Debt Mutual Funds – What returns to expect ??

We had earlier explored Fixed Deposits in detail and found to our dismay that F.Ds are a bad way to save our hard earned money as generally post the taxation impact, the returns do not even cover up for inflation.

So let’s look at our next asset class – Fixed Income (which we will be participating through Fixed Income mutual funds also referred to as Debt mutual funds).

This can be viewed as a close replica of a Fixed Deposit but with few important differences.

Now at a very basic level, both Fixed Deposits and Debt Mutual Funds are simply intermediaries who connect lenders and borrowers.

Every time you invest in  Fixed Deposits or Debt Mutual Funds, you are essentially lending your money. This is extremely important to remember as most of us forget this fact.

This money will be lent to  borrowers in need of money such as individuals (only in F.D and not Debt mutual Funds)  or companies or government. The interest which the borrowers pay for borrowing the money, is passed back to you after the intermediary (i.e banks or mutual funds) takes the inter-mediation charges.

So in simple terms,

  • If the intermediary connecting you and the borrower is a bank it is called Fixed Deposit
  • If the intermediary connecting you and the borrower is a mutual fund it is called Debt Mutual Fund

FD vs Debt Funds

 Lets see how Debt Mutual Funds returns have fared in the last 10 years
Debt Fund ReturnsAs on 31-Dec-2015, Source: Crisil

You can also view the various debt fund category returns aggregate on a daily basis from https://www.valueresearchonline.com/cat_index_returns.asp

 

As seen above the Debt funds (short term will be our preferred long term category) have provided around 8% returns over the long run.

Taxation Advantage
A significant advantage over F.D is derived from the way the debt funds are taxed.

Investment period less than 3 years
The taxation for Debt Funds and Fixed Deposits are almost the same for a holding period less than 3 years where the interest income is taxed as per your tax slab in both the cases. One small advantage that Debt funds have here is that you need to pay the taxes only at the time when you withdraw while in an F.D you must declare and pay taxes on interest income every year (read as additional headache).

Investment period greater than 3 years
However for investment periods more than 3 years, Debt mutual funds have a significant taxation advantage over Fixed Deposits.The long term capital gains or gains from investments over a period of 3 years in a debt mutual fund (i.e your final value – initial investment value – if you invested Rs 100, 4 years back and now it is 135 then the capital gain is  Rs 35) will be adjusted for inflation and then taxed at 20%.Let us take a little more time to understand this. Essentially the government is telling you that if the returns you make is lower than inflation, then the government won’t tax you and will tax you only if your returns are above inflation. So inherently debt mutual funds ensure that you are not taxed unfairly like a Fixed Deposit where you are taxed at your income tax slab irrespective of whether your returns are below or above inflation.Lets assume that the returns from a Debt mutual fund that you had invested was 8% for the last 5 years. Assume inflation was 7% for that period. Hence your tax component will be 20.6% of 1% (8%  return – 7% inflation) i.e ~0.21%. Thus the net returns that we make post tax will be around 7.8%.
FD vs Debt Fund - Tax Illustration.jpg
You can calculate the inflation for your holding period from the Cost of Index provided in below link http://www.incometaxindia.gov.in/Pages/utilities/Cost-Inflation-Index.aspx

Summary:
  1. Debt Mutual funds provide a decent alternative for Fixed Deposits
  2. For investment periods of greater than 3 years, they offer better taxation advantage
  3. The returns from this category can be expected to be ~Inflation+1%
  4. Historically its been around 7-8%
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SIP in Equities – don’t forget this ignored component !!

SIP is the new “in” thing..

Image result for sip mutual fund ad

In recent times there have been several ads and articles focusing on the benefits of SIP (systematic investing plan) in equities (via equity mutual funds).

Systematic investment plan or SIP as it is commonly referred to, is a disciplined investing process where you keep allocating a predetermined amount every month irrespective of the market conditions.

The key advantage is the fact that you don’t need to time the market and it aligns with the income pattern (monthly salary) for most of us.

The basic idea behind SIP is that since we consistently invest over a period of time, we are able to average out both declines as well as upside movements (assuming markets continue to remain cyclical as they have been historically.

