Principal Equity Savings Fund: For investors who look for regular income and capital appreciation

We have reviewed a number of equity savings funds products in the last 12 to 18 months in Advisorkhoj. These funds are good investment options for investors with moderate risk appetite since the active (un-hedged) equity exposure of these funds is much lower than equity funds and even the traditional balanced funds. While most equity savings funds were launched response to changes in debt fund taxation in the 2014 Budget, Principal Equity Savings Fund has a 15 year performance track record. Despite its fairly long history, the investment characteristics of Principal Equity Savings Fund are quite similar to the newer schemes in the equity savings fund product category, launched in the last 2 to 3 years by other Asset Management Companies. We will discuss the characteristics of this fund in our post. We will discuss some interesting additional features offered by Principal Equity Savings Fund, which investors may find useful.

Principal Equity Savings Fund is an open ended hybrid equity oriented mutual fund scheme. The scheme was launched in May 2002. From a taxation standpoint, this fund is treated like an equity fund scheme. Long term capital gains (holding period of more than 12 months) in this fund is tax free. Short term capital gains are taxed at 15%. Dividends paid by this fund are tax free. The scheme benchmark is 30% Nifty and 70% Crisil Liquid fund index. The fund manager of this scheme is PVK Mohan.

Minimum one-time investment amount in this scheme is Rs 5,000 and minimum additional investment amount is Rs 1,000. You can also invest in this fund through Systematic Investment Plan (SIP). Minimum SIP investment amount is Rs 2,000. The expense ratio of the scheme is 2.25%. There is no exit load in this fund. The zero exit load feature not only could enhance returns but also works best in case of investors who are wary of high market and valuations but at the same time want some equity participation. It provides flexibility as they can park investment in this fund and then move to full equity fund without any exit load later on.

Asset Allocation Strategy

Let us now discuss the asset allocation strategy of this fund to understand why the risk profile of this fund is much more moderate than equity funds and even traditional balanced funds. The overall exposure to equity and equity related securities ranges from 65% to 90%, as a result of which the fund enjoys equity taxation. However, fund’s active (un-hedged) equity allocation ranges between 20 to 30% with the objective of capital appreciation. 40 to 70% of the portfolio is allocated to completely hedged equity positions with the objective of generating arbitrage profits. 10 to 35% of the portfolio is invested in fixed income and money market instruments with the objective of generating income. Therefore, 70 to 80% of the portfolio has low volatility and generates regular income. Over a sufficiently long investment horizon, the active equity allocation can also generate capital appreciation for investors.

Investment Strategy and how does it work.

• Arbitrage:

  40 to 70% of the fund’s portfolio can be allocated to arbitrage. Currently 45% of the portfolio is allocated to Arbitrage which is by definition is defined as risk free profit, by exploiting pricing mismatches in the market. Capital safety, returns and liquidity are important considerations in arbitrage strategy. In fact, in volatile market conditions arbitrage funds can provide comparable or even higher returns than low risk money market mutual funds. For the arbitrage portion of the fund portfolio, the fund managers take completely hedged positions to minimize any risk for the investor.



• Fixed Income and Money Market:

  10 to 35% of the fund’s portfolio can be allocated to fixed income and money market instruments. Currently, around 26% of the portfolio is allocated to Fixed Income and Money Market investments (primarily in money market). With the fixed income / money market portfolio, the fund manager employs an accrual strategy to generate income and minimize interest rate risk. The credit quality of the fixed income portfolio is very high (AAA/AA). The fixed income portfolio has a moderate duration of 0.12 years and so the interest rate risk for the investors is very low.



• Active Equity:

  20 to 30% of the fund’s portfolio can be allocated to active (un-hedged) equity with the objective of capital appreciation. Currently, 29% of the portfolio was allocated to equities, net of futures positions. This is near the upper end of the range indicated in the asset allocation mandate (20 – 30%). This shows that the fund manager is bullish on equities within the investment strategy framework of this scheme. The fund manager, however, has the flexibility to reduce the equity allocations and increase exposures to safer options, if volatility increases in the stock market. This investment strategy ensures moderately low volatility for investors.

