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MIP Funds are best option to invest at current stock markets level
A low equity exposure makes them ideal for newcomers to the equity markets. Find out how you can gain from them.
Equity investing is often touted as the best way to create wealth.
Ultra-cautious investors may be missing out on an opportunity to build wealth if they stay away from stocks. Experts, and statistics, say that equities have the greatest potential to create wealth in the long term. But with benchmark indices hitting their all-time highs in recent weeks, these risk-averse investors have become more cautious. For investors like these, monthly income plans (MIPs) from mutual funds can be a low-risk entry point to the equity markets.
MIP funds follow a conservative investment strategy, allocating only 10-25% of their corpus to equities and putting the rest 7590% in the safety of bonds and other debt instruments. This is why the returns from this category are fairly attractive when the going is good and relatively stable over the long term. In the past year, when the markets soared by over 50%, the average MIP fund has given a return of more than 14%. These funds will give investors good returns if the markets do well, but they will also protect against downside because of the limited exposure to equities.
Higher returns, lower tax
In the long term, MIP funds can give better returns than debt instruments like fixed deposits and small savings schemes. This is not the only advantage they offer over these debt investments. MIP funds are far more tax-efficient. The interest earned on fixed deposits and NSCs is fully taxable at the normal rate. For a person in the 30% tax bracket, the post tax returns from a fixed deposit that offers 9% is actually 6.3%. Worse, this income is taxed every year even though he may get it only after the deposit matures.
On the other hand, the gains from MIP funds are taxed only when the investor redeems the investment. If the holding period is more than three years, they will be treated as long-term capital gains and taxed at 20% after indexation. Indexation takes into account the inflation during the holding period and accordingly adjusts the purchase price of the asset. During times of high inflation, indexation can reduce your tax to almost nil. The best part is that the tax is deferred indefinitely till the investor withdraws the investment.
How much is the risk?
The investors who are still dithering because benchmark stock indices are close to their peaks can take comfort. We looked at their track record and found that investments made in these funds even at peak levels have done well. The returns since January 2008 and November 2009 have been fairly decent (see graphic). So, though SIPs are touted as the best way to invest in equities, investors in MIPs need not take that route. Those with a large amount to invest can even put a lump sum in these funds. This also makes means that MIPs can be good source schemes for setting up a systematic transfer plan (STP) to an equity fund or a systematic withdrawal plan (SWP). In an STP, a fixed sum flows out of the scheme to another scheme (usually an equity fund) on a predetermined day of the month or quarter. In an SWP, a fixed sum is redeemed by the investor. SWPs are especially useful for retirees who want a regular income.
Look out for
The most important thing to know about these monthly income plans is that they don't guarantee a monthly income. The name monthly income plan is a misnomer because no mutual fund can guarantee income. Besides, the dividend option of these funds is a very tax-inefficient way to get a monthly income. Though the dividend received is tax-free, it comes to you after a heavy 25% dividend distribution tax. After surcharges and cess, the total dividend distribution tax is 28.32%.
It is best to go for the growth option of the MIP fund and redeem units as and when you need the money. If they can help it, investors should start redemptions after three years of investing for greater tax efficiency.
Investors should also be mindful of the debt portion of the MIP. A portfolio dominated by high quality instruments indicates that the fund is being managed keeping in mind the conservative profile of the investors. Besides the quality, the average maturity of the bonds also matter. A portfolio lined with long-term bonds is more aggressive, but it could prove very rewarding if interest rates fall. Benchmark bond yields are currently at unsustainable high levels and a decline seems imminent.
The other thing to watch out for are the fund management charges levied by the fund. These funds tend to overcharge investors. If almost 8085% of the corpus is in debt and only 10-15% in equities, why do they charge an expense ratio of 2.5.
That's true. High expense ratios can be a drag on returns, especially when the expected returns are in the range of 10-11%. If returns are 10%, an expense ratio of 2.5% means I am paying a fourth of the profit to the fund house. One way to avoid the high expense ratio is to go for the direct plan of the same scheme. Direct plans have lower expense ratios because they are sold to the investor by the mutual fund without an intermediary. But how many first time investors will be able to buy a direct plan is anybody's guess.
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