The Finance Minister presented the final budget for FY2019-2020 on July 5, 2019. Here are the key highlights of the budget.
Income Tax slabs unchanged; Surcharge
increased for the rich
There has been no
change in the income tax slabs. There is a sharp increase in surcharge for those
earning more than Rs 2 crores.
We must understand the impact of the surcharge is not just limited to your salaries. The surcharge is levied on all types of income, even capital gains. Therefore, for a taxpayer with taxable income in excess of Rs 5 crores, the long-term capital gains tax on the sale of equity/equity mutual funds is 14.25% (10% LTCG tax, 37% surcharge and 4% cess). Earlier, it was only 11.96% (10% LTCG tax, 15% surcharge and 4% cess). This is quite a substantial increase.
Additional Tax Benefit on Housing
Loan under Section 80EEA
To give a fillip to the real estate sector, the Government has provided an additional tax deduction of Rs 1.5 lacs per financial year towards interest payment for the housing loan. This is subject to the following conditions
The home loan must be sanctioned between April 1, 2019, and March 31, 2029.
The stamp duty value of the house must not exceed Rs 45 lacs.
You must not own any house on the date of sanction of the loan.
As you can see, this benefit is only for first-time buyers. This tax benefit under Section 80EEA will be available in the subsequent years too.
This tax benefit is over and above the tax benefit of Rs 2 lacs for home loan interest payment under Section 24. Therefore, the total tax benefit for the loan taken in FY2020 can go up to Rs 3.5 lacs.
At the same time, we must also see the utility of it. For a Rs 45 lacs house, you will get a loan of about Rs 36-37 lacs. At an interest rate of 9% and a loan of Rs 36 lacs for 15 years, you will pay Rs 3.2 lacs as interest in the first year. 3.08 lacs in the second year. 2.95 lacs in the third year and so on. The interest amount will be higher if the tenure was longer or the loan amount was higher.
Your actual benefit
will depend on your tax slab too.
We must understand
that the pre-conditions to avail tax benefit for interest payment are different
under Section 24 and Section 80EEA.
under Section 80EEA is available for home loans from banks and financial institutions.
Under Section 24, even interest paid on home loans from friends and relatives
is eligible for tax benefit.
Under Section 24,
you get the tax benefit on interest paid only after you have received
possession of your house (interest paid before possession is eligible for deduction
over the next 5 years in 5 equal instalments). Section 80EE and 80EEA do not
impose any requirement of possession or completion of construction. Therefore, Section
80EEA provides you immediate relief even if you have purchased an under-construction
Push towards Electric Vehicles (Deduction of Rs 1.5 lacs under Section 80EEB)
Good news for the
buyers of Electric Vehicles.
If you take a loan
to purchase an electric vehicle, you will get an additional tax deduction of Rs
1.5 lacs for the interest paid for such a loan under Section 80EEB. The tax
benefit would be available for both cars and bikes.
The tax deduction
is subject to the following conditions:
must be purchased between April 1, 2019 and March 31, 2023.
loan must be taken from a financial institution.
The tax relief is
not just limited to the year of purchase but shall be available in the subsequent
years too. In an additional boost, the Government has proposed to reduce GST on
such vehicles from 12% to 5%.
Additional Announcements in the Budget
from Resident to Non-Residents (NRI)
shall be considered to accrue in India and hence be subjected to income tax. Gifts
received from close relatives, through inheritance or at the time of marriage
continue to be exempt. Exemption of Rs 50,000 worth of gifts per financial year
shall also continue to apply. Read this
post for more on this topic.
Buyback Loophole plugged: Dividends from shares are subject to DDT of 15% (company pays the tax before transferring money to investor account). The dividends are free in the hands of the investors unless your total dividend receipts cross Rs 10 lacs in a financial year. Such investors have to pay an additional tax of 10%. Promoters/rich investors were likely to be worst affected by this rule. To circumvent this tax issue, the companies preferred to take the buyback route (instead of giving dividends). Buybacks of shares were a better and tax-efficient way to transfer money to shareholders. Now, the companies will have to pay 20% of the amount used for share buyback as tax. In a way, they have equalized the tax treatment of buybacks and dividends.
TDS on taxable
life insurance policies increased from 1% to 5%. Your life insurance policy proceeds are
taxable if the Sum Assured is less than 10 times the annual premium. 1% was on the
gross amount. 5% is on the income from the policy.
The Government plans to launch a CPSE ETF along the lines of ELSS. You will get tax
benefits under Section 80C. The Government uses CPSE ETFs for its divestment in
PSUs. The modalities are still awaited. You can expect a lock-in for 3 years.
Definition of a PSU has been revised. Earlier, The Government had to own at least
51% of the entity. Now, the definition is, The Government and the entities
owned by the Government must hold at least 51%. If you view this along with the previous point,
you can see that the Government plans to raise a lot of money through
taxation was revised in December last year. The entire 60%
lumpsum withdrawal permitted at the time of retirement was made tax-exempt. Central
Government was to contribute 14% of the basic salary to its employees. Invest
in NPS Tier II account was also added to Section 80C basket. Enabling provisions
have now been added to Section 80C, Section 80CCD and Section 10.
Custom duty on
gold increased from 10% to 12.5%.
Gold prices shot up on July 5 for this reason.
Extra cess on Diesel
TDS of 2% if the cash withdrawal exceeds Rs 1 crore from a bank account. Well, you can open multiple
accounts. Do note it is TDS. You can claim back the extra tax deducted at the time
of filing ITR.
returns to be made available for investors. The information from various sources (banks, stock exchanges,
mutual funds) shall be auto populated.
mandatory for those who have deposited more than Rs 1 crore in savings/current
account OR have spent more than Rs 2 lacs on foreign travel OR have paid electricity
bill of over Rs 1 lac in a year.
NRIs can now be
issued Aadhaar card after their arrival in India (permanent return in my opinion) without the
waiting period of 180 days.
authority of Housing Finance Companies to be shifted from National Housing Bank
(NHB) to the Reserve Bank of India (RBI).
New coins of 1, 2,
5, 10 and 20 rupees to be launched.
PAN and Aadhaar
card to be made interchangeable. Those who do not have PAN card can file
returns by quoting their Aadhaar card.
A new pension scheme (Pradhan Mantri Karam Yogi Maandhan) for Small Businessmen and Traders with a turnover of less than Rs. 1.5 crores. It is along the lines of Atal Pension Yojana.
SEBI, in June 2019,
made a few changes to investment guidelines and valuation of securities in debt
mutual funds. These changes enhance credit and liquidity profile of the liquid funds.
At the same time, these changes can make liquid funds a bit volatile.
Let’s try to understand the new SEBI rules.
#1 Liquid funds are now required to
hold 20% in liquid assets
funds to hold 20% in assets such as Cash, Government Securities,
T-bills and Repo on Government Securities. This improves credit and liquidity
profile of at least some of the liquid funds to an extent.
#2 Liquid funds will have exit loads now.
graded exit load shall be levied on investors of liquid schemes who exit the
scheme up to a period of 7 days.
Therefore, if you were thinking of putting money in liquid funds for a couple of days (if that ever made sense to you), then be prepared to be charged a penalty. SEBI has not specified the quantum of exit load. However, you can expect it to be very small.
Retail investors have little to worry. In fact, this move helps AMCs more.
#3 Liquid funds will be a bit
volatile. Amortization not allowed now
Earlier, SEBI used to allow bonds with a remaining maturity of up to 90 days to be amortized. Then, the tenure was reduced to 60 days, then to 30 days (in March 2019) and now the amortization has been done away with completely.
What is Amortization?
