Which is better: ULIPs or Mutual Funds?

With the introduction of Long-term capital gain (LTCG) tax on equity, a debate has opened whether equity mutual funds have lost their charm to ULIPs. Many investment Gurus have argued that ULIPs have become more lucrative after the introduction of tax on LTCG from equity investment. There is no tax on capital gains from ULIPs.

Jul 15, 2018 05:07 IST India Infoline News Service

With the introduction of long-term capital gain (LTCG) tax on equity, a debate has opened whether equity mutual funds have lost their charm to ULIPs. Many investments Gurus have argued that ULIPs have become more lucrative after the introduction of the tax on LTCG from equity investment. There is no tax on capital gains from ULIPs. However, taxation is not the only criteria for selecting investment products. There are some other factors which investors should consider while selecting investment products, like the purpose of investment, risk, return, liquidity, flexibility, transparency, cost, taxability, etc.

Listed below are the factors to be considered before selecting investment products

Purpose of Investment

“You can’t reach the destination if you don’t know the address.” Investors with vague goals can’t meet their financial obligations no matter how hard they try. First, your goal and purpose of investment needs to be defined clearly. If your goal is to accumulate Rs1cr in 20 years, then you should invest; on the other hand, if your objective is to have adequate insurance, then you should get a term insurance. Here, we did not recommend ULIP because it can’t provide adequate insurance cover to a person. A person with adequate insurance cover can invest in ULIP as an add-on.

Return

Historically, equity mutual funds have outperformed ULIPs (refer to Exhibit 1). Over a long period, even a small difference of 2-3% can significantly change the corpus due to compounding (refer to Exhibit 2). 

Exhibit 1: Average 5 years CAGR return on ULIPs and Mutual Funds
ULIPs Mutual Funds
Large-cap 15.0% 16.2%
Multi-cap/Flexi-cap 12.7% 18.6%
Mid/small-cap 23.4% 28.5%
(Source: Ace MF, Morningstar. Returns as of February 27, 2018)
 
Exhibit 2: Difference in corpus over different period and returns by investing Rs10lakh
Years
      5      10      15      20
Returns 10% ₹16.1lakh ₹25.9lakh ₹41.7 lakh ₹67.2lakh
12% ₹17.6lakh ₹31.0lakh ₹54.7lakh ₹96.4lakh
13% ₹18.4lakh ₹33.9lakh ₹62.5lakh ₹1.1cr
 
Liquidity

Liquidity is a very important criterion for selecting an investment product. You should be able to liquidate your investments when you need them. Equity mutual funds are highly liquid, a person can redeem his units any time. On the other hand, a person can’t withdraw his money from ULIPs before 5 years as that is the minimum lock-in period.
 
Flexibility

Mutual funds are way more flexible than ULIPs. Mutual fund investors can switch from one scheme to another within a fund house or to another fund house, which enables investors to switch from poorly performing schemes to better ones. On the other hand, ULIPs provide some flexibility to investors to switch from equity to debt and vice-versa within the insurance house only. So, if a fund manager of a ULIP joins another insurance company, the investor can’t switch to the new insurance company, whereas it possible in mutual funds.
 
Transparency

The Indian mutual funds industry is one of the most regulated and transparent industries in the world. The returns, portfolios, and sector allocation of mutual funds are available on AMC and various other websites. The benchmark, expense ratio, and exit load is also disclosed by AMCs and is available on various websites. Besides, many analysts and investment advisors track mutual funds. ULIPs also disclose the same information but they are not widely tracked by the analyst community.
 
Cost

ULIPs used to have very high charges in past but now they compete with mutual fund schemes on charges. If a person invests in a ULIP via online, he does not have to pay administrative or fund allocation charges. Mutual fund schemes also have very competing expense ratios. Investors can further reduce the expense ratios by investing in direct plans.
 
Taxability

ULIPs are always more tax efficient than mutual funds. Capital gains from the ULIP are tax-free, whether it is equity or debt. Whereas, investors have to pay 15% tax on short-term capital gains and 10% tax on long-term capital gains (from April 1, 2018) from equity mutual funds. The short-term gains from the debt funds are taxed at a marginal rate, while long-term capital gains are taxed at 20% after indexation.
 
Conclusion

ULIPs are always more tax efficient than mutual funds, but the recent introduction of 10% LTCG tax from equity investments has given them more advent. However, you don’t select an investment product based on one criterion. Mutual funds outscore ULIPs on other parameters like returns, transparency, liquidity, and flexibility. 

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