While you shortlist an investment product, it is also very important to know the holding period or the ideal period to stay invested in the product. The traditional products like fixed deposits and small savings schemes have a defined maturity which investors are aware of while investing. This is not the case for mutual fund schemes for most categories except the fixed maturity plans.
Investors in mutual funds schemes need to decide themselves on the holding period to stay invested as most schemes are open ended where the investors can onboard or alight at their wish. The 2 standard factors that are important in deciding the period of stay in a mutual fund scheme are exit load and the taxes applicable.
Apart from this comes performance-oriented reasons and a score of other factors which also are deciders on the holding period or investment horizon. This article attempts to guide investors on the ideal holding period and/or the time to exit for various categories of funds and the factors to be considered to ascertain the holding period.
Exit load & capital gains tax
While one invests in mutual fund schemes , the plan should not be to necessarily exit once the exit load period is completed. The exit load period which is 1 year in the case of most funds suitable for long term investments is just the period after which the fund doesn’t charge an exit load and is not essentially the period by which you would have made decent returns or doesn’t mean that is the prescribed holding period.
The Short Term Capital Gains (STCG) tax is higher than the Long Term Capital Gains (LTCG) tax and so it would be wise to stay till the completion of the short term capital gains period. The period till which STCG is applicable is 3 years for all debt funds, fund of funds and international equity funds. For equity funds and hybrid funds which hold more than 65% in domestic equities STCG is applicable only till completion of 1 year.
In the case of the funds mentioned here where the STCG period is 3 years, the STCG tax is the applicable marginal income tax slab rate and LTCG tax is 20% with indexation which ultimately turns out to be 10% or lesser due to the indexation factor. For the rest of funds the STCG tax is 15% and LTCG tax is 10%. So to take home better tax adjusted returns it makes sense to stay till the completion of STCG period.
When your investment is to meet a long term goal, hold the fund as long as you can, even longer than the completion of the STCG period if the fund has been able to deliver returns better than category average consistently.
However if there is a significant difference in the average returns of the top quartile performers and the average return of the category at the end of three years , it may call for a relook and may be required to switch to a fund which consistently reflects in the top quartile performance.
Exit due to underperformance
Over a 5 year period the outperformance of an equity fund which is in the top quartile performance over a bottom quartile performer can be a CAGR of 5-7%. To make you visualise the reality of this, on an investment of Rs.1 lakh over a 5 year period the difference in the absolute returns of a top quartile performer and a bottom quartile performer can be as high as Rs 26000 to Rs 40000 if the CACR difference is 5 to 7%, which is not easy to sacrifice.
Similarly, the outperformance of a long term debt fund with top quartile performance over a bottom quartile performer can be a CAGR of 2 to 3%. As you may not want your hard earned money to be working lazy, you may have to move out from your fund as suggested above if it’s a bottom quartile performer.
While equity investments are advocated to be held long term to reap the best of benefits, it should not be misinterpreted as to stay long term in a fund even if the performance is lagging for a long period. The advice to stay long term is only in the gamut of equity funds and not necessary with the same fund, the reason for which is explained in the previous paragraph. If the need to exit is terrible underperformance over a prolonged period , factors like exit load or short term capital gains tax can be ignored and you should move forward to make the change.
Exit in a bad year
One should not exit from funds in a bad year if the actual goal can wait and this is more applicable for an equity fund. It makes sense to pass through the bad phase of the markets and exit once markets revive and to liquidate with better returns.
Exits for liquidity
When there is a requirement for liquidity you need not exit from a fund completely if only a part of the value is required as partial redemptions are allowed in mutual funds.
Even if you would need regular cash flow from Mutual Funds you can structure it through the Systematic Withdrawal Plan (SWP) option which facilitates withdrawal of a fixed value in a predetermined frequency like monthly or quarterly for a predefined period.
You can plan your withdrawal amount in such a way that the Capital doesn’t get eroded, if your requirement is within that value, as most investors would not like capital erosion.
Until 1st April 2020 , dividends paid by equity funds were tax free and investors used to choose the dividend payout option until then to meet their recurring expenses. The SWP option in a way replaces this now in the absence of tax free dividends.
The SWP option of a Mutual Fund also is superior in tax advantage over a fixed deposit as in SWP the tax is applicable only on the gains part of the units which are withdrawn whereas in an FD the tax is on the entire interest paid.
