Equity savings mutual funds are a solid middle ground for investors looking for steady returns without taking too much risk. For some investors, pure equity funds can be too risky, and for some, debt funds might not offer enough growth. This is where an equity savings scheme comes into the picture.
These hybrid mutual funds invest in a mix of equities, debt instruments, and arbitrage options to deliver stable returns and this asset allocation lets investors enjoy equity-like taxation. In this article, we’ll understand what an equity savings fund is, how it works, and the factors you should consider before investing in one.
What is an Equity Savings Fund?
An equity savings scheme is a type of hybrid mutual fund scheme. Hybrid funds get their name from the fact that they invest in a mix of debt and equities rather than relying heavily on one. Such funds are considered more balanced as they offer moderate returns at medium risk and appeal to conservative investors seeking some equity exposure.
Thus equity savings fund meaning can be understood as a type of hybrid mutual fund scheme which balances risk and reward by investing in a mix of mainly three asset classes – stocks, debt instruments, and arbitrage. According to SEBI, these funds must invest at least 65% of their assets in equity and arbitrage options and at least 10% in debt instruments like bonds.
Since the equity + arbitrage components of an equity savings scheme average over 65% of the total portfolio, it qualifies for equity taxation benefits, which is more tax-efficient compared to debt fund taxation. With this allocation, investors can enjoy the growth of equities while reducing volatility through debt and arbitrage investments.
How Do They Work?
The portfolio of an equity savings scheme consists mainly of three asset classes:
- Equities: A portion of the fund is invested in stocks of large-, mid-, and small-cap companies which can help generate higher returns over the long term. Generally, under 40% of the portfolio is allocated to equity investments. However, to lower the risk, these funds usually focus on large-cap stocks that offer more solidity.
- Debt: Instruments such as government securities, T-bills, CPs, CDs, corporate bonds, and other fixed-income assets comprise the debt portion of the fund. This component helps reduce the risk posed by market fluctuations and provides a steady income.
- Arbitrage: Arbitrage can be understood as simultaneously buying and selling the same security in different markets to take advantage of the differences in price. These investments contribute to the fund’s overall equity exposure and thus enable inventors to enjoy equity fund tax benefits. The arbitrage component is what makes equity savings schemes different from other hybrid funds.
An equity savings scheme’s returns depend significantly on the arbitrage opportunities available in the market. With a mix of these three classes, equity savings schemes aim to generate moderate returns while keeping volatility lower compared to pure equity funds. An investment planner can help you assess whether such a fund would be suited to your unique financial goals and risk tolerance.
Types of Equity Savings Funds
Equity savings funds mainly vary based on their asset allocation. For example, an equity savings fund investing heavily in equities compared to arbitrage and debt would be considered more aggressive. Similarly, a conservative equity savings scheme would allocate a higher percentage of its assets to debt instruments to minimise risk exposure.
Many equity savings schemes offer investors the option to choose from different investment plans, such as growth and IDCW (Income Distribution cum Capital Withdrawal). Investors can pick the more suitable option based on their financial goals and income needs.
Growth option funds reinvest their earnings which increases the NAV of the fund, while IDCW option funds distribute income to their investors in the form of dividends. Investors looking to earn a regular stream of income can choose this option, however, keep in mind that each payout lowers the NAV of the fund. IDCW funds thus present limited opportunities for long-term growth. Moreover, regular income received from IDCW ESS is taxable according to the investor’s tax slab.
Taxation of Equity Savings Funds
An equity savings scheme is taxed exactly like a regular equity fund because even though the equity exposure is split between direct equity investments and arbitrage, the total equity allocation (which includes arbitrage) exceeds 65% of the portfolio. Here’s a complete look at equity savings fund taxation:
1. Capital Gains
Capital gains are profits made upon selling or redeeming an investment. If the units of an equity savings scheme are held for more than 12 months, the profits are deemed long-term capital gains (LTCG). On the other hand, profits from selling units before the 12-month holding period are considered short-term capital gains (STCG).
- LTCG Tax: LTCG in excess of Rs. 1.25 lakh in a financial year is taxed at 12.5%. This is an increase from the previous 10% tax rate, which applied to gains exceeding Rs. 1 lakh.
- STCG Tax: A 20% STCG tax is levied if the investment is sold within 1 year of purchase. This is also an increase from the previous equity STCG rate of 15%.
2. Dividends
Investors choosing the IDCW option also need to pay taxes on the regular income they receive. This annual income is added to their total taxable income under the head ‘Income from Other Sources’ and taxed as per their income tax slab rate. If the total dividend income in a financial year goes over the Rs. 5,000 mark, the mutual fund house is also mandated to deduct a 10% TDS before crediting the income.
Because they are treated like equity funds, ESS are considered more efficient than debt funds. An expert financial consultant can help you understand the tax implications of your investments and help you create a personalised investment plan that maximises returns and minimises taxes.
