been done over a year. In that case, LTCG would be exempted, else the same would be taxable. However, a switch from dividend to dividend-reinvestment option will not invite any tax liability.

Since due to current tax laws, there is no difference between dividend reinvestment and growth, it is suggested that if the switch is being made before a holding period of one year, it should be done in the dividend reinvestment option. This would give a benefit similar to the growth option but without the attendant tax liability.

Source: Sifty.com

5 Mutual Fund Myths

It is easy, even for an intelligent investor, to be taken in by the hype surrounding a mutual fund scheme. Such misconceptions can impact the investments, which is why they need to be debunked. Here are the five common myths:

1. A fund with a net asset value (NAV) of Rs 10 is cheaper than the one whose NAV is Rs 50: The NAV of a mutual fund represents the market value of all its investments. Any capital appreciation in the fund scheme will depend on the price movement of its underlying securities. Suppose you invest Rs 1,000 each in Fund A (a new scheme with an NAV of Rs 10) and Fund B (an older scheme with an NAV of Rs 50). You will get 100 units of Fund A and 20 units of Fund B. Let's assume that both the schemes invest in just one stock, quoting at Rs 100. If the stock appreciates by 10%, the NAVs of the two will rise by 10%, to Rs 11 and Rs 55, respectively. In both cases, the value of investment rises to Rs 1,100-an identical gain of 10%. Fund B's NAV is higher as it has been around for a longer time and had bought the scrip earlier, which appreciated. Any subsequent rise and fall in the funds' NAVs will depend on how the scrip moves.

2. A balanced fund will always have a 50:50 debt to equity ratio: Balanced funds aim to achieve a balance between equities and debt. But the balance can tip depending on the nature of the fund. The equity-oriented balanced funds usually invest at least 65% in equities and the rest in debt. The others do this in a 40:60 ratio.

3. Large corpus funds generate higher returns:  A fund with a very large corpus is prone to inefficiencies as rising assets become unmanageable after a point. Also, most fund managers are more dextrous managing mid-sized funds. A large fund forces them to broaden their stock universe. This can lead them to include less researched or low-potential stocks in the fund's portfolio or increase the stake in certain stocks, leading to a selection bias. HDFC Equity has a corpus of Rs 2,680 crore, but its three-year annualised return is -1.68%, whereas the best performer for the same period is Reliance Regular Savings Fund, with an annualised return of 7.71% and an AUM of Rs 618 crore. At one-fifth the assets, the Reliance fund has fared far better.

4. Funds that regularly declare dividends are good buys: Fund houses declare dividends when they have distributable surplus. However, there are times when fund managers declare dividends as they do not have adequate investment opportunities. In some circumstances, a fund manager may sell some quality stocks to generate surplus for dividend distribution to attract investors.

5. SIP always scores over lump-sum investing: A systematic investment plan (SIP) is the best way to invest during volatility as it lowers the average per unit cost. This is also termed as rupee cost averaging. However, investing systematically during a bull run results in lower returns. When markets are constantly rising, SIP fails to lower the average cost and so results in lower returns compared with a lumpsum investment.

Source: Business Today

Liquid Plus Funds of mutual funds

A few days ago, the Reserve Bank of India (RBI) announced the credit policy. Most of what is said seems like Greek and Latin, and we quickly scan the newsprint to see whether deposit rates are going up, or interest on loans could come down; and when we see the opposite, we are, of course, disappointed. But the RBI uses the credit policy to signal what it wants banks to do. In the recent policy, repo rate — the rate at which RBI lends overnight to banks — was raised 0.25% or by 25 basis points to 5.75% pa, and the reverse repo rate — the rate at which RBI absorbs the surplus overnight funds from banks — was hiked by 50 basis points to 4.50% p.a.

Overnight Funds with Banks

So, as you freely deposit and withdraw money on a daily basis, your bank needs to ensure that it earns money on your deposits, especially as they now pay you interest too on a daily basis. If no other bank wants to borrow money in the inter-bank call money market, your bank will invest these funds with the RBI and earn 4.5% p.a. Obviously they will lend to another bank at a higher rate than that as, for the other bank, that would be cheaper than borrowing from the RBI at 5.75% pa (repo rate). The reason why the bank needs to borrow funds overnight is that they need to maintain a statutory liquidity ratio of 25% and a cash reserve ratio of 6% of the bank’s net demand and time liabilities.

