Mutual Fund Myth Busting – II

In this article, we move forward to the next three commonly held fallacious beliefs about mutual funds.

All debt funds are OK for short term investing
Contrary to the commonly harboured belief that all debt funds are suitable for short term investing, most of them are really not. If you have a time horizon of less than a year, you should ideally not look beyond liquid funds or ultra-short term debt funds. Watch out for a parameter called “modified duration” – if it’s anything more than a year, it’s not suitable for parking your short-term money, as the fund’s NAV could get materially impacted by fluctuations in bond yields. Any fund that falls under the category of “credit opportunities” or “corporate bond” should be invested into with a minimum time horizon of 2 years. For dynamic bond funds and GILT funds, one should aim for a minimum of three years.

Income funds are meant to generate income
The nomenclature “income fund” leads many an investor (and advisor!) to falsely believe that this category of fund is geared to generate income, monthly or otherwise. Resultantly, many investors are disappointed when they fail to generate incomes for them. In reality, income funds are a category of debt fund that generates returns mainly by accruing the “incomes” from their underlying bonds.

In other words, they rely less on the capital gains arising from the potential changes in bond prices, and more on the regular coupon payouts being made by the issuers of the securities within their portfolios. Don’t invest into income funds with the expectation that they’ll be providing you with an income on a regular basis. In fact, by choosing the dividend option in these funds, you’ll be paying a tax of 28.33 per cent at source, so select your option carefully.

Equity dividends are tax free, but after a year
Confusion still abounds among the investing populace regarding mutual fund taxation, and this is one example of it. While most investors know that capital gains arising from equity or equity oriented mutual funds are tax free after a one year holding period, many are yet unclear about the tax treatment of dividends. Several investors believe that they’ll need to hold on to their equity fund units for at least a year for their dividends to become tax free, when in reality, dividends from equity funds are tax-free even when received a day after you make an investment.

Do bear in mind that the NAV of any mutual fund falls in the exact same proportion to compensate for the dividend received thus – in effect, you’ll be receiving nothing but a chunk of your own money in your bank account, not anything above and beyond it!