How SWP from Balanced Mutual Funds can get you income and capital appreciation

Most people invest in mutual funds with the goal of getting capital appreciation in the long term. For income needs, retail investors still rely on bank fixed deposits (FDs) or certain Government small savings schemes like Post Office Monthly Income Scheme. However, in the last 2 years bank FD and small savings interest rates have steadily come down substantially. Bank FDs are now paying 6.5 to 7% interest per annum while Post Office MIS is paying 7.8% interest rate. Moreover, bank FD and post office MIS interest are fully taxable as per the tax rate of the investors. As a result, many investors, who rely on these schemes for their income needs are looking at alternative investment options.

The popularity of mutual funds among retail investors in India has been growing exponentially over the last 4 to 5 years. Large numbers of investors have realized the benefits of mutual fund investments and are also encouraging their friends and relatives to invest in mutual funds for their financial needs. A decade or two back, mutual funds were associated primarily with stock markets and were seen as risky investments, but now many investors know that, mutual funds offer investment solutions for a wide variety of risk capacities and investment needs. One category of mutual funds, which is growing rapidly in AUM and popularity over the last 3 years or so, is balanced mutual funds. Balanced mutual fund AUM has grown at a CAGR of 87% over the last 3 years.

What are Balanced Mutual Funds

Balanced Mutual Funds are equity oriented hybrid mutual fund schemes. Hybrid mutual funds invest in multiple asset classes like equity and fixed income or debt. Balanced Mutual Funds have at least 65% asset allocation in equity or equity related securities and the remaining portion in fixed income or debt securities. While, equity as an asset class is volatile in the short term, it is also the best performing asset class in the long term and ideal for wealth creation. Fixed income (or debt) as an asset class is less risky than equity and can generate income for investors.

Read What are Balanced Mutual Funds in details

Benefits of Balanced Mutual Funds

Since stocks comprise more than 65% of the asset allocation of balanced funds, these funds can generate good inflation beating returns for investors in the long term.

The fixed income allocation of balanced mutual funds serves to moderate the downside risks in volatile markets and also generate regular income

While balanced mutual fund managers maintain equity allocation above 65% (and fixed income below 35%), they can make asset allocation calls within a certain range based on their outlook for relative valuations of asset classes (equity versus fixed income). If fund managers think that the valuations are expensive (high market), they will reduce their exposure to equities and increase their fixed income allocation. If fund managers think that, valuations are cheap then they will increase allocation in equities and reduce fixed income exposure correspondingly. Active asset allocation helps balanced mutual funds deliver superior risk adjusted returns in the long term.

Dynamic asset rebalancing is another benefit of balanced mutual fund investments. Balanced mutual fund managers aim to maintain equity and fixed income allocations within certain target ranges. A prolonged bull or bear market can cause equity or fixed income allocations exceed the target ranges. Balanced mutual fund managers will then rebalance their asset allocation to bring it back within the target ranges. If stock prices run up substantially, then fund managers will book profits in stocks and re-invest in fixed income securities. Likewise, when stock prices fall substantially, fund managers will buy stocks to bring asset allocations back within target ranges. Asset rebalancing results in greater returns stability for balanced mutual funds compared to riskier asset categories like stocks and equity mutual funds.

Balanced funds are good long term investment options for investors with moderate risk capacities. Balanced funds are also good investment options for new investors who do not have experience in equity investing and dealing with volatility of asset prices.

As such balanced mutual funds are ideal for large sections of retail investor population in India.

Did you know which are the top performing Balanced Mutual Funds in the last 5 years

Balanced Mutual Fund Dividends

Over the past few years many investors are shifting from fixed income products to balanced mutual funds for their income needs. Some of the top performing balanced mutual funds have been paying regular monthly dividends for the last 2 or 3 years, e.g. L&T India Prudence Fund (paying monthly dividends from June 2014 onwards), Canara Robeco Balanced Fund (paying monthly dividends from June 2015 onwards), HDFC Prudence Fund (paying monthly dividends from 2016 onwards), ICICI Prudential Balanced Fund (paying monthly dividends from 2016 onwards), DSP BlackRock Equity and Bond Fund (paying monthly dividends from 2016 onwards), Principal Balanced Fund (paying monthly dividends from June 2016 onwards), Reliance Regular Savings Fund – Balanced Option (paying monthly dividends from May 2017 onwards) etc.

The annual dividend yields of these funds have ranged from 7.5% to 9% in 2017 which were significantly higher than FD interest rates. Further, while FD interest was taxed as per the income tax slab rate of the investor, balanced mutual fund dividends were tax free till March 31, 2018. From April 1, 2018 balanced mutual fund dividends will continue to be tax free in the hands of the investors but AMC will have to pay 10% dividend distribution tax (DDT) before paying dividends to investors. Therefore, even after the tax change announced in this year’s Budget, balanced mutual fund dividends will continue to be more tax efficient than bank FDs, especially for investors in the higher tax brackets. Higher yield and tax advantage made balanced mutual fund monthly dividend options very attractive for investors. However, investors should note that, balanced mutual fund dividends are paid at the discretion of the AMC and there is no assurance that the dividend payout rate per unit will be maintained or even that dividends will always be paid at all.

