Why Should You Invest in Equity Savings Funds?

Among the various categories of hybrid funds as per AMFI definition, one of the very intelligent fund in terms of allocation logic is the Equity Savings Fund. In a nutshell, this fund is a combination of equity funds, debt funds and cash-futures arbitrage. What does this fund really try to achieve?

On the one hand, it is predominantly an equity fund with a long term growth perspective. At the same time, the debt component ensures that there is a product in the portfolio which is more stable, lower on the risk scale and also not perfectly correlated to the equity funds in terms of returns. But there is one more aspect of the same.

There is the third aspect of arbitrage where there is buying in cash and selling in futures. Here the product is an equity cum futures product but the returns are like a debt product in that the returns are synchronized with the debt market returns or interest costs. This is a way of locking in returns and also hedging your equity exposure since the futures takes a contrary position i.e. long on equity and short on equivalent futures.

How does an equity savings fund invest in various asset classes?

The investment pattern followed by Equity Savings Fund is of combining equity, debt and arbitrage hedges all in one place. For example, the typical allocation of an Equity Savings Fund to equity would be to the tune of 30% to 35% of total investment corpus. The balance is split between arbitrage positions which are fully hedged and debt positions. The arbitrage positions entail rolling over the futures position each month to earn the spread.

In a way, the ESS fund is like a balanced fund in that they try to get above market returns but also try to manage risk in two ways i.e. via debt exposure and also through arbitrage hedges. These kind of funds can work quite well in the medium term i.e. about up to 5 years and also work quite well beyond that.

Best performing equity savings funds in india

Here are some of the top performing Equity Savings Fund in India as on 07 January 2022 ranked on 5 year returns. While the returns for 1 year and 3 years are also provided, the ranking of ESS funds has been done based on the 5 year returns to give a medium to long term perspective to the investment.

Legal Name 1 yr 3 yr 5 yr
Sundaram Equity Savings - Direct Plan - Growth Option 19.1359 14.5085 12.1112
Axis Equity Saver Fund Direct Plan Growth 15.5044 12.9300 12.0123
Edelweiss Equity Savings Fund Direct Growth 13.0790 12.1921 11.2590
SBI Equity Savings Direct Growth 13.3475 12.6763 10.8202
HDFC Equity Savings Fund -Direct Plan - Growth Option 17.6135 11.7375 10.8194
Kotak Equity Savings Fund Direct Growth 12.7692 11.1795 10.4423
Aditya Birla Sun Life Equity Savings Fund Direct Plan Growth 13.8773 12.1354 10.3027
DSP Equity Savings Fund Direct Plan Growth 14.4778 11.4909 9.9450
PGIM India Equity Savings Fund Direct Plan Growth 13.0611 10.7225 9.5739
L&T Equity Savings Direct Plan Growth Plan 16.3409 11.3621 9.5163
Tata Equity Savings Direct Plan Growth 12.5172 10.8527 8.5297
ICICI Prudential Equity Savings Fund Direct Growth 10.0431 9.0823 8.4047
Data Source: Morningstar

As you can see in the table above, the 5 year returns are lower than equity funds but much better than debt funds or even hybrid funds. In fact, the return profile of the Equity Savings Funds is somewhat akin to the balanced hybrid funds. However, the mix of equity debt and arbitrage hedges ensures that the risk of negative returns even in the short term to medium term is substantially reduced.

How is an equity savings fund taxed in the hands of the investor?

When we say 35% equity exposure in ESS funds, it refers to the net equity. For example, if I hold 70% in equity and half of that is hedged with short futures, then net equity is 35%. However, for tax purposes, they take into account 70% which is more than the 65% stipulated by SEBI so it will be treated as equity fund for tax purposes.

The taxation of ESS will depend on whether it is classified as equity fund or debt for Income tax purposes. It is advantageous to get classified as equity fund as the tax treatment is more favourable for equity funds as compared to debt funds. Remember that any fund with more than 65% holdings in equity is classified as an equity fund for tax purposes. Here is what you need to know about taxation of equity funds.

  • Equity funds gains will be short term if held for less than 1 year and it will be long term if held for more than 1 year.

  • In the case of short term capital gains on equity funds, they will be taxed at a concessional tax rate of 15% on the STCG. However, this will be subject to any cess and surcharge applicable from time to time.

  • In the case of long term gains on equity funds, the first Rs.1 lakh of gains for the entire equity category will be exempt. Any gains above that will be taxed at a flat rate of 10%, without any indexation benefits.

  • Short term capital losses on equity funds can be set off against long term and short term gains. However, long term capital losses can only set off against long term gains. Such losses can be carried forwards for 8 years if not absorbed fully in current year.

  • Dividends on equity funds and debt funds are now treated as other income in the hands of the investor and taxed at the peak applicable incremental rate of tax.

What are the major merits of equity savings funds?

There are several advantages that the Equity Savings Funds proffer to investors. Here are a few of them encapsulated.

  • The equity component offers growth and appreciation of capital. However, since there is an arbitrage component to it, the upside is constrained but that also means that the risk is also limited.

  • The arbitrage position not only leverages the spread between cash and futures riskless, it also gives opportunities to trade on market volatility. There are occasions when a positive arbitrage goes into negative giving above normal profits to the fund.

  • The combination of equity, arbitrage and debt provides a combination of growth, wealth creation, hedging, market volatility opportunities, regular and steady investment, capital protection and a lot more.

  • Equity savings funds tend to be a lot more tax efficient. That is because, Since ESS is normally treated as equity funds for the purpose of taxation and this reduces the tax liability in case of STCG and also in the case of LTCG.

  • Last but not the least, it offers a very solid model to diversify your portfolio by virtually combining 3 asset classes. Also, ESFs act like a fund of funds and fund managers combine the best of categories to give the best overall returns for the investors. That works in favour of returns and risk.