Do you choose your mutual fund options wisely ?
Author: Dr. Renu Pothen, Research Head, Fundsupermart.com India
This article was published in Moneycontrol.com on Thursday, 06 June 2013
Investors, while investing into mutual funds, go around scouting for websites that provide -top rated funds for the year. These top ranking funds then find a place in their portfolios.In this hunt, they overlook the appropriate options that are suitable to them depending on their needs, time horizon and the tax element involved in each of the same. I have been reviewing investor portfolios for some time now and it is surprising to see that many of them are not even aware of the different options available in the mutual fund schemes and blindly follow instructions given by their relationship managers. In this context, I thought it appropriate to share my thoughts on the different options suitable for investors with varying goals and time horizons and have also looked into the tax implications which, in turn, will optimize their decision making while creating their portfolios.
We normally recommend equity mutual funds to our investors and advise them to hold it till their goals are achieved. In this case, investors should go in for the growth option because a surplus kept aside to meet a particular goal can reap the benefit of compounding over a long time period. On the other hand, a dividend option is normally suggested for those who require a regular income. However, as it is not mandatory for equity funds to declare dividends and since most of them are known to declare dividends only once in a year, my opinion is that selecting a dividend option in these funds will not be able to meet this requirement. A dividend option will only make sense to those investors who would want to use these payouts to make investments into other opportunities available in the market. However, my point of contention is that since dividends are not guaranteed and we have no clue about the timing of dividend payouts in equity funds, how much this strategy can help investors is food for thought. Hence my suggestion is that investors should not choose the dividend option if there is no immediate requirement as that surplus which gets credited into a savings bank account will fetch a mere 4%, while it would have grown if it was left untouched in the fund.
It has also been recently observed that many of the investors are treating mutual funds in the same way as stocks. Here I am referring to the investor psyche of booking profits whenever there is a sudden spurt in the performance of their funds in a time span ranging between three to nine months. This behavior can be attributed to the disillusionment caused as a result of seeing their investments in red due to the market volatility witnessed in the last five years. Hence, for those investors who think that they can time the market right and want to stay in equity funds for less than a year, from a tax point of view, a dividend option makes sense as Dividend Distribution Tax (DDT) is nil, while a growth option in this case will mean that the investor will have to pay short-term capital gains to the tune of 15%. In short, although the returns generated in the growth and dividend options are on similar lines, my suggestion is that investors look at their end goals and tax efficiency before selecting different options for their equity investments.
This entirely reverses when it comes to the fixed income space, where we advice our investors to actively manage their portfolios depending on our views on interest rates. Here the tax efficiency of the different options assumes a lot of importance unlike equity funds where the Long-term Capital Gains (LTCG) tax and (DDT) is nil. In this case, if the investor is looking at parking his surplus for less than a year, then investors in the 10% and 20% tax brackets can consider the growth option while those in the highest tax slab can go in for the dividend option as DDT stands at 28.32%. However, if the investor requires payouts on a regular basis, then those in the lowest tax brackets will have to consider the dividend option. Here the only caveat is to make sure that the funds selected have been able to maintain a consistency in the frequency of their payouts. On the other hand, investors with a time horizon of more than a year can consider the growth option as these investments will be subject to LTCG tax of 10% without indexation or 20% with indexation.
At this juncture I would also like to raise the investors attention to the recent initiative taken by the government in the Budget 2013-14 to align DDT in all debt funds with that of liquid funds. Currently, DDT in debt funds stands at 28.32% as against the previous tax rate of 13.52% for all debt funds other than liquid funds. This has led to panic among investors who are rushing to move their entire surplus that has been parked in the dividend option of Ultra Short Term Funds to the growth option of the same scheme. Here our advice is to not follow the herd but take an informed decision based on realities. A quick math reveals that it makes sense for those investors in the 20% tax bracket to move into a growth option while it is advisable for those in the highest tax bracket to stay invested in the dividend option. This change in taxation will not have an impact on other categories of funds like Short Term Funds, Income Funds or even Gilt Funds as the time horizon that an investor needs to hold onto these funds is between 12 and 24 months.
To conclude, this article should be an eye opener to the investor that in their rush to have the best performing funds in their portfolio they should also take some time to think over suitable options available, taking into consideration all the above mentioned factors.