What Are Equity Savings Funds?

With SEBI's recategorization norms coming into force a couple of months ago, we're likely to see a spate of NFO's coming through in the near future as Asset Management Companies rush in to 'fill in the blanks!'. One such relatively underserved category is the recently created "Hybrid: Equity Savings" subcategory of Hybrid Mutual Funds, in which only 17 Mutual Fund houses currently have an offering in place. So, what exactly are "Equity Savings Funds"?

The main problem that Equity Savings Funds aim to solve is an age old one - the trade off between tax efficiency and risk that often leads conservative investors to invest into equity funds for the wrong reasons. Capital Gains from Debt Mutual Funds (which are more suitable for low risk takers) are taxed as regular income, whereas Long Term Capital Gains booked in Equity Oriented Funds are tax free up to Rs. 1 Lakh per fiscal year.

This is where Equity Savings come into the picture. Per SEBI's definition, an Equity Saving Fund is an "openended scheme investing inequity,arbitrage and debt". Per SEBI's circular, at least 65% of the fund's assets are required to be invested into equities. How then, you might ask, are they low risk?

The answer to that lies in the fact that a very large chunk of this 65% is expected to be in "arbitrage" or "hedged" equity. Arbitrage is the term given to risk free profit opportunities that arise due to mispricing of the same security in the spot and futures market. When you buy and short-sell same quantities of the stock, and prices converge on or before the futures expiry date, you book a risk-less profit.

In fact, given the rich valuations prevalent in the equity markets today, we're likely to see fund managers holding no more than 20% to 25% of their portfolios in unhedged equities, thereby bringing down the risk factor considerably.

It's not all rosy, though. A quick look at the 1 year returns of the existing funds in the Equity Savings category will reveal that most of them have delivered sub-FD rate returns in the past year, with only Axis and Edelweiss managing to eke out double digit returns from their offerings. After all, an Equity Savings fund relies on the fund manager to make two very critical decisions: just how much to hold in unhedged equities, and what style of investing to adopt for the debt portion that could range from 10% to as high as 35% of the portfolio. And judging by the fact that so many fund managers took such poor calls on yields (as evidenced by medium term returns from most dynamic bond funds), fund managers are definitely not always going to get it right!

Arbitrage returns, once hovering around the 9% mark a half decade ago, have now dropped to just 5-6% per annum - the same as short term liquid fund returns. This has further put a spanner in the works for equity savings funds as a category.

Bottom line: should you invest? I dare say that you'll get better returns by combining 1 part top-notch equity fund with 2 parts pure arbitrage fund and 1 part medium duration debt fund. If the thought of selecting funds and managing your portfolio actively makes you balk, and you're a low risk taking investor whose fixated on tax efficiency, you could invest a portion of your money into it - and hope that the fund manager takes the right calls on your behalf!