Mutual Fund Myth Busting - 6

In the sixth part in a series of articles, we move forward in our quest to quash the 30 most common myths that prevail about Mutual Fund investing in India. As equity markets continue blazing a new trail, and debt funds continue delivering double digit returns, many of these myths are steadily picking up pace. It's important for Mutual Fund investors to remain alert to them. Here go the next three fallacious beliefs.

Debt Funds are "just like Bank FD's"
Advisors who tout debt funds as "just like FD's" should be asked a simple question -is they indeed are, where do the incremental returns come from? After all, it rings true that when it comes to investments, incremental returns come with increased risk. Debt Funds are in fact, not really like Bank FD's. Whereas Fixed Deposits essentially carry only one risk (the risk of your bank going under, with your money in tow)- debt funds carry credit risk as well as interest rate risk (the risk that bond prices will fall in tandem with rising interest rates, leading to a mark to market loss). In fact, debt funds aim to earn between 20% and 30% of their annualized returns from sources outside the interest or "coupon" payment; this could be achieved by investing into lower rated bonds and taking on a deliberate credit risk, or increasing portfolio maturity in order to benefit from falling interest rates.

Balanced Funds are low-risk
With the NIFTY rising by nearly 1,600 points or 20% in the past year, many investors who missed the ride are now being advised to invest into balanced funds (primarily, equity oriented hybrids) as they are "low risk" in nature. This isn't true, though. Balanced Funds that are equity oriented allocate more than 2/3rd of their portfolios to the stock markets, and can feel some serious amount of heat during market downturns. Consider this - most top performing balanced funds fell between 35% and 40% during the carnage of 2008! Would low-risk taking investors be willing to chance that kind of capital erosion? We think not. From the standpoint if asset allocation, equity oriented hybrids should ideally be considered as equity" funds, and allocations should be made to them accordingly.

Debt Fund dividends are tax-free
While it's true that dividends from debt funds (and debt oriented funds such as MIP's) are tax free in the hands of an investor, it's also a fact that a hefty 28.33% of the dividend declared is deducted at source and transferred to the government exchequer before crediting your account! In other words, if you hold 100 units of a debt fund, and it declares a dividend of Re 1 per unit, you won't receive Rs. 100 as a dividend, but rather, Rs 71.67. In fact, this tax inefficiency is what makes MIP and debt fund dividends poor choices for generating investment income, despite their relative stability. Consult with your advisor on a SWP (Systematic Withdrawal Plan) based income generation strategy instead.