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When we think of the advantages of investing in mutual funds, we think of portfolio diversification, high affordability (with minimum investment as low as Rs 500), high liquidity, rupee cost averaging and professional management. But mutual funds can be classified into various categories and sub-categories – each having their own set of advantages and disadvantages. Being aware of these merits and demerits of each category can help you fine-tune your mutual fund investment portfolio, according to your financial goals.
Here are the advantages and disadvantages of the three most popular categories of mutual funds — equity, debt and balanced funds.
Equity mutual funds: These funds aim to generate long-term capital appreciation by primarily investing it in equity shares of listed companies. Given their historical performance and the future prospects of the Indian economy, you can easily expect at least 12-15 per cent a year return over five-seven years. Their rate of returns can be even higher during the bull market phase. Thus, these funds provide a safer alternative to investors who would like to directly invest in stocks but do not have the required time or knowledge to do so.
The tax treatment of mutual funds is also more favourable than most available investment options. The dividend income from equity funds and the redemption proceeds after one year of investment are entirely tax-free. But gains made from redeeming the units within a year are treated as short-term capital gains and are taxed at up to 15 per cent of your amount redeemed.
Apart from these benefits, equity funds offer customisation by offering various investment objectives and investment style. Therefore, while an investor with high-risk appetite can opt for midcap or sectoral funds, one looking for stability along with long-term growth can invest in largecap fund or a flexicap fund. Ideally, largecap funds and flexicap funds should form the core of your portfolio while the following funds can form the satellites of your core portfolio.
- Midcap and small funds
- Sectoral funds such as infra, banking, pharma and FMCG funds, and
- Thematic funds such as growth, value investment and contrarian funds
However, equity funds have their disadvantages too. With over 40 mutual fund houses and 470 schemes, it can be quite baffling for a new investor to select a mutual fund scheme. Moreover, equity funds can even generate negative returns over the short-term. Hence, invest in equity funds only if you are ready to stay invested for long-term.
Equity-Linked Saving Schemes: ELSS is one of the several schemes eligible for tax deductions under section 80C of the Income-Tax Act. Apart from saving taxes of up to Rs 46,350 per year, they also provide high returns over the long-term. Their lock-in period of three years is also the lowest among all the investment options available under section 80C. Moreover, these funds come under the EEE regime, i.e. their investment amount, dividend income and redemption proceeds are entirely tax-free.
Hybrid Funds: Hybrid funds invest in both equity and debt securities. Their main aim is to provide optimum returns during both rising and falling equity markets. They achieve it by increasing their equity exposure during the initial stages of a bull market and switching to debt securities during falling market or when the equity market is at its peak. Their exposure to equity can be anywhere between 20 per cent and 80 per cent, depending on their investment mandate and market conditions. But most hybrid funds try to maintain an average equity exposure over 50 per cent to avail the tax benefits of equity funds. Hybrid funds are primarily suitable for investors with moderate risk appetite and for those having an investment horizon of three-five years. Some of the sub-categories of hybrid funds include balanced funds, asset allocation funds and monthly income plans (MIPs).
Debt mutual funds: These are low risk funds, which invest in debentures, bonds, government securities and money market securities. These schemes provide better returns than fixed deposits and savings accounts. The safety of your capital, although not guaranteed, is almost similar to term deposits. Moreover, unlike term deposits, these funds do not charge penalty on premature withdrawal. But funds may charge an exit load on redemption before a stated timeframe. Debt funds also outscore bank fixed deposits in terms of tax treatment. While fixed deposits are taxed according to your tax slab, debt funds redeemed after three years are taxed at 10 per cent (without indexation) or at 20 per cent (with indexation). Thus, for investors in higher tax brackets, the post-tax returns on debt funds held for over three years are higher than the FDs held for the same period.
Final word
To sum it up, each mutual fund category has its own set of merits and demerits. While a particular mutual fund category may suit the long-term investors the most, the same category can go wrong for short- and medium-term investors. Thus, first assess your financial goal, investment horizon and risk profile to determine your asset allocation strategy and then go for the final fund selection.
By Naveen Kukreja, CEO & Co-founder, PaisaBazaar.com
(Published in Financial Chronicle on November 28, 2016)