It also needs to be noted, in an equity oriented fund LTCG tax after one year is only 10% regardless of the applicable income tax slab of the individual whereas in the case of interest from FD it can go as high as 30% plus applicable surcharge.
In the case of debt funds the LTCG Tax is only 20% with indexation for SWP done after 3 years and that too only for the portion of the gains of the units withdrawn.
Exits for fulfilling financial goals
Uncertainty of goal period: Investors can park their liquid surplus which is targeted at specific requirements, the requirement period of which is unknown in short term parking funds like liquid, ultra short term and money market funds .
However they should review the requirement period regularly and whenever they get clarity that the period is going to be longer they should move to long term debt funds , hybrid funds or even equity funds based on the period left, to generate higher returns.
Tactical step before goal period: Equity funds are a great solution to meet long term financial goals like higher education, wedding or purchase of a home. But investors need to get a bit tactical before the commencement of such goals.
To avoid your corpus getting eroded due to market corrections one should move the accumulated value to short term debt funds so that they don’t see value erosion when the liquidation needs to be done for the goal.
Strategic planning of retirement corpus: Investments made to build a retirement corpus need to be strategically planned closer to the retirement period. While during the accumulation phase , the investments can be in equity funds to accelerate growth, when the retirement is 3 years away the funds should be moved to less turbulent funds like conservative hybrid funds to avoid value erosion shocks.
From the retirement period which is the beginning of the distribution phase, the investments need to be moved to debt funds, maybe with some allocation to conservative hybrid funds based on the risk appetite of the investor.
However if there is substantially excess corpus created over and above the required retirement corpus which can be left as legacy, such excess investments can be even parked in equity funds to create more wealth for the next generation.
ELSS schemes
ELSS schemes have a 3 years lock-in and offer exemption benefits under Sec 80C. However, 3 years is not the maturity period for someone to necessarily make an exit. If the investor opts to continue having the benefit of equity returns after the completion of 3 years and if the fund continues to perform well he can hold on without redeeming.
That said, in the year of completion of the 3 year lock-in , if the investor has the requirement of making investment to avail 80C benefit, the amount can be redeemed and a fresh investment can be made in the same or different ELSS schemes without having to arrange for funds from other sources.
Up to 1 lakh long term capital gains waiver in a year
Every financial year up to 1 lac of long term capital gains from equities or equity mutual funds is waived from being taxed. So to make use of this benefit investors can redeem equity mutual fund units with up to 1 lacs of long term capital gains every financial year.
Exit from debt funds
Short term capital gains from debt funds, which are gains generated in less than 3 years are taxed are the applicable marginal tax slab of investors. But long term capital gains from debt funds have a significant tax advantage as they are only taxed at 20% with indexation.
So investors can tend to wait for just completion of 3 years from the date of investing in a debt fund and redeem immediately after that just as they have got into a favourable taxation. This may not be a right move and as long as the fund continues to be good the fund need not be redeemed immediately after 3 years.
In fact the longer you stay in a debt fund after 3 years, higher is the indexation benefit you get with every passing financial year. One also needs to be mindful that exiting from a debt fund in 3 years and reinvesting in a new debt fund means another 3 years of waiting to get into the long term capital gains period.
Portfolio Rebalancing
While doing periodical assessment of asset allocation spread if your debt, equity or gold fund has higher % weightage more than the required weightage for your risk proposition, then the excess weightage from that particular asset class of fund needs to be trimmed by making proportionate exit and move to the asset class of fund which is falling short in required weightage.
SIP- enrolment and staying period
Systematic Investment Plan (SIP) investors commonly enrol for SIP for 3 years, 5 years or even longer but that doesn’t mean the liquidation of the investment should be done immediately after the enrolment period. The instalments of the recent 12 months would attract exit load and short term capital gain tax (which is 15% whereas long term capital gains tax is 10%) and so liquidation once the SIP enrolment period is over is not a wise idea.
This fact apart, equities reward investors the longer they stay and as most SIPs are done in equity funds, it is further more beneficial to stay invested for a longer time period in equity funds unless the fund has been underperforming for long.
V Krishna Dassan, Director - Wealth Management, Dhanavruksha Financial Services Pvt. Ltd.