How does this impact you?

The money that you have in your savings bank account earns you 3.5% pa at present. Since the interest rate corridor, or the difference between repo and reverse repo rate, has been reduced, inter-bank and short-term interest will move in a narrow band between 4.5% and 5.75% pa, and these are returns that liquid plus funds could earn. By now, of course, you are well aware that mutual funds have a tax advantage over bank deposits for those in the higher tax bracket — 20% or upwards. So, do consider moving your idle funds in the bank to liquid plus funds, which normally carry no entry or exit load.

Longer term investments

Mutual funds also offer investment opportunities in fixed income products for the longer term such as government securities and corporate bonds. While these instruments carry a fixed rate of interest or coupon, the market rate of these fluctuates virtually on a daily basis. As a result, values of these schemes can fall in the short term: this happens funnily when interest rates are rising. However, if I do buy a bond which will mature in, say, 3 years, and hold on till maturity, I can be oblivious of these daily price movements.

Past track record

I did a study on the performance of a decent performing government securities fund, and found that, while it had fallen 0.08% in the past one month, appreciation in the past one year was over 11%, and the 3-year returns were a healthy 10.6% p.a. compounded annually. After long-term capital gains, this meant a very attractive post-tax return of 9.5% p.a. Similarly, a short-term debt fund has earned 7.3% in the past one year, or an equivalent of earning 10% on a 1-year bank deposit for someone in the highest tax bracket. Do consider debt mutual funds to increase the possibility of returns, but under supervision of a competent financial advisor.

Source: Economic Times

All about exchange traded funds (ETF)

Q: What would you set out as a basic definition of ETFs? What is it about?

Shah: The ETF basically is a fund which you can buy everyday in the market. In simple term, it’s a mutual fund which basically you have to buy, and you can easily buy in the stock exchange.

Q: You agree with that? Is that a fair and simple explanation of the product?

Laxmi: Yes absolutely. An ETF is nothing but a very passive form of investing into the underlying index or the constitution or the asset class and it broadly mimics the underlying index or what the underlying is. You can freely transact it on the exchange by the virtue of it being listed on the stock exchange. So in effect what you are getting is the convenience of transacting in a stock kind of a form in a mutual fund unit.

Q: If you had to set out the key three-four differences between a mutual fund and an ETF, what would you say are the primary differentiators?

Shah: The basic differentiator is that ETFs are usually on a passive fund. So what happens is typically the fund manager is not talking any active calls on the portfolio at all. You just go and buy the underlying asset be it an index, say a Nifty or a junior Nifty, or a bank or you just go and buy gold. In terms of the other funds typically, the fund manager is taking active calls as to what makes sense for him in the market.

The second difference would be that you can buy at real time prices. The biggest advantage of an ETF is that if the markets are down today say at 2% or 3% in a normal fund if you buy the fund on the same day you would get the end of the day NAV. So if the markets moved say since 10:00am in the morning to 3:00pm by 2-3% you would miss out on that movement and you will actually pay 2-3% higher or if you sell you lose out 2-3%.

Thirdly, the difference is all the units of the mutual fund go into a demat account. So it’s not a statement of account, so you can actually see those your units in your demat account and add upto your own portfolio. So these are the basic differences I would say from between an ETF and a normal open-ended fund.

Q: But there are also active ETFs versus passive ETFs. Is that not available in India, what is the difference there?

Shah: Active ETF is a very new concept. It’s just taking shape in the US market. The size is not really grown too much. We don’t have it in India at all at this point in time. What we have in terms of differentiation of a passive ETF is the whole idea of fundamentally weighted index and you weight the stocks in a very different manner and you create your own index and then invest in them.

It is a little different from the public indices which you have like S&P 500 or Nasdaq or Nifty—these are indices which everybody owns and themselves do it but again its investing in an index be it that you are investing in an index which is your own index. Active ETFs have just about started taking off in the US. We don’t have a lot of size in that—the total size as I understand is as about USD 2-3 billion and in India you don’t have it in this point in time at all.

