In the 11th May 2016, edition of the Mint newspaper, as a part of an investor awareness initiative - swatantra, I answered a few questions centered on how a salaried individual could invest his bonus. As is usual in such instances, the lack of space constrains the answers one can give and in addition the editor’s sword dangles over every written word. While I was able to convey my principal point about the risk in deploying one’s entire bonus in an equity fund in one lump sum investment, there were a host of other points I would have liked to bring to fore for the benefit of the lay investor.
The additional points I had to make were not so much about the deployment of a bonus but more so as to the mechanics of how one should stagger investing in equity. As I have belabored multiple times in my blogs, making large lump sum investments in equity/equity mutual funds, exposes one to a single price point in the market. With volatile markets becoming the norm, wisdom says that that a staggered market entry is the prudent approach. There is no doubt that staggered entry into the markets, while providing optionality to the investor, comes at a cost. This cost is felt acutely when markets rise rapidly and portfolios that are under invested in equity underperform. I once again reiterate that this is a cost that we are willing to bear and over time, as volatile markets provide opportunities to enter at reasonable prices, these very same portfolios would eventually outperform.
A more nuanced point I would like to touch upon, is whether the cost of remaining underinvested can be reduced i.e could idle funds that remain on the side to provide optionality to the investor, be better deployed while retaining the optionality that cash provides. The answer is yes. Let me explain. Most investors in India today keep their idle funds in a fixed deposit, a savings account, or even worse, in a current account. The savings account yields an interest of 4%, a fixed deposit currently yields a pretax interest of ~7.5% which is 5.25% post tax (for a 30% tax bracket individual), while a current account pays no interest. Is there a better way to deploy funds such that the principal is protected, liquidity is available when needed and has a higher post tax return? The answer is yes – and that is liquid funds. Liquid funds are mutual funds that invest in money market instruments – namely commercial paper of AAA rated Indian corporations and certificate of deposit of Indian banks of residual maturity less than 91 days. These corporations and banks need short term money to meet their working capital needs and go to the market to borrow. Though these instruments are not backed by the Government of India, they have default probabilities pretty similar to that of a fixed deposit of any Indian bank. In any case even fixed deposits in any Indian bank are guaranteed by the Government of India only to the extent of one lakh rupees. These liquid funds currently generate pre-tax yields of ~7.5%, and have significantly superior post-tax benefits if held beyond 3 years as compared to fixed deposits and have excellent liquidity. They beat both current accounts (of course) and savings accounts hands down and for terms beyond three years have significantly better post tax yields. The major downside is that the yields are not guaranteed and move in line with the short term interest rate in the economy.
Let me explain the mechanics of investing in a liquid fund in a little more detail. The two primary modes of investing in a liquid fund are either through the 'growth' option or the 'daily dividend' option. In the daily dividend option, everyday the fund’s growth is accrued and paid out as dividends. These dividends are taxed at source and re-invested as units in the same fund. The dividend distribution tax is 28.235% which is still lower than the 30.90% (including education cess) tax rate for the highest tax slab. When units are redeemed there is no capital gain (and hence no capital gains tax) since the Net Asset Value of the fund remains the same (as when purchased).
In the growth option, all interest is credited back to the fund and the Net Asset Value (NAV) of the fund consistently increases. When the investor redeems his units, the gains are taxed as capital gain (short-term if redeemed within 3 years or long-term if redeemed after 3 years). Short term capital gain is taxed at the tax slab of the investor, while long term capital gain is taxed at 20% after applying indexation – which will be significantly superior to a fixed deposit which offers no such indexation benefit.
A further benefit that is largely untapped, is that if one has incurred short term capital losses – which is highly likely in current volatile markets – these market losses can be offset against the short term capital gain that will arise from the redemption of liquid funds before 3 years. Investors also need to be aware that mutual funds also provide for a systematic transfer plan (STP) from any in-house liquid fund to an in-house equity fund – thus making an SIP redundant (SIP is a systematic investment plan which regularly transfers money from your savings account to your desired equity fund). In other words, your savings account can be made redundant. I have thus made the case for investment in liquid funds as a superior alternative to current accounts, savings accounts and even fixed deposits. Thus an investor, by carefully applying the situation that is unique to him, can without compromising on default risk or liquidity, significantly reduce his tax burden by making a judicious investment in liquid funds.
Please be aware that to push yields up, the market is rife with 'short term' and 'ultra-short term' mutual funds, which are NOT liquid funds as they invest in instruments that have residual maturity greater than 91 days. Liquid funds by definition invest only in money market instruments that have a residual maturity of less than 91 days.