PrimeInvestor Recommendation: A low-risk, low-tax option for short-term holdings

When you have a holding period that is less than 3 years, your options are limited. Because this short period gives very little room for risk, pure equity is out of the question. But in debt funds, though returns may be reasonable, taxation for a less than 3-year period cuts into return.

Equity savings funds fit this gap. Being equity-oriented, their tax treatment is more favourable than debt funds. And since equity savings funds hedge the better part of their equity exposure, the risk level is well within limits for short-term periods of 1 to 3 years.

But in this category, it is important to understand what the fund has a clear strategy, is consistently following it and whether it is doing its job of containing volatility and downsides well (given that it is meant for short term holding). In this regard, our pick is Kotak Equity Savings, which is also part of Prime Funds. Here’s why, and how to use the fund for your goals.

#1 Stability in returns

In the equity savings category, two aspects are important given the short-term nature of the holding period. One, limiting the extent of losses and two, keeping volatility under control.

The equity exposure of equity savings funds, however small, opens them up to losses during market corrections. The average minimum 1-year return that funds in this category delivered in the past 5 years was actually a loss of 10.9%. On a 1-month basis, the loss was higher at 15.5%. This loss was concentrated in the March-April nifty correction this year, when, even as stocks tanked, returns from arbitrage and liquid funds came under pressure as well.

On a 1-year basis, the equity savings category generated 1-year losses about 12% of the time on a rolling basis over the past 5 years. All this goes to show that equity savings have an element of risk that makes them unsuitable for any timeframe that’s less than a year. Kotak Equity Savings has fared better than category on containing losses. The fund was lossmaking 4% of the time on a 1-year rolling return basis.

Even in shorter periods such as 1 month, 3 months or 6 months, loss occurrences were lower than peers. Its 1-month losses during March-April was just below the average at about 15%. In other markets as well, the fund’s loss periods were better than peers’, and its ability to keep losses less than benchmark and peers were strong.

This downside containment has helped keep volatility in check for the fund. Going by the deviation in returns for different timeframes across a 5-year period, Kotak Equity Savings has lower volatility than almost all peers. The fund also keeps volatility in check through a comparatively conservative approach.

#2 Higher hedging than other equity savings funds

Kotak Equity Savings, by mandate, cannot hold more than 50% of its portfolio in unhedged equity. That’s more or less the norm for equity savings funds.

However, Kotak Equity Savings doesn’t utilize the higher limit much. The average unhedged equity the fund has held in the past 3 years is 30%. In some months, such as in 2019, open equity can even go below 25%. The highest the fund has gone in the past 4 years is 45%, in May this year given the attractive market levels.

In most months, therefore, the fund’s open equity exposure stays within a 20-40% range and usually is below the average for the category. Other equity savings funds tend to be more aggressive, such as SBI Equity Savings or Axis Equity Saver, which hover close to or above 40%.

On the debt side, Kotak Equity Savings tends to be short-term in maturity profile. Apart from deposits (as margin money for derivatives), the fund holds money market instruments, short-term bonds, or short-term government paper. Over the past year, the fund has moved towards holding a chunk of its debt exposure in Kotak Money Market Fund; this fund is a high-quality, above-average performer. While there is an expense ratio component in the debt fund, some comfort comes from Kotak Money Market’s low expense ratio of 0.22%.

#3 Beats peers consistently

Despite an expense ratio that’s higher than peer average, Kotak Equity Savings scores on returns. Rolling the fund’s 1-year return over the past 3 years, its returns beat the category nearly all the time. Thanks to lower volatility, the fund’s risk-adjusted return is also above category. Current top performers, such as Mirae Asset Equity Savings or Principal Equity Savings, are more aggressive and more volatile. The closest comparable in terms of aggression is ICICI Pru Equity Savings, but this fund is less consistent than Kotak Equity Savings.

Considering a longer 2-year return over a 5-year period, Kotak Equity Savings’ average 8.07% return is well above the category’s 7.04% average. Given that equity savings funds are meant for the short term, debt fund returns can be compared.

On this count, debt funds delivered slightly better. Short-term funds, which also work for a 2-year timeframe delivered about 8.3% on an average in the same 5-year period. Ultra-short duration funds clocked in a 7.9% average return.

However, on a post-tax basis, returns for Kotak Equity Savings will be a step higher as equity is low tax compared to short-term debt taxation. Assuming the highest 30% tax bracket for debt funds and a 10% tax for equity, the post-tax 2 year return changes to 7.2% for Kotak Equity Savings and 5.9% for debt funds.

While Kotak Equity Savings beats peers in both the regular and the direct version, it is preferable that you go for the direct plan. Return potential is typically lower in equity savings funds, and the in general has a higher expense ratio. The current direct expense ratio, at 1.24% in the direct plan is much lower than the 2.2% in the regular plan.

Fund suitability and portfolio role

Kotak Equity Savings can be used by any investor with a timeframe of 1 to 3 years. It is especially useful for those in the higher tax-brackets, since it is a more tax-efficient option.

Conservative investors and those in the low tax brackets need to have lower allocations to this fund and higher allocations towards pure debt funds. High-risk investors can take higher allocations. The fund does not suit time-frames of less than 1 year.

This fund needs to be necessarily mixed along with pure debt funds and shouldn’t form the entirety of a portfolio for a short-term goal. As seen earlier this year, very steep equity market falls can wipe out a big part of the fund’s gains. If markets don’t recover fast enough, it will impact overall return and very high allocations can do more harm than help.

While it can be tempting to use this fund for long-term portfolios, it’s best avoided. Debt funds may be able to generate similar if not higher return and the tax advantage significantly reduces once the 3-year period is crossed. The equity exposure, unlike balanced advantage funds, is not high enough to generate better returns.

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21 thoughts on “PrimeInvestor Recommendation: A low-risk, low-tax option for short-term holdings”

  1. Superb Article.
    I have one question though. Why is an equity savings fund or a dynamic asset allocation fund then not a part of the 3-5 years timeframe ( for ex education ) equity component of the recommended portfolio? Given their low volatility and tax advantages (over debt funds) they fit the bill perfectly for this duration.

    While I understand the role of a nifty next 50( in a small allocation % ) to provide the kicker in returns but isnt a large cap fund more riskier than the above two funds for say 3-5 years?

    Please note this query is only to understand your perspective and not question your judgement. My conservative mindset needs to know what i am missing here since I am creating a portfolio for my son’s education.

    1. The 3-5 year portfolio has 50% in debt. This allocation is good enough to compensate equity volatility. Using an equity savings fund here would reduce potential for performance, if we reduce equity further. Debt fund taxation is not a major deterrent once the 3-year period is done – it is for shorter periods that the equity tax benefit of equity savings/BADAA funds would come in. If you’re conservative and you want to further reduce equity risk, you can replace part of the Nifty Next 50 exposure with a BADAA fund. – thanks, Bhavana

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