Saturday, June 26, 2010

Optimal strategy - Equities, hybrids or MIPs

One of our readers who had a windfall from his employer to the tune of Rs 6 lakh informed us that that he was planning to invest this sum for long term in a combination of equity funds, hybrid debt-oriented schemes and monthly income schemes (MIP) for diversification. Would this be an optimal strategy?

Maybe not. If one has the risk appetite for equity investment and if the time horizon is long, an ideal strategy would be to invest in a pure equity fund and just stagger the investment over a long period.

Hybrid funds or monthly income plans are not good options to route the equity part of your investment. The expenses ratio and capital gain taxes are two major hindrances for the investors investing in them. Here is why.

Tax factor

Hybrid debt schemes have expense ratios varying from 0.75% to 2.5% a year and MIPs, by and large, have expense ratios of about 2%.

Consider this: An investor is willing to invest in a hybrid debt scheme a sum of Rs 2 lakh for a ten-year period. Assuming his investment is generating hybrid debt return (11.7% over the past five years) for next 10 years, an investment of Rs 2 lakh will become Rs 6 lakh at the end of the maturity period.

Since these are debt schemes, long-term capital gains in respect of units held more than 12 months are chargeable to tax at 20%, after factoring in the cost of inflation index. Alternatively, they are taxed at 10% without indexation. This means the investor would end up paying capital gains tax for the entire returns, including the equity portion.

For an appreciation of Rs 4 lakh, if the long-term capital gains are taxed at a flat 10%, the total tax out go will be Rs 40,000. Had the investor, instead, split his investment between equity and a debt fund, his tax outgo would be much lower because equity funds enjoy a more favorable tax structure.

If the investor had instead spread out the Rs 2 lakh as Rs 1.2 lakh in a debt fund and Rs 80,000 in equity fund, the maturity value could be Rs 5.8 lakh assuming that he generate similar returns. Under the second option, LTCG will be just Rs 24,000 and his overall return could have increased by Rs 16,000.

Similar to hybrid debt schemes, investors in MIPs too suffer higher tax incidence. Hence, investors will be better off separating the debt and equity investments to save a higher tax outgo and to generate higher return if their time horizon is for longer period.

However, debt would be a better option if your investments are for less than three years and you would like to stay away from the vagaries of the equity market.

Investors can separate their debt and equity investments to reduce tax outgo and generate higher returns over a longer period.

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