Topic 3: Three ways to use Covid-19 blow to your MFs’ benefit
It is an old saying that every cloud has a silver lining. The meltdown in India’s markets on account of the Covid-19 outbreak has cut into the value of people’s mutual fund investments. However, on the positive side, this may have also lowered or even completely wiped out any taxable gains, allowing investors to make changes to their mutual fund portfolios without incurring income tax liability while doing so.
According to experts, there are four such changes you can make in your portfolios in order to optimize your gains from any future recovery in the markets.
Revisit your MF asset allocation
A sharp fall in the equity market would have shifted your asset allocation in favour of funds that invest in other assets like debt or gold. If you think you should carry on with the earlier asset allocation, you can now move some money from debt and gold funds into equity funds to take advantage of more favourable valuations. For instance, if a 50:50 equity-debt portfolio has become 40:60 in favour of debt, you can move it back to 50:50 by redeeming your debt funds and buying equity funds.
Investors should not worry about missing out on gains in the process of shifting to equities. For example, if the switch takes two to three working days and the market moves up by 5-10% in the interim, you may miss out on some gains, but a staggered approach can average it out for you in the long term. Nobody can catch the absolute bottom or the top. In the long term, these will get ironed out. To reduce risk, you can do this in a staggered manner. For example, if you want to shift ₹10 lakh from debt to equity, make redemptions of ₹2.5 lakh each over four weeks, accompanied by fresh purchases into equity as soon as the money hits your account.
However, ensure you have adequate liquidity before committing more money to equities in these uncertain times. Keep in mind your risk profile and financial goals while switching your funds. If you are retired or face unemployment you may need the debt portion to survive. However, if you have emergency funds or have a debt corpus in excess of what you require in the next two to three years, you can still carry out this switch.
Shift to funds that are outperformers
Investors have a tendency to hang on to duds. Some of this stems from an inability to admit and accept mistakes in selecting funds in the past. Continuing with an underperforming fund will mean that your money is not working as hard as it could for you. The present volatility owing to the pandemic gives you a great opportunity to start over with a clean slate.
But be careful when choosing an outperforming fund. It is not just a fund that’s done well over the past year but one that’s done well over multiple market cycles. You should carefully examine how it has contained its downside in slowdowns or recessions. Also, pay attention to the rolling returns rather than trailing returns which can be biased by a single point in time. Rolling returns average out returns using multiple start and end points.
Note, however, that although the correction may have wiped out the tax liability which you may have incurred when switching funds, you may still need to pay an exit load, wherever applicable.
Typically, exit load is imposed in equity funds for up to one year after the purchase. You can also use the correction to switch from dividend to growth plans of mutual funds. Budget 2020 abolished the dividend distribution tax (DDT) on stocks and mutual funds and made dividends taxable at slab rate in the investors’ hands. This significantly increases the burden for investors in the 30% tax bracket. Earlier, dividends were tax-free in the hands of investors although DDT was imposed on equity funds at 11.65% and debt funds at 29.12% (including surcharge and cess).
However, remember that a shift from the dividend to growth option and vice-versa is seen as a redemption and is liable to capital gains tax and exit load.
Pare down your portfolio
Many investors buy mutual funds as if they are stocks and end up with vast portfolios of 20-30 schemes. Since a mutual fund typically holds 30-50 stocks, a portfolio of more than six to eight equity funds will tend to just replicate the market on average and cancel out any outperformance or alpha. It will give returns similar to an index fund without the low costs of an index fund. Since index funds mimic the index they track, there is only a small fund management fee you have to pay. Investors should consolidate their portfolios. Get down to four to eight funds, ideally index funds. This will also help you track your funds better and rebalance your portfolio on a regular basis. Such an exercise can also be used to give the portfolio some intra-asset class diversification. For instance, if you own too many large-cap funds, you can consider switching to the multi-, mid- or small-cap categories, depending on your risk profile. Investors should ideally split their money between market segments as per their risk appetite. Those wanting index-like returns should stay with large-cap funds while those prepared to take on more risk can go into mid- and small-cap funds. A multi-cap fund combines the best of both worlds, some years, such as 2019, favour large-caps, while others favoured mid- and small-caps. I would suggest roughly a 60:40 split between large and mid/small, as a rule of thumb.