Let’s say you purchase a bond for Rs 98, and it matures at Rs 100 in 90 days (zero-coupon bonds). By the way, treasury bills work in this fashion too. The bond is traded on the market and you will always have market value. Let’s say SEBI allowed amortization for bonds maturing in 90 days.
value of your bond will increase from 98 to 100 in 90 days. You will get your
money back on the date of maturity. With amortization allowed, you could simply
increase its value by Rs 2/90 (Rs 0.022) every day. The fund manager (or the
investor) does not have to worry about the rating downgrade, market fluctuations,
interest rate movement, fair value or anything else. The bond value (and
concomitantly the fund NAV) can inch up in a straight line. Everything is hunky-dory until such time there
is a default.
provision for amortization, liquid fund NAV could follow a smooth path. And
this is what the biggest liquid fund investors want.
Treasuries/businesses park a lot of money into liquid funds. After all, they earn
0% in their current accounts. Such investors can park money for a few days or
even overnight. Given the quantum of
their investments, even a couple of days of investments means lakhs of rupees.
A Rs 1,000 crore investment can earn about Rs 19-20 lacs per day in a liquid
fund (assuming 7% return).
that liquid funds must follow mark-to-market approach to their investments
(with amortization done away with), such investors would be cautious.
For the corporate treasuries, they don’t want to see a downtick in their portfolios, which now is a possibility. Earlier, it could have happened only in case of credit default. Even though the liquid funds carry very limited interest rate risk and typically the credit rating of the investments is also high, the quantum of investment and very short investment horizon makes it tricky for the biggest investors. Adverse volatility for a few days and a few heads will roll. It is possible that businesses or corporate investors may now prefer to invest in overnight funds.
though retail investors like you and me can also invest in liquid funds for a
few days, how many of us do that? At least, I don’t. Even if the money was
needed after a few days, I would rather keep the money in my bank account. Of course,
my investment amount is low too. Therefore, this move does not really affect
us. In fact, it is a good move because it keeps the fund asset prices closer to
This article from Deepak Shenoy has addressed this topic in a brilliant fashion. This is a must-read article. I learned a lot myself.
#4 Liquid funds and overnight funds not allowed to invest in short term deposits, debt or money market instruments having structured obligations and with credit enhancements
Such structures could be a loan that is backed by a guarantee from the promoter group entity and backed by shares of the promoter company. Now, liquid and overnight funds can’t make such investments.
Other variants of debt mutual funds can have up to 10% of the portfolio in such securities. Any debt security with credit enhancement backed by equities must provide security cover of at least 4 times.
exposure to a corporate group is capped at 5%.
The sectoral cap has
been reduced from 25% to 20%. For investment in Housing Finance companies
(HFCs), there is an additional exposure of 15%.
#5 Mutual fund schemes must now
invest only in listed Non-convertible debentures and listed commercial papers
This shall be done
in a phased manner.
Chairman made an interesting comment recently, “Mutual funds are not banks and
they are investing and not lending.” Some of the recent troubles with debt
mutual funds can be attributed to a few AMCs not adhering to this basic principle.
deals for Loans against shares (with limited recourse in some cases) were struck
with powerful promoters. Essentially, the mutual funds indulged in primary lending.
When there was default, the AMCs agreed with the promoter not to enforce
security (sell shares). As I understand, the fund houses won’t be able to do
such deals in the future.
my opinion, all the moves are retail investor friendly and are a step in the
On June 4, 2019, DHFL could not make the interest payment on one of its bonds. It says that it will pay in another week. Does not matter. Even the slightest delay is considered a default. As per extant rules, even if a default happens in one security by DHFL (not the one held by the fund scheme), the value of the all the bonds from DHFL held by the fund scheme must be written down. And that’s what happened. On June 5th, CRISIL and ICRA also downgraded DHFL to D (Default). Many debt mutual fund schemes suffered badly.
is the single day fall in NAV of a few debt mutual fund schemes.
in NAV of some of the schemes is simply mind-boggling.
The reason why this credit event has impacted so many funds is that DHFL used to be a AAA rated (best rated) company a few months back. For this reason, many funds have been caught off-guard. DHFL found a place in not just credit funds but also in some of the seemingly safer ultra-short duration and low duration funds.
You might ask how these fund schemes could hold such concentrated exposures in a single company. Well, it was not always like this. These schemes must have had exposures within limits. However, ever since the issue of IL&FS and DHFL cropped up last year, these funds have seen an exodus of money.
Let’s say there is a fund A of Rs 5,000 crores that hold Rs 200 crores of DHFL debt. So, DHFL exposure is 4%. However, investors (smarter ones) start taking money out once there was a hint of trouble. Let’s say investors take out Rs 4,000 crores from the fund scheme. To meet the redemptions, the fund schemes must sell its holdings, but it cannot sell DHFL. Why? Because nobody wants to purchase it or purchase it at the price at which the fund manager wants to sell it. (This is also a commentary on lack of depth of bond markets in India). The fund size is down to Rs 1,000 crores. The fund still holds Rs 200 crores of debt. A 4% exposure has now become 20% exposure. If there is default now, the NAV can go down up to 20%.
Tata Corporate Bond lost 29.7% on a single day. As on June 4, 2019, the fund size is Rs 184 crores (it was Rs 536 crores in August 2018). I can safely say almost all this money is from retail investors. If such investors were working with an advisor, they must fire their advisor. Do note, the default did not happen out of the blue. There were concerns about DHFL for a few months now. If your advisor didn’t realize this, you have a problem. Remember
institutional investors/corporate treasuries are major investors in debt mutual
funds. They will take out their money at the slightest hint of risk.
Some of the aforesaid plans are Fixed maturity plans (FMPs). FMPs are closed-ended debt funds. FMP investors are even worse off. Even if they realize that one of the portfolio holdings has a problem, they can’t exit their position. Recently, HDFC and Kotak AMC held back payment on their FMPs on maturity since they were yet to receive payment from the Essel group. More on this in this article in Mint.
You can’t eliminate risks from Debt Mutual Funds
is no way you can eliminate risk from your debt mutual fund investments. You
need to select the right kind of funds for your portfolio. As per SEBI classification,
there are 16 types of debt mutual fund schemes.
you can see, even Government security funds (Gilt Funds) can hold up to 20%
non-Government securities. Government securities have no credit risk. Since
there is no category for short term gilt funds, your gilt funds can carry substantial
interest rate risk.
What happens next?
It is possible
that DHFL may make the interest payment on bonds it defaulted soon. The fund
schemes that held those specific bonds will write back the interest payment to
their NAVs. No such luck for the principal payments or for the schemes that
hold other bonds from DHFL.
Some of the debt
funds have their exposure maturing in the near future. If they are lucky to get
their money back, they will write back to entire amount (both interest and principal
payment) to their NAV and such investors wouldn’t have lost anything (if they
didn’t redeem and the mutual fund stopped fresh purchases).However, there is a
big “What if”.
What if DHFL does
happened is history. You can’t change it. Let’s look forward and understand
what you can do to avoid this mess in the future.
Make a choice between debt mutual funds and bank fixed deposits. A debt mutual fund will never be as safe as bank fixed deposits. If capital security is your primary concern, then bank fixed deposits are a clear winner. At the same time, debt mutual funds enjoy a much favourable tax treatment as compared to debt mutual funds, which may tilt the choice in favor of debt mutual funds. Your tax bracket and investment horizon also play a role. Investors in the 5% tax bracket have limited incentive to go for debt mutual funds. I have discussed these aspects in detail in the following posts. Post 1Post 2
Choose the right type of debt mutual funds. For most of my clients, I prefer funds with low-interest rate risk (overnight, liquid, ultra-short, low duration, money markets funds, etc), low credit risk and low expense ratios. I prefer big schemes (large AUM) from bigger fund houses. I have discussed the checklist in detail in this post. If you are picking up a fund with higher credit risk, appreciate the risks involved. Do not chase the past returns. More often than not, this approach will land in trouble in case of debt funds.
It is important to keep an eye on the size of your fund and the concentration of exposure to a company/promoter group. It is a red flag if the size of your fund has been dropping consistently. You can find this out on ValueResearch website. Alternatively, the AMCs disclose scheme portfolios once every month. Keep an eye.