What one shouldn’t expect from Mutual Fund Scheme

Look at Coal India investors . They have made a cool 40% on listing on Thursday and look at my mutual fund scheme; it has just given around 20% in the past on year. These are the kind of refrains you hear from some mutual fund investors. For them, mutual fund is one-stop shop, where the fund manager will do everything for them: asset allocation, profit-booking, rebalancing of the portfolio… the list just goes on. Sure, you can do most of these things with the help of mutual fund schemes, but still you have to do them. This is because your fund manager won’t offer you customised solutions – largely, he doesn’t have any clue about you at all, all he hopes is that you have understood the scheme and invested in it after that.

Flash In The Pan: You must have read about stocks hitting the upper circuit of 10% or 20% in a day in the stock market. But you may have seldom heard about mutual fund schemes doing the same. In fact, if it does, you should be worried, not the other way around. A mutual fund scheme’s portfolio comprises various stocks, ideally reputed companies with long-term track records. These stocks are unlikely to hit the upper or lower circuit, unless something extraordinary has happened to the company. “ mutual funds are meant to deliver over a long period of time, and not overnight. To make the best of the investments in mutual funds, its is better to invest in a diversified equity fund with a good long-term track record,” says Nikhil Naik, managing director of Naik Wealth, a mutual fund distributor. A classic example is HDFC Equity Fund that has multiplied the initial investments 30 times over the past 16 years since its inception.

This must be seen in the light of approximately five times growth in S& P CNX Nifty over the same period of time. Thematic funds may, in some cases, ride the booming sentiment and deliver well in a short period of one month to one year. But if you cannot time your entry and exit, you may land on the wrong side of the market, hurting yourself. It is advisable to let the fund manager of a diversified mutual fund take a call on sector allocations from time to time to enjoy growth across sectors and companies across market capitalisation.

Personalised Solutions: Don’t expect the fund to offer you customised investment options. A mutual funds work on the premise of pooling mechanism. Typically, a mutual fund scheme will have people with different needs. In certain case, it can be even contrasting. This factor becomes very crucial when it comes to booking profits. For example, redemption pressure during dull market conditions may force a fund manager to sell stocks that have huge potential. This can have an adverse impact on you as an existing customer in the scheme. You may also have some preferences when it comes to investments, but in most cases last-mile customisation is not possible in a mutual fund scheme. However, there are ways to handle this issue.

“Systematic withdrawal plan, where you can redeem a certain amount of money at regular interval say each month, can come to help for those with income needs,” says Nikhil Naik. Trigger options launched by mutual funds help investors to book profits at a pre-determined rise in NAV over the floor NAV. Products like ethical fund by Taurus AMC and shariah-compliant fund by Benchmark AMC offer investors investment opportunities in a socially responsible way to a certain extent. But, keep that in bold letters, you have to make these choices.

Asset Calls:Mutual funds go by the mandate of the scheme. For example, equity funds have to invest at least 65% of the money in equity and related instruments. This mandate offers the fund managers a limited scope to book profits and increases their exposure to short-term fixed income instruments at high levels in equities. The same holds true for sector funds, too. The fund manager doesn’t have the liberty to dump the sector despite knowing that the sector is not going to do well. That is why, it becomes imperative that the investor himself has an asset allocation plan and rebalances the portfolio at regular intervals. “Invest proportionate amount in a diversified equity and pure debt fund and keep a track of it,” says Abhishek Gupta, CEO of Moat Wealth advisors, a financial planning services provider.

Multi-Baggers: Does the term ring a bell? Well, it refers to stocks that deliver many times their purchase cost. They can also come in various denominations like 10-baggers and 20-baggers. A fund manager invests in stocks that are approved by the investment committee of the fund house. The process ensures risk management of the fund in which your money is invested. This benefit also brings in some disadvantages. Low market capitalisation and low liquidity in stocks of small companies is a hurdle the fund managers cannot jump over in ‘investment-process driven houses with strong risk management practices’. This means your fund manager won’t be featured along with the top guns in the market.

Though good diversified equity funds may not come with such stocks, they are still good candidates for your core portfolio holdings. Let the fund manager manage a ‘core portfolio’ for you. You can look separately at companies that do not fit into the mutual fund’s investment universe but look promising (you can use a small or micro scheme for the purpose). “Portfolios of companies with established track record offer you stability. If you combine them with small companies with growth potential, you can enjoy higher returns, though at a higher risk,” says Ganesh Shanbhag, managing director, SMS Financial Services. If you do not have skills to identify such opportunities, then better restrict yourself to equity mutual funds.

