Equity savings funds explained: A substitute for FD with a marginally higher risk?

• An equity savings fund is a type of mutual fund that provides investors with a combination of equity, debt, and arbitrage investment.
• Equity savings funds have a minimum of 65% in equities, so they receive the tax treatment of an equity fund.
• Equity savings funds are more stable than pure equity funds but have a long-term growth perspective.

Equity savings funds are probably not as well known as their cousin, equity linked savings scheme or ELSS which comes with tax benefits under section 80C. However, in recent times they have caught the attention of investors, especially after the new tax regulations regarding debt mutual funds.

Are they an alternative to traditional saving schemes like the fixed deposit offering slightly better returns with only a marginally higher risk? We will try and understand that but let’s start at the very beginning.

What is an equity savings fund?

An equity savings fund is a type of mutual fund that aims to provide investors with a combination of equity, debt, and arbitrage opportunities. These funds typically invest a portion of their assets in equities (30%-40%), providing the potential for capital appreciation. However, they also allocate a portion (25% to 35%) to debt securities, and engage in arbitrage strategies (25% to 35%) to manage risk, and enhance returns. An arbitrage strategy leverages the price difference in markets to generate profits.

“Hence two thirds or more of these funds, by character, are like fixed income because the character of arbitrage is that of fixed income. One-third or less is equity,” says Dhirendra Kumar, CEO, Value Research.

Equity savings funds and tax treatment

For tax purposes, arbitrage is treated as equity even though in character, they are like fixed income. Hence, equity savings funds always have a minimum of 65% in equities, which is why they receive the tax treatment of an equity fund. Hence they are taxed as 10% for long term capital gains, and 15% for short-term capital gains.

Before April 1, investors in debt funds were subject to income tax on capital gains based on their income tax bracket for the initial three years of holding. After this period, the tax rate was either 20% with the benefit of indexation, or 10% without indexation. However, the LTCG benefit, and the indexation benefit are no longer available on debt funds.

This is because in accordance with the amendments made to the Finance Act, gains from investments in mutual funds, where the allocation to domestic equities does not exceed 35%, are now subject to taxation at the maximum marginal rate.

Effective from April 1, 2022, any capital gains resulting from the redemption of debt funds purchased on or after this date will be taxed based on the income tax slab rate applicable to your income. This means that the capital gains will be subject to tax at the individual's applicable income tax rate, rather than a fixed rate, and there will be no indexation benefits.

Potential returns provided by equity savings funds

Devender Singhal, Executive Vice President, and Fund Manager, Kotak AMC (Asset Management Company) breaks down the potential returns equity savings funds can give over the long term.

Over the long term, equity gives a return of 12%-15% as absolute returns (pre-tax and pre-expenses). Debt funds give a return of 7-8%, while arbitrage gives a similar return. If we consider 30% in equity, and 70% in debt, and arbitrage, the pre-tax, pre-expense return is 4.5% from the equity portion, and 4.9% from the debt and arbitrage portion.

So the broad returns from equity savings funds are about 9.4% on a long term basis. If you hold these funds for one year, you pay a LTCG of 10%, and after considering expenses, you have a return of around 7%. Now, if we consider debt funds with a return of 7%-7.5%, the post tax return if you are in the 30% tax bracket would be around 5%. The same goes for FDs. “So there is a post-tax return differential of almost 200 basis points.

However, we cannot compare equity savings funds to debt funds, because you are taking a higher risk. But if you look at the track record of these funds, then the volatility has not been much over the longer period,” says Singhal.

According to Value Research, equity savings funds as a category have given 11.36% over a 3 year period, and 7.26% over a 5 year period.

Returns of equity savings funds


Source: Value Research

Should you invest?

Equity savings funds are more stable than pure equity funds, but have a long-term growth perspective due to the equity component. “These funds are meant for conservative investors. Anybody who has not invested in equity all his life, needs slightly higher returns than fixed income, and is wary of investing in all equity investments should look into this,” says Kumar.

Also, equity savings funds make asset allocation easier. “If you have ₹1 lakh, and invest 33% in equities, and the rest in fixed income, then the ₹66,000 in fixed income will be taxable, which is not the case with equity savings funds. Also you do not have to bother about periodic rebalancing as it is taken care of by the fund manager,” says Kumar.

Not just debt funds, equity savings funds have the potential to give higher returns than FDs. However, if you need your money in a short period of time, you may face nominal losses if you invest in equity savings funds, as FDs guarantee returns.

To sum up, equity savings funds have some equity allocation, some debt allocation, tax benefits too.