In case you want to check Balanced Mutual Fund dividends do refer this link

Investors should understand that, as per SEBI guidelines mutual funds will have to pay their dividends from the accumulated profits. The level of accumulated profits will change with dividend payout and market conditions, since mutual funds are market linked investments. Therefore, even though some of the top performing balanced mutual funds have paid regular monthly dividends over the past 2 or 3 years and may continue to pay monthly dividends in the coming months or years, there is no guarantee that they will be able to sustain in the long term. The uncertainty with the dividend payout can cause problems in your financial planning, especially if you depend on this income to meet some fixed expenses. Fortunately, mutual funds offer a smart solution to investors to meet their regular monthly income needs through Systematic Withdrawal Plan (SWP).

What is Systematic Withdrawal Plan?

In a Systematic Withdrawal Plans (SWP) investors can regularly withdraw a fixed amount of money from their investments in mutual funds. The amount to be withdrawn and the frequency of withdrawal are fixed by the investor. So you can have a monthly, quarterly or annual frequency for any fixed amount that you wish to receive. Unlike mutual fund dividend options, the monthly payment in SWP is fixed as long as you have sufficient unit balance – therefore, there is no uncertainty in cash-flows and your financial planning. However, investors should note that SWP generates fixed cash-flows for investors by redeeming a certain number of units at prevailing NAVs. While unit balance goes down every month, the unredeemed units continue to accrue returns for the investor over the SWP tenure. The more you draw, the less will be your capital appreciation and vice versa.

Let us illustrate this with the help of an example. Suppose you can invest Rs 50 lakhs from which you need an income of Rs 40,000 per month. You can invest Rs 50 lakhs in lump sum in growth option of a balanced mutual fund.To illustrate this we have given the example of SBI Magnum Balanced Fund to show how SWP can create regular income stream for the investor for long tenure and also capital appreciation for moderate withdrawal rates. We chose a period of Jan 1, 2006 to April 30, 2018 to observe the SWP results. We chose a long period for SWP because income planning is usually done for a long period. Further, over a long historical period, we can observe how the SWP performed in different market conditions (multiple bull and bear market cycles). Please note that for the sake of simplicity we have ignored the effect of exit load and short term capital gains tax.

You can see that, despite drawing Rs 40,000 every month – Total Rs 480,000 in a year - (around 9.6% of invested amount per annum) to meet income needs, the investment in SBI Magnum Balanced Fund grew from Rs 50 lakhs to Rs 1.15 Crores in 12 years.

Please see the detailed SWP result of SBI Magnum Balanced Funds

The results of SWP are best over a long investment horizon and moderate rates of withdrawal. In the chart below you can see that, the residual investment value dipped below the investment amount in 2008, but the investment recovered and continued to grow despite withdrawals. In fact, over the 12 year period the cumulative withdrawals exceeded the one time (lump sum) investment amount (notice the shaded area in the chart crosses the red dotted line in early 2016). Despite withdrawing more than what he had invested, the investor was still able to more than double his investment.

Did you know the top Balanced Mutual Funds which gave the best SWP returns in last 5 years

Importance of moderate withdrawal rate

The withdrawal rate is very important in SWP. While you should withdraw as per your personal needs, you should note that if your withdrawal rate is too high, more units will have to be redeemed to generate your SWP amount and you will have less units remaining – with less units, you will be able to generate less profits and in the long term your SWP may not be sustainable.

Please note that, in this example, we used an annual withdrawal rate of 9.6%, which we think is on the higher side. Even with such high withdrawal rate, SWP was able to give such excellent results. This is because the market has been very good from 2014 onwards, despite intermittent volatility. Such good conditions may or may not prevail in the future. However, if the withdrawal rate per annum is lower the average long term annualized returns of the fund, then investor can get both regular income as well as capital appreciation. An annual withdrawal rate of around 8% or less, is usually recommend for balanced mutual funds.

Tax Advantage of SWP compared to dividends in mutual funds

The recent changes announced in the budget makes SWP in balanced mutual funds more tax efficient. The Finance Minister announced that from this year onwards equity oriented mutual fund schemes (including balanced mutual funds) will have to pay 10% dividends distribution tax (DDT) before paying dividends to investors. SWP, on the other hand, is subject to long term capital gains tax or LTCG (provided you begin your withdrawal one year or longer after the investment date). In SWP you are likely to have long term capital gains every year because redemptions are made every month or quarter. However, the Finance Minister has announced that long term capital gains of up to Rs 1 Lakh is tax free every year – long term capital gains in excess of Rs 1 Lakh will be taxed at 10%. So while the entire dividend pay-out amount is taxable (at the DDT rate of 10%), Rs 1 Lakh of long term capital gains is tax free per annum. Depending on your investment and capital gains amount, this means that you can save up to Rs 30,000 in taxes every year by going through the mutual fund SWP route. This can be a substantive financial advantage over a long tenure.

Conclusion

In this article, we have discussed why balanced mutual funds are ideal for investors with moderate risk profile. SWP from balanced mutual funds can help you with your income needs and also grow your capital, in a very tax efficient way.

We suggest you to read which are the best mutual funds to invest based on your risk appetite