Assured Returns: Your mutual funds can’t offer guaranteed returns to you. Sebi has done away with the practice long time ago. So, make sure you understand the risk you are taking while investing in a particular mutual fund scheme. This is called investment risk. Simply put, investors have to accept both gains and losses after investing in a fund. There is little that an investor can do after he invests in a fund. So better ascertain why you want to invest in a mutual fund. If you are aware of your risk appetite, you can accordingly invest. Never invest in a fund with no or limited track record.

 
Source: Economic Times

All about Mutual Funds Systematic Investment Plan (SIP)

An SIP or Systematic Investment Plan is a way to invest in mutual funds at regular intervals. In SIP method of investment, the investor has to invest a fixed amount in a particular mutual fund regularly, say monthly or quarterly.

The minimum period of investment is one year and mutual funds are sold in units. Investor can purchase the units at market rate for a fixed amount. For example, you can invest Rs 12,000 in a mutual fund at one time or you can use SIP and invest Rs 1,000 every month for 12 months (January 2010 to December 2010). If the net asset value of the fund on say January 7 was Rs 50 per unit, the investor will purchase 240 units of the mutual fund. However, if the investor uses SIP to purchase the mutual fund, the number of units purchased on January 7 will be 20. Every 7th day of the month, the fund house will sell the number of units worth Rs1,000 to the investor. The total number of units purchased under SIP will be 249 units (rounded off). Note that when prices are rising, the total number of units purchased under SIP would be lesser. If the market rates are falling, the investor will get a greater number of units for the same investment.

Some companies also have daily SIPs. Here the investor has to invest a fixed amount daily in the mutual fund. For example, Bharti AXA and IDFC permit daily SIP. If the market is relatively stable, the number of units purchased through daily SIP and monthly SIP will not vary much.

An investor can issue post dated cheques or give instructions to banks to release payment regularly.

Why should you invest in SIP?

SIP has several advantages for the investor. To begin, people who cannot afford to make lump sum investments and hence shy away from mutual funds can invest through SIP. SIP permits small regular payments and modest investors can use this method to invest in mutual funds. For example, it may be difficult to invest a lump sum of Rs12,000/ but it is more affordable to keep aside Rs 1,000 per month. Most mutual funds permit a monthly SIP investment of an amount as little as Rs500 per month.

Another big advantage of SIP is that it irons out the market rate fluctuations from your investment. Since units are purchased every month, the numbers of units purchased by the investor are more representative of the market rate. SIP has the benefit of averaging the purchase cost of the investment. If the net asset value falls in the following months, you actually stand to gain in the long run since you purchase more units of the mutual fund in contrast to if you make a single investment. SIP promotes regular investment. In addition one can also hold a diversified portfolio.

The minimum investment for SIP is Rs 500 per month in most cases. Hence if you have Rs 1500 to invest per month, you can purchase 3 mutual funds instead of one. A diversified portfolio reduces the risk factor of your investment.

Source: Yahoo Finance

What are Balanced mutual funds?

Hybrid equity funds, commonly known as balanced funds, are ideal candidates for constituting the core of a portfolio. In a balanced fund, the fund manager balances the fund’s equity-debt allocation according to the market conditions.

The only drawback of having balanced funds is that one cannot specify the equity-debt mix. This will be determined either by the law or the fund house.

WHAT IS IT?
Balanced funds combine a stock component, a debt component and sometimes a money market component in a single portfolio. They generally stick to a relatively fixed asset allocation. It is geared toward investors looking for a mix of safety, income and modest capital appreciation. The amount such a mutual fund invests in each asset class remains within a set minimum and maximum limit.

HOW DIFFERENT?
The objective is to provide capital growth via a mix of equity and debt. The unique proposition of spreading investments among two broad asset classes is hard to find in other types of funds. The higher equity allocation gives these funds the opportunity for high growth, while the debt component provides a cushion when the equity component fails to perform. At the same time, the same debt allocation pulls the fund’s return lower during a bull run, since these funds are not fully invested in equities.

The best balanced funds keep allocation flexible and open to changes as demanded by market conditions (but subject to regulations). Balanced funds have the lowest downside standard deviation, a measure of volatility.

PLUSES
Switching: Their key advantage is the ability to switch from a high equity allocation when the market is bullish to low equity allocation when the market turns bearish.