Exit funds that are losing corpus and are developing concentrated exposure. Tax liability on exit may prevent you from exiting immediately, especially for those in the 30% tax bracket. Consider the pros and cons before making a choice.
IL&FS and DHFL used to be AAA rated companies (Can’t trust credit rating
agencies). If such companies start going bust overnight, it is only a matter of
time when you get caught (as a debt fund investor). The lack of depth in bond
markets may prevent fund managers from adjusting their positions despite
knowing about the prevailing issues. By the way, fund managers can’t be
completely absolved either. Understand the risks associated with debt funds
before considering them as replacement for bank fixed deposits.
yes, spare a thought for those who invested in NCDs from DHFL.
clients and I had a minor impact due to DHFL default. We had exited the big
positions in the funds (where DHFL exposure was high) much earlier. We did not
exit some positions because of the tax considerations or because the fund
allocation was very small. Therefore, the
overall impact was very limited.
we plan for a goal, we assume a rate of return on investments for the goal and plan
investments accordingly. Picking up the long-term average return is a rational
choice. Long term averages are fine (even though long term averages can also change).
However, the sequence of returns matters too. For the same level of long-term return, the actual
output can be very different depending on your investment pattern and of course,
the sequence of returns. And this has implications on your financial planning,
especially during your retirement.
try to understand this with the help of a few examples.
Sequence 1: You earn 8.96% every year for 30 years.
Sequence 2: You earn 6% p.a. for the first 15 years
and 12% p.a. for the next 15 years.
Sequence 3: You earn 12% p.a. for the first 15 years
and 6% p.a. for the next 15 years.
An investment of
Rs 1 lac would grow to Rs 13.72 lacs under all the 3 sequence of returns. The
path taken to reach the final amount will be different. However, at the end of
30 years, you will end up with the same corpus.
Let’s now change
things a bit. Instead of investing lumpsum, you decide to invest Rs 10,000 at
the beginning of each year. Let’s see what happens then.
As you can see, you end up with very different amounts in the three cases. The difference is substantial too. The corpus under Sequence 3 is over 40% higher than the corpus under Sequence 2. This is the sequence of returns risk.
shows that the sequence of returns matters during accumulation phase. It may not matter for lumpsum one-shot
investment, but it clearly matters when your investments are spread out over several
years. And this is likely to be the case for the most of us. By the way, even
for the lumpsum investment, the sequence of returns can affect your behaviour.
For instance, a poor sequence of returns may frustrate you to the extent that
you decide to liquidate your investment. Worse still, you may exit the
investment just before the good times come.
Now, you can’t control this sequence of returns from an asset class that you will experience. All you can do is to tweak your allocation to the asset class based on your market outlook. By the way, your outlook should turn out to be correct too (more often than it turns out to be wrong). Alternatively, you can work with an asset allocation approach and rebalance your portfolio at regular intervals and hope to earn some rebalancing bonus.
the way, the sequence of returns is also a reason that the investors earn
different returns in the same fund. You may be investing in the same fund, but
the quantum and the timing of the investment may be very different.
Retirement/Withdrawals: Sequence of returns pose a much bigger problem
We have seen how the sequence of returns can affect your final portfolio value. However, during the accumulation phase, you at least have an opportunity to make a course correction or take steps so that your goals don’t get compromised. For instance, you can try and invest more when you find that your portfolio is suffering. Moreover, a bad sequence of returns during the early investing years can be quite beneficial (so long as you can control your emotions). However, the biggest advantage is that you are not withdrawing from your portfolio.
During retirement, you must make withdrawals. A poor sequence of returns (especially during the early part), along with withdrawals can spell disaster for your portfolio. You can run out of money.
Let’s see this with an example.
you had accumulated Rs 1 crore for retirement. Let’s say you need Rs 8 lacs per
annum towards your expenses. You withdraw the amount at the end of each year
(for the ease of calculation).
Assume you live in a world of no inflation. With your expense inflation at 0%, your annual expenses stay constant. You assume that you can earn 8% p.a. return (alternatively I could have assumed a rate for inflation and expressed returns as real returns).
If you earn 8% year after year and need to withdraw only Rs 8 lacs per annum, you will never run out of money. You will have Rs 1 crore intact even after 50 years. However, if you are investing in risky assets, this 8% is not guaranteed every year. Over the long term, you may be able to earn 8% p.a. though.
if you earn -10% in the first year and -5% in the second year?
What you had expected: Your Rs 1 crore would become Rs 1.08 crore after the first year. You would withdraw Rs 8 lacs and left with Rs 1 crore. The same cycle will repeat in the second year too and you will still have Rs 1 crore at the end of 2nd year.
What actually happened: Your Rs 1 crore becomes 90 lacs at the end of the first year. You withdraw Rs 8 lacs and you are left with Rs 82 lacs. In the second year, you lose a further 5% and end the year with Rs 77.9 lacs. You withdraw Rs 8 lacs. You are left with Rs 69.9 lacs.
you have lost 30% of the corpus over these two years. Once you start losing money, the odds start
getting against you. This is maths. You have to lose 50% to go from Rs 100 to
Rs 50. However, to go back from Rs 50 to Rs 100, you must go up by 100%.
need Rs 6 lacs of income every year (0% inflation). You want to plan for 30
years. Assuming you can earn 10% return each year, you need Rs 62.21 lacs at
the start of your retirement. Your portfolio will go to zero at the end of 30
let’s assume another sequence of returns with long term CAGR of 10% but with
variable returns. I pick a sequence with poor returns initially.
You run out of money in the 18th year. The initial set of bad returns caused so much damage that you couldn’t recover. Remember, the long term average is still 10% p.a.
poor sequence of returns hurts you more during the early part of retirement
than a bad sequence during the latter part of retirement.
How is this different from accumulation phase?
The difference is that, during the withdrawal phase, you are taking out money from the corpus. Therefore, your losses become permanent. There is no way you can recover the loss once you have sold the investment. The investment may recover per se (your mutual fund or the stock may give roaring returns thereafter) but your portfolio won’t experience the recovery.
By the time good sequence of returns comes around, you may not even have sufficient corpus to benefit from it. Worse still, you may have run out of money.
When you are in the decumulation/withdrawal phase, rupee cost averaging works in reverse (against you). Why? Because when the markets are down, you must sell a greater number of units to maintain the same level of income.
How to reduce Sequence of Returns risk?
There is no way to eliminate the risk completely with volatile investments. You can’t decide the sequence you will experience. You can only try to reduce the impact if a bad sequence comes your way.
During Accumulation Phase
a super-smart investor. Exit equity investments and shift to safer investment
just before equities start doing badly. Get back into equities just before
equities are about to start performing well. The problem is, is this even
If you can’t do the above, it is better to stick with an asset allocation approach and rebalance your portfolio at regular intervals. You can decide your asset allocation depending on your risk appetite, goals and investment horizon. You can make minor tweaks to target asset allocation depending on your market outlook but don’t overdo it. For instance, you may have started with 60:40 (equity:debt) target asset allocation. If the equities look very expensive, you can change the target allocation to say 55:45 or 50:50 or say 40:60. However, taking binary decisions i.e. exiting equities completely or reducing allocation to 5% or 10% if you feel the markets are overvalued, is likely to be counter-productive over the long term.
This is a much bigger challenge because you must withdraw from the corpus. A poor sequence of returns clubbed with withdrawals, can be a disaster for your portfolio.
There can’t be a one-size-fits-solution either. It will depend on your accumulated corpus, income requirement, your risk appetite, and risk-taking ability.
are a few things you can do.
Have a bigger corpus. Or rather plan for longer life, say 40 years instead of 30.
Reduce withdrawals if you encounter a bad series of returns. For an illustration, refer to this post.
If you encounter a poor series of returns, be prepared to work part-time to support expenses. This may be possible if you encounter a bad series during the initial part of retirement. Remember, a bad sequence during the initial years hurts more.
Shun risky investments altogether. Stick with fixed deposits. There will be no sequence of returns risk. However, it will be difficult to beat inflation. Can be a problem unless you have lots of money.
