To Invest In Equity Or Debt Funds?

I am 53 years old. I retired 3 years ago and the majority of my monthly income comes from rent as most of my investments are in real estate. After expenses and my monthly investment in fixed deposits, I have about Rs 35,000 left each month. Should I invest this in equity or debt funds? I pay tax at 30 per cent.

- Sam Abdul Master

Go for the best of both worlds by investing in both equity and debt funds! You could follow the “core and satellite” approach. Debt funds should form the bulk of your portfolio (the “core”), while a small portion can be invested in equity funds for higher returns (the “satellite”). A modest allocation to equity funds will enable you to beat inflation in the long-run.

Between January 2006 and December 2013, annual inflation (measured by the Wholesale Price Index) has averaged 6.86 per cent.  As shown in the chart, the Nifty has beaten inflation and has generated a CAGR of more than 10 per cent. The CRISIL Liquid Fund Index and the CRISIL Short Term Fund Index have generated marginally higher returns than inflation while the CRISIL Composite Bond Fund Index (which is the benchmark for long-duration funds) has not managed to beat inflation. 

However, the CRISIL Composite Bond Fund Index has generated higher returns during periods of falling interest rates. Currently, interest rates are close to the peak. On January 28th, the RBI Governor hinted that further rate hikes are not imminent and even suggested that the central bank may be able to focus on growth and reduce interest rates if inflation declines faster than expected.

Consequently, the investments in long-duration funds may help you benefit from capital appreciation over the next few years if interest rates fall. The table below highlights this phenomenon.

For example, in November 2011, the benchmark 10-year government bond yield was close to 9 per cent but fell to nearly 7 per cent in May 2013. During this period, the CRISIL Composite Bond Fund Index outperformed the CRISIL Short Term Bond Fund index and the CRISIL Liquid Fund Index as shown in the table.

However, this trend was reversed last year and the benchmark 10-year yield closed at 8.74 per cent on 7th February 2014. As shown in the table, money market funds and short-term funds are generally less affected by rising interest rates than their long-duration counterparts.

Hence, your fixed income portfolio should include a combination of short, medium and long-term funds. Currently, the yields of open-ended medium/long-term debt funds are around 10 per cent. These funds currently have durations of 3-4 years. The exposure to long-duration funds should be divided between open-ended long-term funds and Fixed Maturity Plans (FMPs) with maturities greater than 3 years. 

These funds are close-ended and have a hold-to-maturity approach and unlike open-ended schemes, are not sensitive to changes in interest rates. 

Given the economic slowdown, interest rates are likely to fall eventually. The investments in long-duration funds may help you benefit from capital appreciation over the next few years if interest rates fall. But by limiting the exposure to these funds, you will also be able to limit downside risk if interest rates rise. 

The allocation to money market funds will also provide liquidity as most of these funds have no exit loads so you can easily redeem your investments in these funds if required.

A small allocation to large-cap equity funds can supplement the return from your other investments. These funds generally invest in large-cap “blue chip” stocks of well-established companies with strong financials and steady growth prospects. These characteristics make these funds less volatile than small & midcap funds. The top actively managed large-cap funds have outperformed the Nifty over the last few years. Over the last 15 years, the Nifty has generated a CAGR of 13 per cent while top large-cap equity mutual funds have outperformed the Nifty by 2-3 per cent.

You can use SIPs to invest about Rs 7,000 in these large-cap funds each month. The remainder (Rs 28,000) can be used for SIPs in debt funds. 

As shown in the chart and table, the bulk of your mutual fund investments should be invested in debt funds to restrict uncertainty. In the long-term, equities have outperformed fixed income (as shown above) but are also more volatile than fixed income instruments, especially in the short-term.

As you are in the highest tax slab, you should opt for the growth options of debt funds and hold these funds for at least a year. You will incur long-term capital gains tax and you can choose to pay either 10.3 per cent without indexation or 20.6 per cent with indexation. Returns in equity funds are not taxable after the first year.

In conclusion, your proposed allocation is geared towards debt and includes a modest allocation in relatively stable equities. This allocation should enable you to earn a positive real rate of return and simultaneously limit downside risk. Your proposed allocation has the potential to generate a return of around 10 per cent (pre-tax) and should enable you to beat inflation as over the last 15 years, consumer price inflation has averaged 7 per cent (measured by the Consumer Price Index for Industrial Workers).Over the next few years, inflation is projected to decline in India.

As you age, you should gradually reduce your equity investments so that the majority of your overall portfolio is invested in debt to minimise risk.