July 31, 2014

The new usefulness of equity funds

This isn’t for everyone, so unless you are confident that you understand the risks involved and are willing to live with a potentially unfavourable outcome, don’t attempt this on your portfolio without consulting a good investment advisor.

Till recently, for investors in the higher tax brackets, with an investment horizon of between 1 and 3 years, debt funds were arguably the most attractive investment option, in terms of potential return that could be earned, relative to the risk.  In the wake of the taxation changes announced in the recent budget, these funds are now, more or less, as attractive (or unattractive) as any other debt instrument.  The taxes that such investors would now have to pay in these funds could well be up to three times (or even more) what one would have paid based on the earlier tax laws.  This would also be the case for investors who have already made investments in debt funds and need to withdraw some or all of those investments, some time after the completion of 1 year (from the date of investment) but before the completion of 3 years from that date.

For all such investors, who are uncomfortable with the additional tax now needed to be paid, I would like to propose the case for a greater allocation to equity oriented funds.  A note of caution: Equity funds are not a natural substitute for debt funds or any debt instrument.  These require far greater risk management as compared to debt funds, and it would help to bear that in mind while evaluating this.

The background: According to the new budget proposals, gains from exiting a debt fund before completion of 3 years will now be taxed at one’s normal tax rate.  Gains from exiting an equity oriented fund after completion of 1 year continue to be tax-free.  At the time of writing, a deposit with State Bank of India for a period of between 1 and 3 years, is assuring an annualized return of 9.31% p.a.  If taxes were to be taken at 30%,  then this roughly translates into a post-tax return of 6.52% p.a.  One could say that an equity oriented fund needs to produce returns in excess of this number for it to be a more worthwhile investment.

The case: To understand the odds, I looked at data of the NSE-50 Total Return Index, and tried to examine the outcome from making a hypothetical investment in this index on each day between 11 Feb, 2000 and 5 Nov, 2010 (both dates represent market peaks).  More specifically, I tried to see how long would it have taken such an investment made on each day to deliver an annualized return of 7.00% p.a., after taxes (subject to a minimum absolute return of 7.00%, after taxes).  Tax (on investments held for less than a year) was assumed at 15%.  Here are some of the key observations:

  • Of the 2682 trading days in this period, there were 2207 days (82%) on which, if an investment were to have been made, would have resulted in this target return in a period of 1 year or less.   
  • There were 1864 days (70%) on which,  if an investment were to have been made, would have resulted in this target return in a period of 180 days or less. 
  • There were 621 days (23%) on which,  if an investment were to have been made, would have resulted in this target return in a period of 30 days or less.  
  • There were 179 days (7%) on which, if an investment were to have been made, it would have taken over 3 years to achieve this target return.  These include 43 days on which, if an investment were to have been made, this target return would have not yet been achieved (as on 30 June, 2014).  
  • The longest wait to achieve this target return would be for an investor who invested on 29 Oct, 2007.  As on 30 June, 2014, he/ she would have waited 6 years and 8 months.  As on that date, the return on his/ her investment would have been 5.06% p.a.
  • There were 1754 trading days on which the trailing Price-Earnings (P/E) Ratio of the NSE-50 was below 20.  An investor who invested on any of these days would have had to wait no longer than 2 years and 11 months to achieve the target return.  Of these, there were 1553 days (89%) on which, if an investment were to have been made, would have resulted in this target return in a period of 1 year or less.   

In case you think there is a case for using this information to formulate a strategy, here are some suggestions:

  • I believe that the primary motivation for using this information as part of a strategy should be to bring down taxes.  This will help determine how much should be additionally allocated to equity funds.  Any motivations beyond that should be carefully assessed before moving ahead. 
  • Judiciously pick the moments when you would want to allocate money to equity funds.  The P/E Ratio can be a good indicator.  In addition, I would also consider how much below the last peak is the index.
  • Don’t defer your exit from an equity fund till the time when you need the money.  If, at that time, prices are down, it may have far more adverse consequences than you may realize. 
  • Do bear in mind that any gain from exiting an equity fund before the completion of 1 year is not tax-free.

At the time of writing, the P/E Ratio of the NSE-50 stands close to 21, and markets are around their all time high.  Personally, I would use this as an opportunity to exit equity funds to the extent that I can anticipate a need that would otherwise increase my tax liability.

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