Keep a low percentage of your money in volatile assets such as equities. You may need a bigger corpus.
As advised above for accumulation phase, work with asset allocation approach and rebalance at regular intervals.
Divide your portfolio into buckets. For instance, the money that you need in the next 5 years can go to liquid funds. For the years 6 till 10th year, you can put in ultra-short or low duration bonds funds. For the expenses to be incurred from the 10th till the 15th year, you can put the money in a hybrid (balanced) fund. Anything above can be invested in equities. The idea is to give your volatile assets time to deliver returns. You don’t want to sell them when the markets are down. Do note, at the most basic level, this approach is not much different from an asset allocation approach. However, there can be benefits if we consider the behavioral aspects. It is easy to maintain discipline during a market downturn when you know that your next few years of expenses are taken care off (that money is in less volatile investments).
You can’t choose the sequence of returns you will experience. To an extent, it also depends on your luck. After all, you can’t always choose when you retire. Depending on your portfolio size, market outlook and income requirements, you can merely position your portfolio to reduce the impact.
regular intervals, you bring your portfolio to original asset allocation mix.
say you have Rs 10 lacs to invest. You have two asset classes Equity and Debt.
invest Rs 5 lacs in Equity and Rs 5 lacs in Debt. Asset allocation of 50:50.
the next 1 year, Equity gives 20% returns while Debt gives 5% returns.
investment in Equity grows to Rs 12 lacs. Investment in Debt grows to 10.5
lacs. Total portfolio is 22.5 lacs.
you rebalance, you will have equal amounts in equity and debt i.e. Rs 11.25
achieve this, you will have to sell some portion of Equity and use the proceeds
to purchase some debt.
repeat the exercise every year. And that’s what rebalancing is all about.
How Rebalancing helps?
Rebalancing can help
reduce volatility in your portfolio. In some cases, it can lead to higher
Let’s understand this
with the help of an example.
invest Rs 10 lac on January 1, 1989. You
invest half the amount in a Sensex index fund and the other half in a fixed
deposit that gives you a guaranteed 8% p.a.
8% p.a. for 30 years on a fixed deposits for 30 years sounds unreal but play
along. For the sake of simplicity, let’s ignore taxes. Let’s further assume that
the index fund perfectly replicates performance of the index. I have considered
the Price index (and not the total returns index) for calculations in this
Scenario 1 (You leave the corpus untouched)
5 lacs invested in the Senex index fund on January 1, 1989 grows to Rs. 2.7 crores
as on December 31, 2018. That is a CAGR of 14.2% p.a. over 30 years.
5 lacs invested in the fixed deposit grows to Rs 50. 31 lacs as on December 31,
the two numbers, you have a sum of Rs 3.21 crores. CAGR of 12.26% p.a.
return for the year:
return for the year: -44.94% (2008)
of years with negative returns:
loss more than 15%: 1
deviation of annual returns:
23.84% (Std. deviation is a measure of volatility).
the end of 30 years, your portfolio is 84.3% equity and only 15.6% debt. This
is because equity have given much higher returns over the last 30 years.
Scenario 2 (You rebalance at the end of every
than letting the portfolios grow, you rebalance your portfolio at the end of
each year i.e. you make adjustments so that the asset allocation goes back to
equity has done better during a particular year, you sell some equity and
equity has performed badly (worse than fixed deposits), you take out some money
from the fixed deposit and put that in the index fund.
this approach, at the end of 30 years, you end up with 3.22 crores, slightly
higher than the untouched corpus. CAGR of 12.27%. Clearly, not too big a
difference to bother about.
However, you must also think about how you got there.
return for the year: 45.05%
return for the year: -22.22% (2008)
of years with negative returns:
loss more than 15%: 2
deviation of annual returns:
16.17% (Std. deviation is a measure of volatility).
the path in Scenario 2 is much smoother as compared to Scenario 1.
I don’t care about volatility. I want the best
may argue that you could have stayed put with an all equity portfolio throughout
these 30 years and ended up with Rs 5.41 crores. This number is much higher
than either Scenario 1 or Scenario 2. However, you must note equity investments
have been a clear winner over the last 30 years. We don’t know if the equity
investments will be a winner over the next 30 years by such a wide margin or be
a winner at all.
don’t ignore the volatility. Standard deviation of annual returns (32.34%) is
much higher than Scenario 1 and Scenario 2.
You would have lost more than half your wealth in 2008. You would have
lost more than 15% in 6 out of 30 years. Not sure how many of us have the
courage to stick with our strategy after witnessing such carnage in our
portfolios. I will lose my sleep for sure.
can still afford to ignore volatility of equity when you are in accumulation
phase (before retirement).
However, volatility is extremely important in a decumulation portfolio (post
retirement). A bad sequence of returns in the early part of your retirement and
you will struggle during retirement. For more on this topic, refer to this
the way, it is not that you will always end up with a higher number for an all
equity portfolio. If you had started with Rs 10 lacs on January 1, 1994 and
invested the entire amount in the index fund, you would have ended up with Rs
1.08 crores on December 31, 2018.
you invested in a 50:50 portfolio and rebalanced annually, you would have ended
up with Rs 1.13 crores. Yes, a higher corpus with only 50:50 portfolio over 25
years. I believe 25 years is a long term
for most of us. You can call this Rebalancing bonus. Untouched portfolio
would have given only 88.13 lacs.
reason why this happened was because Sensex returned 9.98% p.a. CAGR during
these 25 years. The difference between FD return (8%) and Sensex return (9.98%)
is not as wide. Of course, the sequence of returns also played its part.
Buy low and selling high
any capital asset, the only way to make money is to Buy low and Sell high. There
is no other way. With rebalancing, this becomes an automatic exercise.
the equities do well during the year, you will have to sell equity at the end
of the year to stick to your target allocation.
forces you to sell equity when the markets have risen and buy equity when the
markets have fallen. Automatic buying low and selling high.
many of us, rebalancing may look like an option for cowards. However, if you
see, this defensive and simple approach of resetting the asset allocation every
year, you also end up with a bigger corpus.
Points to Note
have considered just two assets. You can consider other assets such as gold or
international equities as part of your portfolio mix. Adding asset classes will
result in better diversification.
helps if the correlation between the assets considered is low. In this post, I have considered fixed deposits
give a return of 8% p.a. irrespective of the returns from Sensex. Essentially, I
have considered there is no correlation between equity and debt returns. In the
real world, that may not be the case. Rebalancing won’t serve much purpose if the
correlation between the assets is high. For instance, rebalancing between large
cap equities and small cap equities may not serve as much purpose. Of course, we will have to test this.
primary purpose of rebalancing must be to reduce risk in your portfolio. Rebalancing
may not always result in higher returns. If the returns between the asset classes is very wide as we
saw in 1989-2018 example, you will be better off keeping your portfolio
untouched or keeping 100% in the higher yielding asset. The problem is you
wouldn’t know these returns in advance. Therefore, this can’t be decision factor.
Better to start with an asset allocation approach and rebalance at regular
What is the best asset allocation?
Again, this can only
be told in hindsight. Next 30 years can be very different from the last 30.
However, 50:50 equity: debt (considering only 2 assets) looks a healthy compromise.
destination is financial security and adequate money for your goals including retirement.
There may be many ways to reach there. If the path is too tumultuous, you can
quit the journey and give up on your goal. Regular rebalancing can help make
your journey comfortable and stick to the investment discipline.
the way, many times, rebalancing looks like a contrarian call. Selling equity
when the markets are hitting new highs every day is not that easy. Therefore,
if you can’t do it yourself, seek professional assistance from a financial
planner or a SEBI Registered Investment Adviser.
As investors, we like to compare different investment products while making an investment choice. Most of us compare different products on their returns. We look at 3-year, 5-year, 10-year returns. We look at rolling returns for various horizons. That is good. However, we must also look at the way the performance is reported.
