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Mutual Funds - Four ways to use covid-19 blow to your MFs’ benefit

08 Apr 2020

It is an old saying that every cloud has a silver lining. The meltdown in India’s markets on account of the covid-19outbreak has cut into the value of people’s mutual fundinvestments. However, on the positive side, this may have also lowered or even completely wiped out any taxable gains, allowing investors to make changes to their mutual fund portfolios without incurring income tax liability while doing so.

According to experts, there are four such changes you can make in your portfolios in order to optimize your gains from any future recovery in the markets.

Revisit your MF asset allocation

A sharp fall in the equity market would have shifted your asset allocation in favour of funds that invest in other assets like debt or gold. If you think you should carry on with the earlier asset allocation, you can now move some money from debt and gold funds into equity funds to take advantage of more favourable valuations. For instance, if a 50:50 equity-debt portfolio has become 40:60 in favour of debt, you can move it back to 50:50 by redeeming your debt funds and buying equity funds.

Investors should not worry about missing out on gains in the process of shifting to equities, said Amol Joshi, founder, PlanRupee Investment Services, a financial planning firm. For example, if the switch takes two to three working days and the market moves up by 5-10% in the interim, you may miss out on some gains, but a staggered approach can average it out for you in the long term. “Nobody can catch the absolute bottom or the top. In the long term, these will get ironed out. To reduce risk, you can do this in a staggered manner," he said. For example, if you want to shift ₹10 lakh from debt to equity, make redemptions of ₹2.5 lakh each over four weeks, accompanied by fresh purchases into equity as soon as the money hits your account.

However, ensure you have adequate liquidity before committing more money to equities in these uncertain times. Keep in mind your risk profile and financial goals while switching your funds. “If you are retired or face unemployment you may need the debt portion to survive. However, if you have emergency funds or have a debt corpus in excess of what you require in the next two to three years, you can still carry out this switch," said Joshi.

Shift to funds that are outperformers

Investors have a tendency to hang on to duds. Some of this stems from an inability to admit and accept mistakes in selecting funds in the past. Continuing with an underperforming fund will mean that your money is not working as hard as it could for you. The present volatility owing to the pandemic gives you a great opportunity to start over with a clean slate.

But be careful when choosing an outperforming fund. It is not just a fund that’s done well over the past year but one that’s done well over multiple market cycles. You should carefully examine how it has contained its downside in slowdowns or recessions. Also, pay attention to the rolling returns rather than trailing returns which can be biased by a single point in time. Rolling returns average out returns using multiple start and end points.

Note, however, that although the correction may have wiped out the tax liability which you may have incurred when switching funds, you may still need to pay an exit load, wherever applicable.

Typically, exit load is imposed in equity funds for up to one year after the purchase. You can also use the correction to switch from dividend to growth plans of mutual funds. Budget 2020 abolished the dividend distribution tax (DDT) on stocks and mutual funds and made dividends taxable at slab rate in the investors’ hands. This significantly increases the burden for investors in the 30% tax bracket. Earlier, dividends were tax-free in the hands of investors although DDT was imposed on equity funds at 11.65% and debt funds at 29.12% (including surcharge and cess).

However, remember that a shift from the dividend to growth option and vice-versa is seen as a redemption and is liable to capital gains tax and exit load.

Pare down your portfolio

Many investors buy mutual funds as if they are stocks and end up with vast portfolios of 20-30 schemes. Since a mutual fund typically holds 30-50 stocks, a portfolio of more than six to eight equity funds will tend to just replicate the market on average and cancel out any outperformance or alpha. It will give returns similar to an index fund without the low costs of an index fund. Since index funds mimic the index they track, there is only a small fund management fee you have to pay. “Investors should consolidate their portfolios. Get down to four to eight funds, ideally index funds," said Gaurav Rastogi, CEO, Kuvera, an online mutual fund investment platform. This will also help you track your funds better and rebalance your portfolio on a regular basis.

Such an exercise can also be used to give the portfolio some intra-asset class diversification. For instance, if you own too many large-cap funds, you can consider switching to the multi-, mid- or small-cap categories, depending on your risk profile. “Investors should ideally split their money between market segments as per their risk appetite. Those wanting index-like returns should stay with large-cap funds while those prepared to take on more risk can go into mid- and small-cap funds. A multi-cap fund combines the best of both worlds, some years, such as 2019, favour large-caps, while others favoured mid- and small-caps. I would suggest roughly a 60:40 split between large and mid/small, as a rule of thumb," said Joshi.

Shift to direct funds and fee-only advice

If you are a do-it-yourself (DIY) investor and are confident of your ability to plan finances, you can take this opportunity to shift out of any legacy regular plans you may have and move into direct plans. In doing so, you can rebalance your mutual fund portfolio, if required.

Direct plans were introduced by capital markets regulator Securities and Exchange Board of India (Sebi) in 2013 and do not charge distributor commissions. Typically, commissions are 1% in equity funds and 0.5% in debt funds. Though they appear to be minuscule, over a period of time, they can eat into your returns in a big way.

If you are not a DIY investor and you do need advice, you can shift from a distributor charging commissions to a Sebi-registered investment adviser (RIA) who charges a fee. Typically, fees tend to be negotiated at lower levels compared to distributor commissions, particularly for investors with large portfolios.

However, some experts have noted that investors may not see the cost saving potential of a switch. “Psychologically, I don’t think clients will shift from distributors to RIAs. People see fees as more expensive than commissions and I don’t think they’ll want to shift at a time when their portfolios and, possibly, incomes have been hit," said Nishith Baldevdas, a Chennai-based Sebi RIA.

Other experts have pointed out that the covid-19 correction may in fact be a good time to get some advice. “A lot of DIY investors have approached us to find out where they went wrong and why their funds have lost money. If you are in this situation, you can get things streamlined by approaching an RIA. This will let you stay with direct plans of mutual funds and yet get financial advice in a transparent way," said Vinit Iyer, a Pune-based Sebi RIA.

Conducting any or all of these four shifts can potentially reduce costs and improve the returns of your mutual funds portfolio. Proceed cautiously and only make the changes that are right for you, given your goals, risk appetite and ability to manage your own mutual fund investments.