Benefits of Equity Savings Funds
Why should you invest in an equity savings scheme? Check out some of the major benefits that make an equity savings fund a smart investment choice:
1. Lower Risk
Equity savings schemes are hybrid mutual funds that generally dedicate less than 40% of their total portfolio to stocks, making them less volatile compared to pure equity funds like ELSS or large-cap funds. The majority of the portfolio (around 50% to 60%) consists of debt and arbitrage options which effectively balance risk and reward. This composition makes these funds a great option for conservative to moderate investors.
2. Medium to Long-term Horizon
Investors with an investment horizon of 3 to 5 years or more can consider equity savings schemes. They offer better returns than debt funds but with lower risk than pure equity funds.
3. Tax-efficient Investment
As far as taxation is concerned, equity savings schemes are considered as equity funds and thus enjoy more favourable tax treatment compared to debt or debt-oriented hybrid funds. LTCG tax is levied at 12.5% in excess of Rs. 1.25 lakh if the investment is held for at least 12 months before being sold. An early redemption, however, attracts a much higher tax rate of 20%, which applies to STCG.
4. Arbitrage Component
Arbitrage is the unique component of equity savings schemes which sets them apart from other hybrid mutual funds. Not only does it help maintain the fund’s 65% equity exposure (which ensures equity taxation benefits), but its low-risk nature also lowers the volatility of the portfolio.
5. Diversification
Diversification reduces the risk associated with individual investments. An equity savings scheme’s portfolio is designed to take full advantage of this principle as it invests across three asset classes – equities, debt, and arbitrage. These funds make sure that market fluctuations in one component do not have an overwhelming impact on returns.
6. Professional Management and SIP Option
Experienced fund managers conduct extensive market research to find the right balance between growth and risk management. Investors can leave the hard work to professionals and easily make regular contributions through SIPs.
How to Choose the Best Equity Savings Fund?
A number of factors should be considered to select a suitable equity savings scheme:
1. Past Performance
A fund’s historical performance should be assessed over different periods, like 3, 5, or 7 years to ensure you don’t make the final decision based on short-term trends or recent performance. A consistent fund that has performed well across different market cycles indicates that it’s managed well and has a reliable investment strategy.
2. Fund Manager’s History
An experienced fund manager can make all the difference in how an equity savings fund performs over time. Their expertise in asset allocation, risk management, and market timing has a direct impact on returns, so make sure you understand how well they’ve done in the past and whether their investment philosophy aligns with yours.
3. AMC’s Track Record
It’s often best to select a well-established AMC with a proven history of managing funds successfully. A higher AUM is a positive indicator, as it suggests investor confidence, efficient fund management, and the AMC’s ability to handle investments.
4. Expense Ratio and Exit Load
The expense ratio is the fee charged by the AMC to manage the fund. A lower expense ratio allows you to keep a higher percentage of your returns, but you should balance this factor with other aspects of fund performance. For example, a fund may charge a higher expense ratio because it employs an experienced fund management team or has a strong track record of delivering superior returns.
The AMC may charge an exit load if you prematurely redeem your units before a specified holding period. Check the fund’s exit load structure and plan according to your investment horizon.
5. Risk-adjusted Returns
Metrics like the Sharpe, Treynor, and Sortino ratios can help you gauge just how much risk a fund takes to deliver the returns it does. The higher the ratio the better as it indicates the fund generates higher returns per unit of risk taken.
Assessing the standard deviation will reveal the volatility of a fund’s returns over time. Alpha can be analysed to understand the extra return the fund delivers compared to its benchmark, and Beta analysis can help you gain insights into the fund’s sensitivity to market movements.
Ultimately, the best equity savings fund is the one that not only scores well on the above factors but also complements your financial goals, risk profile, and investment horizon.
- Financial goals: It is essential to ensure your choice aligns with your financial goals so that you can easily achieve them. For example, if your goal is to grow your capital over the medium to long term with lower volatility than pure equity funds, an equity savings scheme can be a great option. Similarly, if you’re looking for better post-tax returns compared to debt funds, the equity-like taxation benefits of ESS can be a wise choice.
- Risk appetite: Generally, equity savings funds are geared towards investors with moderate risk appetite, but they can also appeal to conservative investors looking for some equity exposure without much volatility.
- Investment horizon: Equity savings schemes are best suited to investors with a 3 to 5-year investment horizon.
Before making the final decision, consider consulting with a mutual fund investment planner. An expert can help you assess all the factors we’ve discussed above and make personalised recommendations based on your unique profile.
Conclusion
An equity savings scheme balances equity, debt, and arbitrage to deliver moderate returns with moderate risk, which makes it a good choice for investors seeking stability and diversification. Due to their significant arbitrage allocation, these funds enjoy the benefit of equity taxation while maintaining a lower risk profile compared to pure equity funds. To select the best equity savings fund, make sure to assess your financial goals, risk profile, and investment horizon. Also consider factors such as the fund’s historical performance, asset allocation, expense ratio, and the fund manager’s track record.