You may not get what is reported. In this post, I look at 4 investment avenues (mutual funds, ULIPs, NPS and PMS) to understand how your actual returns may be different from the reported performance.
How it works in a mutual fund scheme?
case of mutual funds, you get what you see.
say this is what you see for mutual fund performance.
5-year performance of a mutual fund indicates that you earned 20.93% p.a. and
you invested exactly 5 years back in the scheme, you will earn exactly the same
return. Let’s say the NAV was Rs 100 on the date of your investment and you
purchased 100 units. After five years, NAV would grow to Rs 258.6.
10,000 invested (100 units X 100) exactly 5 years back would grow to Rs 25,826
(return of 20.93% p.a.).
the costs (Fund management, distribution etc) are already built into the NAV. In case of mutual funds, all these costs
can be combinedly represented by its expense ratio. Since reported performance
is calculated based on growth in NAV, you will earn the reported returns on
you and your friend invested in the same scheme on the same day, you will earn exactly
the same return.
Many times, you see returns in ValueResearch or MorningStar and wonder why you have earned lower returns in the same mutual fund. Such difference in returns is due to timing of your investments (and not due to any charges). These websites primarily show point-to-point returns. 5-year return implies the return on your investment if you had made the investment exactly 5 years back. However, you didn’t do that. You may have invested on a different date or you may be investing by way of SIPs. Therefore, your return experience from the product may be different from what you see on these websites. CAGR vs IRR vs XIRR?
What happens in a ULIP?
case of ULIPs, your net returns will be lower than the fund performance. Why? Because your ULIP fund units are
redeemed to recover the charges.
say you have invested in a single premium plan and you received 100 units of Fund
X. Let’s assume Fund X delivers the same returns as mentioned mutual funds
example above. Just to be clear, Fund X is a ULIP fund and not a mutual
on the date of your investment is Rs 100. Your wealth is Rs 10,000 (100X 100). In
5 years, the NAV of the unit grow to Rs 258.6 at CAGR of 20.93% (NAV in the
mutual fund example also grew to the same number).
net wealth after 5 years is 90 units X 258.6NAV/unit = Rs 23,276.
effective compounded return is only 18.04% p.a. (and not 20.93% p.a.)
be fair to insurance companies, this is the only way they can report ULIP fund
returns. In a ULIP, every
investor will experience different returns. This will happen even if you
purchase the exact same plan on the same date, pay the same premium, choose the
exact same funds.
does this happen?
is because your
age plays an important role. Even though all the other charges can be same
for all the investors, the mortality charges are linked to investor’s age. Greater
your age, higher the impact of mortality charges since a greater number of
units need to be redeemed to recover the charges. Everything else being
same, a 25-year-old (entry age) will earn higher returns than a 35-year-old. A
35-year old will earn higher returns than a 45-year old and so on.
wouldn’t be fair to expect the insurance company to report returns for each
entry age. Therefore, it reports performance after accounting for fund management
charges or other fund expense items, if any.
put it crisply, Mutual fund NAV is net of all the charges. This is not the case
with ULIPs. To recover other charges,
your ULIP fund units have to be redeemed. Your NAV remains the same but the
portfolio value goes down due to redemption of units.
The intent of this post is not to get into whether ULIPs are better than mutual funds or vice-versa. For my views on ULIP vs Mutual Fund debate, refer to this post.
However, since NPS is a pure investment product, there is no concept of mortality charges. Moreover, the charges (not included in the NAV) are nominal, it does not affect your performance much. Therefore, the returns you earn will be quite similar to the reported performance (provided your NPS portfolio is not very small).
is one of the reasons I advise older investors to stay away from ULIPs.
Mortality charges can eat up a good chunk of their returns.
What about Portfolio Management Schemes (PMS)?
In the case of PMS, the reported performance typically does not even adjust for fund management fee or the performance fees. These expenses are over and above. You need to get to good hang of PMS expenses and fees to assess the impact.
There is an additional issue. In a PMS, you hold securities directly in your demat account. Any churning in the portfolio gives rise to capital gains tax liability. You may not take out money from the PMS and still have taxes to pay due to this churning.
case of mutual funds, a fund manager can keep churning the portfolio. It does
not generate any tax liability for you or for the fund. Your tax liability arises
only when you redeem your units.
the way, I am not implying that mutual funds are better than PMS. All I am
saying you need to dig deeper into costs of PMS to compare reported performance
against mutual fund performance.
know that mutual funds, ULIPs, NPS and PMS are not the same products. ULIPs
provide life insurance too. NPS is a retirement product and provides for
mandatory annuity purchase. We have different financial needs and different risk
appetite. Therefore, the choice between these products should not be made on return
performance alone. For instance, you can’t compare performance of 10 stock deep
value PMS offering (potentially very high risk) with a diversified multi-cap
mutual fund. However, while comparing returns, we must still make an
Investors have different levels of risk tolerance. Some don’t bat an eyelid even if their portfolio nosedives by 25-30% while others worry even if their portfolio is down half a percent.
first category of investors are likely experienced investors while the second category
have a low level of risk tolerance. How should such investors with low risk appetite
or tolerance invest their money? Is it a must for them to take exposure to
equity or equity funds? Here, I want to contrast between risk taking ability
and risk tolerance.
taking ability depends on age, net worth, cashflows, financial goals, family
situation etc. A and B need Rs 1crore for retirement. At
the time of retirement, A has net worth of Rs 1 crore while B has net worth of Rs
10 crores. Risk taking ability for B is clearly higher than A. Even if B loses
some money, he still has money for a comfortable retirement. No such luxury for A.
Risk tolerance is more about your behaviour if the markets move adversely. By the way, investors with low risk tolerance need not be risk averse in general. It is not that they do not make risky investments or do not take risky decisions. Just that they struggle to cope with volatility in equity prices. Let’s consider a few examples.
estate prices are volatile too. However, since we do not see market value of
property change every minute, we are fine holding real estate for long term. More
importantly, there is a conviction that real estate prices always go up (which may
not be correct). Whatever the reason, it helps you hold on to your real estate
(a volatile asset) for long term and ignore volatility.
Because of my profession, I interact with many entrepreneurs and professionals (non-salaried). Even though they are game with the risk associated with their work (and have chosen riskier career paths), not all of them are comfortable when it comes to volatility with investments. Surprising, isn’t it? Perhaps, they want to be in control. Had something gone wrong with their business, they at least could have done something about it. With market investments, firstly, it is not easy to figure out what went wrong. After all, it was the same a few days, weeks or months back. Even if you do, there is little you can do about it. Someone else runs that business and stock markets can be irrational. By the way, this is just my guess.
It could be about perception too. Possible that they do not consider real estate investments or their businesses risky.
Whatever the reasons are, we still get to figure out what such investors with low-risk tolerance for equity investments can do. Here are a few ideas.
you cannot digest market volatility, you don’t have to invest in equity
you may have to forgo greater return potential that equity markets offer, avoiding
equities altogether is a million times better than (buying high and) selling
equities at market lows due to fear. You are unlikely to make any money by
buying high and selling low.
it is not that you cannot achieve your goals if you don’t invest in equities.
Parents of many of us never invested in equities. Are they not leading a
comfortable retirement? I am sure many of them are. If they are not, not
investing in equities is unlikely to be a reason.
say you want to accumulate Rs 1 crore for retirement in 20 years.
You invest in a multi-asset portfolio (let’s say just equity and debt) and
expect to earn 10% post-tax on your investments. You need to invest about Rs
14,000 per month and you live with volatility.
By the way, I may be wrong in depicting volatility to be something benign. At the same time, short term volatility is a lesser problem to a patient investor who is in accumulation phase. For such an investor, the losses are only notional. To an investor who is withdrawing from the portfolio, market volatility translates to real risk of missing out on your goals (not having enough money or running out of money too early).
You shun all volatility and simply invest in EPF, PPF and bank fixed deposits.