According to experts, there are four such changes you can make in your portfolios in order to optimize your gains from any future recovery in the markets.
Revisit your MF asset allocation
A sharp fall in the equity market would have shifted your asset allocation in favour of funds that invest in other assets like debt or gold. If you think you should carry on with the earlier asset allocation, you can now move some money from debt and gold funds into equity funds to take advantage of more favourable valuations. For instance, if a 50:50 equity-debt portfolio has become 40:60 in favour of debt, you can move it back to 50:50 by redeeming your debt funds and buying equity funds.
Investors should not worry about missing out on gains in the process of shifting to equities. For example, if the switch takes two to three working days and the market moves up by 5-10% in the interim, you may miss out on some gains, but a staggered approach can average it out for you in the long term. Nobody can catch the absolute bottom or the top. In the long term, these will get ironed out. To reduce risk, you can do this in a staggered manner. For example, if you want to shift ₹10 lakh from debt to equity, make redemptions of ₹2.5 lakh each over four weeks, accompanied by fresh purchases into equity as soon as the money hits your account.
However, ensure you have adequate liquidity before committing more money to equities in these uncertain times. Keep in mind your risk profile and financial goals while switching your funds. If you are retired or face unemployment you may need the debt portion to survive. However, if you have emergency funds or have a debt corpus in excess of what you require in the next two to three years, you can still carry out this switch.
Shift to funds that are outperformers
Investors have a tendency to hang on to duds. Some of this stems from an inability to admit and accept mistakes in selecting funds in the past. Continuing with an underperforming fund will mean that your money is not working as hard as it could for you. The present volatility owing to the pandemic gives you a great opportunity to start over with a clean slate.
But be careful when choosing an outperforming fund. It is not just a fund that’s done well over the past year but one that’s done well over multiple market cycles. You should carefully examine how it has contained its downside in slowdowns or recessions. Also, pay attention to the rolling returns rather than trailing returns which can be biased by a single point in time. Rolling returns average out returns using multiple start and end points.
Note, however, that although the correction may have wiped out the tax liability which you may have incurred when switching funds, you may still need to pay an exit load, wherever applicable.
Typically, exit load is imposed in equity funds for up to one year after the purchase. You can also use the correction to switch from dividend to growth plans of mutual funds. Budget 2020 abolished the dividend distribution tax (DDT) on stocks and mutual funds and made dividends taxable at slab rate in the investors’ hands. This significantly increases the burden for investors in the 30% tax bracket. Earlier, dividends were tax-free in the hands of investors although DDT was imposed on equity funds at 11.65% and debt funds at 29.12% (including surcharge and cess).
However, remember that a shift from the dividend to growth option and vice-versa is seen as a redemption and is liable to capital gains tax and exit load.
Pare down your portfolio
Many investors buy mutual funds as if they are stocks and end up with vast portfolios of 20-30 schemes. Since a mutual fund typically holds 30-50 stocks, a portfolio of more than six to eight equity funds will tend to just replicate the market on average and cancel out any outperformance or alpha. It will give returns similar to an index fund without the low costs of an index fund. Since index funds mimic the index they track, there is only a small fund management fee you have to pay. Investors should consolidate their portfolios. Get down to four to eight funds, ideally index funds. This will also help you track your funds better and rebalance your portfolio on a regular basis. Such an exercise can also be used to give the portfolio some intra-asset class diversification. For instance, if you own too many large-cap funds, you can consider switching to the multi-, mid- or small-cap categories, depending on your risk profile. Investors should ideally split their money between market segments as per their risk appetite. Those wanting index-like returns should stay with large-cap funds while those prepared to take on more risk can go into mid- and small-cap funds. A multi-cap fund combines the best of both worlds, some years, such as 2019, favour large-caps, while others favoured mid- and small-caps. I would suggest roughly a 60:40 split between large and mid/small, as a rule of thumb.