Diversification: These funds offer diversification in the true sense, with a portfolio of stocks and bonds, thereby offering a blend of growth and safety.

Hassle-free: You do not have to take the trouble of managing an assortment of investments yourself. One fund does it all.

DISADVANTAGES
Active-management risk: The active-management risk can get amplified because the fund’s exposure to equity or debt is a function of the fund manager’s view about the direction of equity markets.
 

Objective mismatch: Such funds may have bonds of lower tenure. Long-term bonds earn significantly more than short-term ones.

TAX INCIDENCE
Most balanced funds are treated as equity funds. Currently, they are subject to just short-term capital gains tax (at 15 per cent). Both dividend income and long-term capital gains are tax-exempt.

The tax rules play to the strengths of balanced funds. Investors need to rebalance their portfolio at the end of every year to maintain the desired asset allocation. But the short-term capital gains tax will make rebalancing before one year a tax-inefficient strategy.

In balanced funds, fund managers do the rebalancing. The current tax laws do not have a provision for taxing the fund manager’s actions.

HOW TO BUY IT
You can check for ratings of the fund before investing in them. However, these ratings are quantitative measures. The way one 5-star fund may have generated returns might not suit your risk appetite. Hence, you should dig deeper and try to gather more information about the fund. One should look at how active the fund manager has been in asset allocation. Check whether in the process of generating excess return, he has allowed equity allocation to go beyond 65 per cent.

Opt for funds that have shown consistent results. A fund like Escorts Balanced tops the chart during bull runs but finds itself at the bottom of the heap during bear runs. Such funds lack the consistency desired in a core portfolio fund.

Finally, find where the fund manager invests, both in the equity and the debt portfolio. Funds like HDFC Balanced and Escorts Balanced invest in mid- and small-cap stocks in their equity portion, while Magnum Balanced and UTI Balanced consistently invest in large-cap stocks. As an investor, you need to decide which style suits your portfolio. Also, find where the manager puts the money in the debt portion.

Confused over Growth, Dividend pay-out, Dividend Reinvestment or bonus option in Mutual Funds

Rajeev Mehra (name changed) a young IT professional has identified the mutual fund scheme that he wishes to invest in.

However, while filling in his investment application, he is perplexed with the various investment options available viz. growth, dividend pay-out, dividend reinvestment and bonus.

Despite being aware of what these options meant, he could not decide which was most suitable for him.

Irrespective of the scheme option chosen, the gains that you receive (excluding the tax implications) would be identical across all. Therefore, you should keep in mind your investment horizon and tax liabilities, while choosing the scheme that is most suitable for you.

Taher Badshah – Sr. Vice-President & Co-Head of Equities, Motilal Oswal Asset Management Co. Ltd., echoes a similar thought, “The scheme option such as dividend, growth or dividend reinvestment will essentially be a function of the investor’s requirement for periodic returns or cash flows – which in turn will be a function of his or her investment horizon.”

Here are some situational thumb rules you could use:

Equity oriented mutual fund scheme

Case 1: Investment term less than 12 months

If you wish to generate regular income, the best option would be the dividend pay-out option. However, if a regular income is not required, dividend reinvestment is a better option. Moreover, the dividends declared are exempt from Dividend Distribution Tax* (DDT) and are also tax-free in the hands of an investor.

Case 2: Investment term greater than 12 months

The growth option, in this case, will enable the investment to benefit from the effect of compounding.

 

Debt oriented mutual fund scheme

Case 3: Investment term less than 12 months

If you are a tax payer and fall in the 10 per cent tax slab, you could choose the growth option or the bonus option as your returns will not attract DDT* while the capital gains tax that you pay will be at the rate of 10 per cent.

However, if you fall into a higher tax slab, then, it would make more sense to opt for the dividend pay-out or reinvestment option, which will save you more on the capital gains tax even after factoring in the DDT in most cases.

Case 4: Investment term greater than 12 months

It would be advisable to choose the growth or bonus option in this case because the long term capital gains tax liability is calculated at the rate of 10 per cent, without indexation, or 20 per cent with indexation, whichever is lower and the DDT is not applicable.

Note: DDT rates applicable in case of individuals is 27.68 per cent, in case of money market or liquid funds and 13.84 per cent in case of other debt funds. All tax laws are for the financial year 2010-11.

Source: Economic Times