You earn 7% p.a. on your investments. In this case, you will have to invest
about Rs 20,000 per month to reach your target in 20 years. So, you need to
invest Rs 6,000 more and you are good. You don’t have to worry about
if you check your equity portfolio 5 times a day or you lose sleep when your
equity investments go down, there is little point in investing in stocks or
mutual fund investments. Stay away.
invest only that portion of your assets into equity market that you don’t worry
about. It could be 10% or
20% or whatever you are comfortable with. Many of us think about lotteries in
such a way albeit with much lesser amounts.
right percentage for you is one that you wouldn’t worry about checking the value
of equity investments for a couple of years. Or even if you do, you wouldn’t
have second thoughts about your allocation. You can rebalance your portfolio at
regular intervals to keep equity allocation within your comfort zone.
divide your investments into buckets.
Let’s say the money that you need over the next 5-10 years goes to fixed
deposits. Anything longer, you consider some exposure to equities. Mathematically,
there is not much difference between (2) and (3). However, in terms of
investment behaviour, this may just be the right medicine. You won’t be as much
worried about market movements if you know that you won’t need to touch these
investments over the next 10 years. This
approach can be extremely useful during retirement.
What should you do?
Whichever approach you use, stick with it.
Don’t try to be someone else.
is no dearth of retail investors whose risk tolerance automatically goes up
when the markets are hitting new highs every day. These investors never looked
beyond bank fixed deposits/PPF/EPF in their lives. Suddenly, they think you can’t
go wrong with equities. We all know the result for such investors. When they
lose money, fear replaces greed. They panic and exit taking huge losses. Such
investors either never come back or come back when the markets are again
hitting new highs for the cycle to repeat.
an investor, you can go through the most complex risk profiling questionnaire,
you will get to know of your real risk tolerance only when you see deep red in
your portfolio. Therefore, give yourself time to understand the kind of investor
you really are. Unfortunately, even professionals can’t help you there. They
can’t figure out before you figure out.
You may a young investor or an old investor who is planning to invest in equities for the first time. If you are new to equity investments, do not dive headlong. Start small. Make a small allocation. As you learn more about your true risk tolerance, you can tweak your allocation.
best portfolio for you is the one that lets you sleep peacefully at night.
Moving abroad for employment or planning to shift back to India permanently? How will your income be taxed? Can you continue holding NRE deposit and continue to get tax-free interest? Well, everything begins with finding out whether you qualify as an NRI or a resident.
And this may not always be easy. To add to the confusion, the definition of Non-resident is different under the Income Tax Act and Foreign Exchange Management Act (FEMA).
Why do we need to worry about the definitions as per the Income Tax Act and FEMA?
FEMA decides where you can invest. For instance, you can open NRE or NRO accounts if you qualify as NRI (person resident outside India) as per FEMA. Your resident status as per the Income Tax Act does not matter when it comes to deciding whether you can make a particular investment in India.
Income Tax Act decides how the income from various investments will be taxed. For instance, the provisions of the Income Tax Act will decide how income from NRE and NRO deposits will be taxed.
Another example: Your residential status as per FEMA will decide if you must make your investments in mutual funds as Resident or as an NRI. On the other hand, your residential status as per the Income Tax Act will determine if your MF investments get taxed as Resident or as an NRI.
To make matters complicated, your residential status per FEMA and Income Tax Act can be different. And this leads to a good bit of confusion.
While the Income Tax Act looks at the matter mathematically to decide whether you qualify as a resident or non-resident, FEMA looks at the intent too.
In this post, let’s understand the difference between definitions of a non-resident under FEMA and the Income Tax Act.
As per Section 6 of the Income Tax Act, there are 3 residential statuses.
Resident and Ordinarily Resident (ROR)
Resident and Not Ordinarily Resident (RNOR)
Non-Resident Indian (NRI)
You are a Resident if you satisfy ANY of the following two conditions:
You are in India for 182 days in the financial year; OR
You are in India for 365 days in 4 preceding financial years AND 60 days in the financial year
Condition 2 will ensure that most of those who are going abroad for the first time will not be eligible for NRI status.
There are a few exceptions though:
Condition 2 is not applicable if you are leaving India for employment or as a member of crew of Indian merchant ship. For such cases, 60 days in condition 2 is replaced by 182 days. Hence, condition 2 automatically becomes ineffective.
Condition 2 is also not applicable of Indian Citizens or persons of India Origin (PIO) who stay abroad but are on a visit to India. In this case, period of 60 days is replaced by 182 days rendering
As per Income Tax Act, a person is of Indian Origin if he or either of his parents or any of his grandparents were born in undivided India.
An NRI is a citizen of India or PIO who is not a resident.
This is applicable to Non-residents who are returning to India. Even if you are a resident (as per above definition), you can be either ROR or RNOR.
You are an RNOR if you satisfy ANY of the following conditions:
You have been an NRI in 9 out of 10 years preceding the financial year under consideration. OR
You have been in India for no more than 729 days during 7 previous years preceding the financial year under consideration.
You can see RNOR status may come into picture when you have been an NRI for many years.
I have discussed RNOR status with illustrations in my post on Returning NRIs.
If you qualify as RNOR, your foreign income won’t be taxed in India (barring a few exceptions). Therefore, tax treatment on foreign income for RNOR is similar to that of NRI.
So, if you are planning to return to India, time your return in a way that you can enjoy RNOR status for a few years.
Points to Note (Income Tax Definition)
For those who are returning permanently to India, 60 days is not replaced by 182 days (under Condition 2). So, if you have been outside India for 365 days in 4 preceding financial years and return to India permanently before February, you will be considered Resident for the financial year as per Income Tax Act.
Preceding financial year means the financial year that precedes the financial year under consideration. So, if you are trying to determine residential status for FY2017, four preceding financial years will be FY2013-FY2016 i.e. April 1, 2012 to March 31, 2016.
Definition of Non-resident as per FEMA
The definition for non-resident is provided under Section 2 of Foreign Exchange Management Act.
FEMA uses the term Resident Outside India (for Non-residents).
FEMA has two classifications for residential status.
Resident in India
Resident outside India (NRI)
Non-resident Indian (NRI) means a person resident outside India who is a citizen of India or person of Indian origin (PIO).
When are you a resident as per FEMA?
You are a Resident in India if you have been in India for a period of more than 182 days during the preceding financial year.
There are a few exceptions. The above definition does not apply:
If you have gone out of India (or stay outside India) for taking up employment
If you have gone abroad (or stay abroad) for carrying out a business.
If you have gone abroad (or stay abroad) for any purpose that indicates your intention to stay abroad for an uncertain period.
In such exceptional cases, you can be considered Resident Outside India even if you have been in India for a period of more than 182 days.
When are you a Non-resident as per FEMA?
Continuing with the definition in the previous section, you are a Resident Outside India (NRI) if you are in India for 182 days or less during the preceding financial year.
There are a few exceptions. The above definition does not apply:
If you come to (or stay in) India for taking up employment.
If you come to (or stay in) India to carry on a business or vocation
If you come to (or stay in) India for any purpose that indicates your intention to stay in India for an uncertain period.
In such cases, you will be considered Resident in India even if you have stayed in India for less than 182 days during the preceding financial year.
If you are settled abroad and have come to India for a purpose other than employment or business and have no intention to stay in India permanently, you will continue to be considered Resident Outside India (NRI) irrespective of your duration of stay in India.
Points to Note (FEMA Definition)
If you go abroad for employment, business or vocation, you are NRI as per FEMA from day 1 of your departure. The period of stay in India does not matter in this case. You may have left on Feb 15. You will still be NRI from Feb 16 as per FEMA.
Similarly, persons returning to India permanently are considered residents from day 1 of return. By the way, only you know if you have returned permanently. Hence, there can be an element of subjectivity in this case.
There is no requirement of continuous stay in India. Your stay in India can be staggered over multiple trips/visits.
Financial year is not defined in FEMA. However, it is assumed to refer April 1-March 31 period.