Moderately Low Volatility and benefits

The main advantage of equity savings funds are low volatility and income. Risk and return are directly related; higher the return, higher is the risk. If you are looking for very high returns then equity savings funds are not for you. However, if your primary investment objectives are, low volatility, high liquidity, inflation beating returns(through limited equity exposure) and tax efficiency, then Principal Equity Savings Fund can be a good investment option for you.

The standard deviation of returns of Principal Equity Savings Fund is only 4.5%. The average standard deviations of returns of Balanced Fund category is 10.3% (average standard deviations of returns of Equity Funds are even higher). In the last 10 years, Principal Equity Savings Fund gave negative annual returns only once, in 2008. In 2008, the return of Principal Equity Savings Fund was -2.6%, whereas many equity funds gave -40 to -50% returns in that year. Volatility can be stressful for retail investors and many investors prefer to sit on cash or low yielding term deposits, earning little or no real post tax returns, because they are scared of losing their money in the stock market. For such investors, Principal Equity Savings Fund can be a good investment option.

For first time investors, stock markets can be bumpy ride. Even if they are investing in a bull market, a sharp correction can make first time investors very jittery. The recent correction in the market, from a Nifty level of 10,100 to 9,700 is a good example. We are still very much in a bull market, but the correction made many investors I know, quite nervous. At a time when interest rates are on their way downwards, the relatively low volatility of Principal Equity Savings Fund can put the money of first time investors at work, without causing any stress.

Psychological considerations aside, low volatility is often a necessity for investors who want regular income from their investments. Reliability of cash-flows from investments is a critical need for some investors, especially investors like senior citizens, who have no other source of income, other than investment income. Stock market volatility can cause disruption in cash-flows for such investors and therefore, these investors usually relied on traditional fixed income products like bank fixed deposits and small savings schemes. But declining interest rates and the taxability of interest income from the traditional fixed income products have made these investors now concerned about how to meet their income needs. The tax efficiency of equity savings funds and low volatility can make these products very useful for such investors. Principal Equity Savings Funds offers solutions to investment needs of such investors or for that matter, any investor, who needs regular income from their investments.

Regular Withdrawal Plan

Regular Withdrawal Plan (RWP) is a smart investment option offered by Principal Mutual Fund. It gives investors the flexibility to draw the amount they need from their mutual fund investments at a regular frequency (e.g. monthly), by redeeming a certain number of units based on applicable Net Asset Values. The balance amount remains invested in the scheme and continues to earn returns for the investor. Unlike mutual fund dividends, which have to be paid from the profits of the scheme and therefore cannot be assured, investors can get fixed cash-flows using “Regular Withdrawal Plans”.

Regular Withdrawal Plan from Principal Equity Savings Fund is also more tax efficient than other fixed income options. Interest income from traditional fixed income schemes are taxed at the applicable tax rate of the investor. Long term capital gains of equity or equity oriented funds are tax free. So all withdrawals made from Principal Equity Savings Fund after a year from the date of investment are totally tax free. Further, all withdrawals made within one year from the date of investment, will be subject to 15% short term capital gains on the profits of the units redeemed within the one year period. So for investors in the 20% or 30% tax slabs, regular withdrawal plan from Principal Equity Savings Fund offers tax advantage versus traditional fixed income investments.

A feature which makes Principal Equity Savings Fund more attractive than other products in the category is the zero exit load feature. Many investors are forced to postpone their withdrawals from their mutual funds by as much as a year or sometimes longer due to exit load. The zero exit load feature of Principal Equity Savings Fund offers investors the convenience of initiating their withdrawals at any point of time, as per their needs.

Conclusion

For long term investors with moderate risk appetite, Principal Equity Savings Fund has the potential to generate both income and capital appreciation. Investors can take advantage of Regular Withdrawal Plan to generate regular income. Investors should consult with their financial advisors if Principal Equity Savings Fund is suitable for their long term investment portfolios.