Now the overall intent behind an SIP is good – i.e to make investing in equities simple and to address the behavioral biases of investors.

However I believe there are few important caveats which are not being discussed and might lead to a sub optimal experience for investors. Let us see them in detail below:

But remember “Equity returns are non linear”..

The most important thing in my opinion for any investor while investing in equities is to understand the fact that

“Equity returns are non linear”

i.e the returns in equities are not equally spread across years and are extremely volatile. The returns fluctuate between high and low significantly and as seen below while the overall average returns are good, they hide the intermittent sharp declines and sharp up moves which occur in intermittent periods regularly.

Sensex Returns
Source:BSE

And there is the ignored 100% equity exposed portfolio which keeps growing with time..

An SIP addresses the volatility issue reasonably well during the initial years. But however what is being ignored is the fact that as the time period of an SIP increases you also end up with a reasonably sized corpus which remains 100% invested in equities and hence exposed to the volatility of equity markets.

Lets assume you had planned an SIP of Rs 10,000 in HDFC Top 200 (a popular equity mutual fund) every month for 15 years starting from 01-Jan-1998.  The value of SIP as on 01-Jan-2008  would have become Rs 94.5 lakh. But one year later, on 01-Jan-2009 the value of the SIP would have become 53.3 lakhs (remember the 2008 subprime crisis , the Sensex fell 52% while the fund fell 45%) . Basically in one year your corpus has come down by a whopping ~41 lakhs.

That’s a huge decline from an absolute perspective and behaviorally it becomes extremely difficult to remain in equities. (Now before you go blaming equities..Relax, the SIP value recovered to Rs 1.03 cr as on 01-Jan-2010 ).

The same SIP had it been started on 01-Jan-2005 you would have ended with Rs 7.4 lakhs in 01-01-2008 and a year later would have declined to Rs 5.0 lakhs as on 01-Jan-2009. Here the impact on corpus is not that high, with the decline being ~ 2.4 lakhs.

Do you see where we are getting at??

In the initial years the SIP corpus is small and while the volatility of equities continues to keep the corpus volatile, the impact on an absolute basis is to a great extent manageable provided you have a long investment time frame and reasonable confidence on the fund.

But as time progresses, the compounding effect comes into play and your corpus also becomes sizable. The sizable corpus is 100% invested in equities irrespective of the market conditions which implies a 2008 like crisis can have a significant impact on the overall portfolio and most importantly to your sleep 😦

As portfolio crosses the threshold, shift to an Asset Allocation Strategy

So the key is to decide a threshold corpus beyond which we will move the existing corpus into an asset allocation strategy (a mix of debt, equity and gold based on the time period left).

While a temporary loss (provided you don’t panic and sell) of 50 lakhs might be ok for someone, I might be able to withstand only say Rs 30 lakhs.

The ability to withstand a decline is different for different people..

So how do we decide the threshold level ??

As a thumb rule, equity investors must be prepared for a temporary decline of 50%  as evidenced for the Indian equity market history and as seen in other global markets. Now generally losses for human beings are not in % terms but in absolute value terms. So a 50% decline on Rs 10,000 is qualitatively significantly different from the same 50% decline on Rs 10 lakhs.

I personally would like to evaluate my investment corpus in terms of my annual income.

So let us assume someone earns Rs 5 lakhs per year. He has managed to save around Rs 30 lakhs. Now a 50% decline will imply a Rs 15 lakh fall. But a better way of appreciating the true impact is to view it as his 3 years of hard work vanishing on a computer screen in just 6 months !!

I would be ok to handle a temporary loss of up to 2.5 years of my annual income in promise of higher returns in the future. So that implies I am ok with a 100% equity exposure till my corpus reaches 5x my annual salary.

Now different people will have different tolerance levels.

You can decide on your tolerance levels based on years of your annual income which you don’t mind seeing a temporary loss.

Summing it up,

As a quick rule of thumb, you may keep approximately 5x your annual income as a threshold for your equity SIPs (or adjust it based on your risk taking ability).

The moment it crosses the threshold you will need to start actively managing the equity exposure i,e follow an asset allocation with debt, equity and gold (will write a separate post on how we can do that). So when you are running an SIP in equity mutual funds, make sure you set your threshold.