Differences between definition under FEMA and Income Tax Act
For you to be resident in India, Income Tax Act requires stay of 182 days in India while FEMA requires a stay of more than 182 days.
Income Tax Act considers Current Financial year for determination of residential status. FEMA considers preceding financial year.
Income Tax Act DOES NOT consider the reason of stay in India or visit abroad for determination of residential status. FEMA does. Income Tax Act merely considers number of days of stay in India.
When it comes to Income Tax Act, you are either resident or non-resident for the entire financial year i.e. you cannot be resident for part of the year and non-resident for rest of the year.
The aforesaid limitation does not apply to FEMA. For instance, in the above example (leaving India for employment abroad), you are resident till Feb 15 and non-resident after Feb 15.
How does it matter?
Your investments are governed by definition as per FEMA.
For instance, you have to be NRI as per FEMA in order to own NRE/NRO/FCNR(B) accounts.
Whether you can open a PPF or purchase agricultural land depends on your residential status as per FEMA.
On the other hand, taxation of your income is governed by Income Tax Act.
It is quite possible that you are an NRI as per FEMA and a Resident as per Income Tax Act. The opposite is also possible.
You leave India on November 15, 2015 to visit your brother in the US. You return to India on August 20, 2017.
Income Tax Act
FY2016: You are Resident since you have stayed in India for more than 182 days during FY2016.
FY2017: You are NRI as you have been outside India for the entire year.
FY2018: Resident since your stay in India will be more than 182 days.
FY2016: You are Resident since you were in India for 365 days during FY2015 (preceding financial year)
FY2017: You are Resident since you were in India for more than 182 days during FY2016 (preceding financial year)
FY2018: You are Resident since you have returned to India permanently (even though your stay abroad was more than 182 days during FY2017)
You leave India for employment on November 15, 2015.
Income Tax Act: Since you are in India for more than 182 days, you will be considered Resident in FY2016. Your foreign income will also be taxed in India.
FEMA: Since you are going abroad for employment, you will be considered NRI from day 1 of your departure. You will be Resident until November 14, 2015 and non-resident thereafter.
You have been abroad for many years. You return permanently to India on Feb 15, 2016.
Income Tax Act: You are NRI for FY2016 since you were abroad for over 300 days in FY2016. Your foreign income won’t be taxed in India. For FY2017, you will still be resident. However, the decision between RNOR and ROR status will be based upon the period of stay abroad.
FEMA: You are NRI till Feb 15, 2016. Since you have returned permanently, you are resident after Feb 15, 2016. For FY2017 too, you will be considered resident.
Disclaimer: My understanding of Income Tax law and FEMA regulations is limited. You are advised not to make decisions on the basis of this post alone. A decision taken solely on the basis of contents of this post can land you in financial and legal trouble. You are advised to consult an expert or seek professional advice before making a decision.
you are new to equity markets, you may some discomfort with volatility. If you
are closer to retirement or you are making a lumpsum investment, this
discomfort is quite justified too. You can lose a lot of money and put your
financial well-being in danger.
if you are a young investor, volatility should not concern you too much. Let’s
try to understand why.
say you land up your first job at the age of 23 and you can invest Rs 5,000 per
month. Every year, you can increase the amount by 5% every month. By the way,
Rs 5,000 from your first salary may not be as easy since many non-discretionary
expenses may not leave you with much. Let’s assume you earn a constant return
of 8% on your portfolio.
What does this table show?
you are a new investor, bulk of the increase in portfolio size is due to fresh
investments. The returns on your portfolio do not add significantly to your
portfolio. As you move
closer to the retirement, your portfolio becomes bigger and fresh investments are
only a small portion. At such times, you need to take greater care of
shows that you can start small and still accumulate great wealth (at least in
nominal terms) if you stick with the investment discipline.
about volatility? After
all, the concern that we are trying to address is volatility. Equity returns
are volatile and it is not fair to expect equity markets to deliver 8% year
now look at that.
As you can see from the table, a major portion of the increase in the portfolio size comes from the fresh investments that you make during the year. If you were to have a down year, these percentages will only grow. As a young investor in the accumulation phase, you shouldn’t worry much about volatility or even bear markets (easier said than done). Volatility can be your friend during accumulation phase.
than getting scared if the markets don’t do well in your initial years of
investments, you should be happy that you are getting to accumulate units
(ownership) at a lower price. When the good times come, you will get greater
bang for the buck since you accumulate units or shares at a lower price.
look at an alternate sequence of returns. You have 38 years of working life in
the example discussed above.
earn -5% p.a. for the first years. Then you earn 22.78% for the next 5. This
goes on for the first 30 years. For the last 8 years, you earn a return of 8%. With
this sequence of returns, the CAGR is 8% p.a. (as discussed in the previous
this sequence of returns, you will retire with a portfolio of Rs 3.45 crores.
In the constant return (no volatility) example, we have ended with Rs 2.55
I concede I have chosen the sequence of returns to suit my argument. With a different sequence, the returns can be completely different. However, my intent is to show that even when you start with a bad sequence of returns, you can end up with a higher corpus. In fact, it is these bad returns that result in a bigger corpus. The premise is that long term CAGR is intact at 8%.
You can end up with a bigger corpus even with a lower CAGR
now work with a lower CAGR of 7%. You earn -5% p.a. for the first years. Then
you earn 20.52% for the next 5. This goes on for the first 30 years. For the last
8 years, you earn a return of 7%. With this sequence of returns, the CAGR is 7%
p.a. (as discussed in the previous example).
In this case, you retire with Rs 2.73 crores (higher than Rs 2.55 crores with constant returns of 8% p.a.).
this shows how volatility has helped you.
behavioural aspects to worry about too.
a small portfolio size, the absolute impact of good or bad returns is also
small. For instance, the difference between year end balance for -10% p.a. and
+10% p.a. on Rs 1 lac portfolio is only Rs 20,000. It is Rs 20 lacs for a Rs 1
if you are investing Rs 60,000 per annum, you will still end up the year with
Rs 1.5 lacs (with the added benefit of accumulating units at a lower price). However,
the same Rs 60,000 is change for Rs 1 crore portfolio. You will still end the
year in red at Rs 90.4 lacs. Your portfolio can go up or down by more than Rs
60,000 (your annual investment) in a day.
Poor returns from volatile assets (say equity) can be damaging when you are about to retire or in early years of your retirement. To put it another way, poor returns can cause a very big problem when you are about to enter decumulation phase or have entered decumulation phase (drawing from your portfolio to meet expenses). By the way, poor returns are damaging during any part of retirement but the damage is much bigger if your portfolio sees big drawdowns during early part of retirement. I have covered this aspect in detail in this post.
your short-term goals and emergencies, keep money in fixed deposits or debt mutual
with an asset allocation approach for long term goals such as retirement. While there are many suggestions about the
right asset allocation for you, a 50:50 equity:debt allocation sounds like a
very healthy compromise. For now, I am not getting into gold, real estate or
foreign equities as part of asset allocation.
Asset allocation approach is also important because you are not sure of your risk tolerance to begin with. My experience suggests that everybody is extremely risk tolerant during bull markets. Most investors don’t figure their real tolerance out until they go through a severe market downturn. Heavy portfolio losses in the initial years can scar you and keep you away from equities for a long period. This won’t be good and you won’t be able to able to get the benefit of rupee cost averaging during the accumulation phase.
Rebalance at regular intervals. Again, the “right interval” is tricky to arrive at. Think you can give yourself a long rope. Keep tax aspects and exit penalties in mind while rebalancing.
Focus on earning more. Your time is better utilized acquiring new skills than figuring out the best mutual fund for you. Better skills can help you earn more and increase your potential to invest. Finding the best mutual fund is a never-ending exercise since the baton keeps on passing. Moreover, since your investment portfolio is small at this stage, your energy is better spent elsewhere.
To keep things simple, pick up an index fund or an ETF and start investing regularly (through SIP or otherwise). If you prefer active managed, pick up no more than 2 actively managed equity funds.
