We are sure you've heard the Long Term investment Mantra many times. Of course we are worried about the future – kids’ education, marriage, our own retirement, etc. But, there are shorter-term goals that also need attention.
While the long-term answer is so easy - go the equity way - it is the short to medium term goals that really need smart choices. And these are not easy. Would you like to pay higher tax or can you handle the higher risk?
When the markets were going up, everyone thought that was the best way to make some quick short-term money. We had instances of people buying stocks to target goals as close as three months away. Well that's clearly courting disaster as many of you must have found out by now - caught in a bear market. Clearly equity does not work for the very short-term buy. How about 3 to 5 years? Say for building a corpus for down payment for a house or a child's education fee 3 to years away? Now that's a little dicey! We'd say some equity is a must but what if you're looking at less risky or safer products, what then? That's what we're asking, as are many of our viewers.
For instance, Sagar from Hyderabad sends us an email. He says, “I have borrowed 3 lakhs from one of my friends. As a deal I will have to return it back exactly after three years. I would like to return that amount with interest, what he could have got from fixed deposit. I want to gain maximum possible return from my savings to pay back my friend.”
We also had a question last week asking for advice to build a risk free corpus for a down payment on a house. Is debt the only way out?
The Big Question: What are your options for targeting a goal less than 5 years away?
A fund manager friend had this story to tell: It is January of 2008 and he gets a call from an investor in Punjab who runs a small business. The guy has to pay advance tax in March of about Rs 1 crore. So he puts some 80 lakh in individual stocks to target 1 crore in under three months. When the fund manager expressed distress at this, the answer was: I will become a long term investor from short term investor if the market falls!
# The equity route to target any goal becomes very attractive in a bull run, but that is totally the wrong way to do it. A goal that is five years or less away needs a certain level of certainty that the funds will be there to meet that goal.
# Traditionally we have used the FD, RD route to targeting these goals. Though totally safe, the problem is that these take away a chunk of the return in taxes.
# For example, a 9 per cent return on a FD gets reduced to about 6 per cent due to the income tax bite.
# For those who are willing to take a bit of risk, there is a category of mutual funds that can help you target a goal that is less than 5 years away
# Arbitrage funds is a relatively little known style of funds
# It is essentially an equity fund that operates between the cash and futures market
# These funds will buy a stock on the spot market for say Rs 100 and simultaneously sell it forward for Rs 110. Irrespective of what the price is three months later, Rs 10 minus the carry cost is the profit. If the stock went to Rs 150, you would miss the Rs 50 upside, but if it fell to Rs 50, you would not have to bear that loss.
# So it is like a cycle with side wheels for those equity investors who are either very risk averse or for those who want better returns than what a tax heavy FD will give to target a goal that is 5 years or less away.
What is an arbitrage fund?
# it is an equity fund
# Operates between cash and futures market
# Usually gives FD plus returns
# Mainly due to easier tax treatment
To sum up, arbitrage funds are not equity funds, even though they invest in stocks. They only use the opportunity between cash and future markets to generate fixed income irrespective of the share market trend. What your fund earns is the spread between the purchase price of the equity shares and the sale price of futures contract.
Now, the pros of arbitrage funds - why they work? You can get 7 to 9 per cent year on year and post tax they work out better than FDs. At a time when interest rates are swinging quite a bit, if you're not sure in which direction, they are also much safer compared to income funds. Our only worry is sometimes there may not be enough arbitrage opportunities for mutual funds to take advantage of, especially in a prolonged bear phase of equities when liquidity starts drying up.
Pros and Cons
# + Average return of 7-9 per cent year on year irrespective of market conditions
# + Better return than a 6 per cent post tax return on a 9 per cent FD
# Arbitrage opportunities may not be there
# Liquidity in the stock/cash and futures could dry up
The main reason that we like arbitrage funds is that for a small risk, the option to target a return between 7 to 9 per cent a year is there.
The interest from an FD is added to your income and you are taxed at your marginal rate. This takes a big bite out of the returns
# Arbitrage funds are treated like equity funds
# This means that returns are not added to taxable income
# The long term capital gains is zero
# The short term capital gains is 17 per cent
# And there is no dividend distribution tax
Tax treatment
# Returns not added to income
# No long term capital gains tax
# No dividend distribution tax
# Short term tax at 17 per cent
There are 15 arbitrage funds in the market but only two have made our cut for you to look at. These come with four or five star rating from Morningstar. ICICI Pru Blended Arbitrage fund has given 7.52 per cent returns over a year and 8.69 per cent over 3 years. Kotak Equity Arbitrage Gr have slightly lower returns - 7.08 per cent over a year and 8.25 per cent over 3 years.
So, considering pure income target 3-5 years - a little bit of equity works doesn't it?
ICICI Pru Blended A Gr
1 year return: 7.52 per cent
3 year return: 8.69 per cent
Expense ratio: 1.50
Star Rating: 5
Kotak Equity Arbitrage Gr
1 year return: 7.08 per cent
3 year return: 8.25 per cent
Expense ratio: 1.10
Star Rating: 4
Another option will be to use balanced funds. But do remember that the degree of risk increases with the return. But over 5 years these are good, but anything less than that there is danger of capital erosion.
Now, coming to looking at a new product this week: REC 54 EC Bonds Series VIII
# Interest rate: 6.25 per cent
# Face Value: Rs 10,000 (minimum amount you can invest)
# Maximum application: 500 bonds
# Open till: 31 March 2009
# Tenure: 3 year
# Long term property capital gains or profit can be invested in the bonds to save on tax of 20%.
# You need to invest within a period of six months from sale of property.
# Also, if you buy another property for the proceeds of the old property you do not need to pay capital gains. but you cannot sell that for the next three years.
# NRI investing out of NRO account on non-repatriable basis can use these bonds.
Rating : Can Buy
To end with, it’s wonderful to get your feedback and questions – it keeps us on our toes to keep researching new products suited for different investment needs. So keep those coming. See you next week...goodbye!