Keep your head down and keep investing. Do not worry about volatility and severe downturn. Just keep investing every month. Remember, during accumulation phase, volatility can be your friend. You just have to get comfortable with it.
You have decided to invest in mutual funds. You have selected the best mutual funds for you. You have also decided whether you want to invest
sum or through Systematic Investment Plans (SIPs) or STPs.
There is one decision that you are yet to make. Which investment option to select?
Growth or dividend or dividend re-investment?
In this post, we will discuss the difference between the three options. We will also discuss various elements that can influence investors’ preference for one of the options. First, let’s see what these options are all about:
What are Growth and Dividend options in Mutual Funds?
#1 Growth option
No dividend is declared or paid to the investor. This means you do not get any cash flow from the investment until you sell your MF units. It is more suited to investors who are looking for long term growth. Under such a plan, an investor realizes the greatest benefit of compounding.
#2 Dividend option
Under dividend option, the mutual fund scheme pays a dividend on a regular basis and the NAV of the fund goes down by the same amount (a bit more as we would see later). It is more suited for investors who desire regular income from their investment. Please note the payment of dividend (or its quantum) is not guaranteed. It is the discretion of the fund manager. Moreover, the MF schemes can pay the dividend only from the profits generated by the scheme. Therefore, in bad times, the ability to pay dividends (especially for equity funds) can be severely compromised.
#3 Dividend re-investment option
Dividend reinvestment option is a variant of dividend option. Under this option, dividend is not paid out to you but gets reinvested in the scheme i.e. you get additional units for the dividend amount. Please understand this dividend re-investment will be considered a fresh investment and these new units will be subject to lock-in restrictions. Can be a problem in case of ELSS. Exit load and capital gains implications will also be there if you sell off these new units soon after. Since the scheme does not pay out anything to you, you can look at dividend re-investment option as an alternative to growth option.
The choice between the dividend reinvestment and growth options depends upon investment horizon, applicable income tax slab and tax treatment of capital gains and dividend income.
Please note that the fund portfolio is exactly the same for growth, dividend or dividend reinvestment plans.
How Mutual Fund Investments are taxed?
Mutual fund taxation keeps changing. Till FY2018, long term capital gains and dividends from equity mutual funds were exempt from income tax.
However, Budget 2018 changed everything. Now, even LTCG from the sale of equity funds and dividends from equity funds are taxed.
Here is how the mutual fund taxation looks like. I have included the rates for both residents and non-residents.
Now, the tax treatment of capital gains and dividends is one of the deciding factors between choosing growth or dividend or dividend re-investment option.
If the tax regime provides favourable tax-treatment to one kind of income (capital gains or dividends), you must invest in a more tax-friendly option.
If capital gains get better treatment, Growth option is better.
If dividends get better tax treatment, Dividend (or reinvestment) option is better.
By the way, if there were no tax difference, there wouldn’t be much difference between growth and dividend because you can always sell your units to generate income (instead of waiting for the dividend). Alternatively, whatever dividend you generated could be reinvested. Unfortunately, that’s not the case. And that forces us to do some work.
Dividends or Capital gains?
There are two kinds of income on which a person may be required to pay tax. Dividend income or Capital gains.
Under a growth fund, all income will be in the form of capital gains (since no dividend is paid out). Under the dividend/dividend re-investment option, income will be in form of both dividend and capital gains.
If a mutual fund pays the dividend, its NAV will go down by the same amount and will reduce potential capital gains on the sale of units. In fact, if you select the dividend option, the NAV of the fund will go down by more than the amount received (or re-invested) as dividend because of Dividend Distribution tax (DDT).
As per the current tax laws, the dividend received from mutual funds is exempt from tax in your hands. However, the fund house deducts the TDS (or DDT) before paying the dividend to you. And that explains why the NAV falls more than the dividend received. For more on how DDT is calculated, refer to this post.
What to do in case of Equity Mutual Funds?
Suppose an equity MF unit cost you Rs 100 at the time of purchase. After 2 years, NAV of the same unit has risen to Rs 140. Subsequently, the MF scheme announces a dividend of Rs 30 (for dividend and dividend reinvestment plans). The investor sells the units soon after. Exit load implications not considered.
Dividend option: The MF scheme announces a dividend of Rs 30, you get a dividend of Rs 30 per unit (total dividend of Rs 30,000). Due to DDT, the NAV will fall to Rs 106.12. If you decide to sell MF units subsequently, your capital gains will be Rs 6.12 per unit (total of Rs. 6,117.4). After capital gains tax, your net in-hand cash is Rs 1,35,481.
Growth option: Since there are no dividend payments and you sell off the unit, you will make capital gains of Rs 40,000. At LTCG tax of 10.4% (includes 4% cess), your CG tax liability is Rs 4,160. Your net cash received is Rs 1,35,840 (higher than the dividend option).
Dividend re-investment: No payout will be made to the investor. Dividend (declared and not paid out) will be used to buy additional units (Additional units = Dividend declared/Revised NAV i.e. 30,000/106.12=282.7 units). In this case, dividend is not paid and all the cash inflow will be only at the time of redemption. After accounting for LTCG tax, net cash received is Rs 1,35,481.
In case of equity funds, short term capital gains (less than 1 year) are taxed at 15% while Long term capital gains are taxed at 10%. Dividends are taxed at about 11.46%. Moreover, LTCG on equity funds is exempt from tax up to Rs 1 lac per financial year. No such relief for Dividends. If you incur loss on sale of equity funds, you can use it to set off your capital gains. No such thing for dividends.
Clearly, in case of equity funds, capital gains get more benign tax treatment. Therefore, in the case of equity funds, growth option is a far better choice.
Many investors invest in dividend option of equity mutual funds for regular income. It is not a good choice. Why? Refer to this post.
You may argue that the STCG on equity funds is 15%. Effective impact of DDT is much lower. You are right. However, equity investments are not really for the short term. Moreover, dividend (or its quantum) or are not guaranteed. In my opinion, this debate is meaningless.
In case of equity funds, Growth option is a clear winner.
I do concede there may be merit in considering dividend options of arbitrage funds (because they behave like debt funds but are taxed like equity funds).
What to do in case of Debt Mutual Funds?
Again, the tax treatment is a key factor.
In case of debt funds, short term capital gains (holding period upto 3 years) are taxed at your slab rate. If you are in 5% tax slab, you have to pay 5%. If you are in 20% and 30% tax bracket, your STCG on debt funds will be taxed at 20% and 30% respectively. Cess extra. Surcharge if applicable.
LTCG (holding period above 3 years) is taxed at 20% after accounting for inflation.
The dividend distribution tax is 25% in case of debt funds. Given the way DDT calculation works and including cess and surcharge, your effective tax hit is 27.97%.
In the case of debt funds, the choice is quite clear.
If you are in 5% or 20% tax brackets, the Growth option is a clear winner (whether for short term or long term). This is because DDT is way higher.
If you are in 30% tax bracket and you are investing for less than 3 years, the Dividend/dividend re-investment option is a better choice (since your capital gains will be taxed at over 30%. DDT is lower).
If you are in 30% tax bracket and you are investing for more than 3 years (or you are not sure if you will need this money in 3 years), Growth option is a better choice (since Capital gains are taxed at only 20% after indexation).
In the below tabulation, I show the workings for short term capital gains. I have chosen the quantum of dividend in a way that Capital gains tax liability does not arise in case of dividend options.
You can see that if you plan to sell your debt funds investments before 3 years, your tax slab becomes a key determinant. If you are in the highest tax bracket, you will find dividend option better. Others will benefit from the Growth option.
If you have been holding for over 3 years (rather your investment horizon is less more 3 years), then Tax on LTCG (20% after indexation) is far better than DDT. So, Growth is a clear winner.
Growth option is a clear winner in most cases. Here is a crisp recap of what you should do. From the perspective of decision making, replace “holding period” with “Investment horizon”.
This post was first published in March 2015 and has been updated since.