SWP & STP The Smart MF Strategies

Many investors are worried about their regular cash flows after the introduction of DDT . DSIJ explains various tools available in MF, which can be used smartly to optimise your returns and maintain their regular cash flows. 

The wisdom of investing is all about taking smart investment decisions that maximise returns on your investments. The only thing that helps you in achieving this is your entry and exit at the right time. Investors are usually advised to invest for the long term in mutual funds. There are situations, however, which prompt investors to exit from the fund early. This may adversely impact the overall returns. The Union Budget 2018 was one such occasion which created a dilemma in the minds of investors regarding continuing with their investments in mutual funds. 

The Union Budget 2018 has affected mutual fund industry considerably with its decision to reintroduce long term capital gain (LTCG) tax on equities and equity-related instruments and the introduction of dividend distribution tax (DDT). With the introduction of DDT, category that has really got impacted is the balanced funds and dividend option of equity funds. They are losing their popularity among the investors. The reason being, earlier all the dividend distributed by the fund houses were tax free; however, now the fund houses need to pay DDT at the rate of 10 per cent, which will ultimately impact returns of the investors as the tax will be deducted from the scheme’s net asset value (NAV). The impact of introduction of DDT is clearly visible on the inflows into these category funds in the last couple of months. The balanced funds are on a losing streak and witnessed a huge decline in their inflows. The inflows have more than halved in the last three months ending April 2018. 

Although the fresh inflows are dwindling, investors who had already invested in the funds are finding it hard to decide what to do with their investments and how to exit from these funds efficiently. Investors who were relying on these funds for regular income now want an alternative that will help them exit from these funds without hampering their regular inflows. In the ensuing paragraphs, we have explained how an efficient exit strategy can be formulated in such a situation. There are tools available with mutual funds that can be used by investors to switch their investments in a staggered manner. 

Having a proper exit strategy is as crucial as choosing a right investment option. Right investment options give you the desired returns and a perfect exit strategy optimizes the returns. Indian mutual fund houses allow investors to redeem or exit their investments in two broad ways,namely, full redemption and systematic redemption. Investors usually tend to redeem their investment in full to invest in other schemes. But the systematic approach, which offers good exit option, seems to be under-utilised option due to its low popularity. Let’s now understand how these systematic exit strategies work. 

Systematic Withdrawal Plan (SWP) 

We use systematic investment plan (SIP) to grow our investments. Similarly, we can use systematic withdrawals plan (SWP) to withdraw certain amounts from our corpus as per our requirement. SIP is now pretty much known to the investors, but SWP seems to be less popular among investors primarily due to lack of information and awareness about the option. 

SWP is the facility provided by mutual fund houses to an investor where he can withdraw money invested in a staggered manner at predetermined intervals. The investor has the option to redeem only capital gains or he can withdraw a fixed amount periodically. In the fixed withdrawal method,an investor decides an amount to be withdrawn at specific time intervals and, in the case of appreciation, the amount of appreciation can be withdrawn. The interval of these withdrawals can be monthly, quarterly or yearly. The basic requirement to start the SWP is that the minimum corpus should be Rs 25,000. 

How SWP Works Suppose an investor had invested in certain balanced funds and was getting Rs 20,000 every month in terms of dividend. Now,if he continues with the same investment, he will have to bear the dividend distribution tax, which will eventually reduce his returns. So, in this case, he can use SWP to improve his returns. 

Now, how is this possible? Let us assume he had invested in a fund (one year back and hence no short term capital gain tax ) that imitates returns of a large cap fund. The data of 60 large cap funds for the last 10 years show that, on an average, these funds have generated returns of little more than 12% per annum and 1.38% on a monthly basis. Now, let us see how SWP can be used to optimise returns. Using the data and assumptions, we experimented the whole scenario 1000 times with the NAVs of funds moving in all possible directions. 

The results of these experiments show that the average return (XIRR) generated by SWP method was16.57%. (See figure : Distribution of SWP Returns) The other important result was that in only five per cent of cases, your return would have been lower than one per cent. Nonetheless, there are also cases where your return could have been more than 32 per cent. The most important point is that in 0.4% cases, you may not get any returns at all. This may be a case when the market is erforming exceptionally bad and your fund value or corpus exhaust Compare this to a case where he withdraws a lump sum at the end of any month, the returns generated are almost the same, but with a little higher volatility. 

In the case of lump sum withdrawal, you will have to pay LTCG if it exceeds Rs 1 lakh. Hence, the returns will be slightly less than the SWP. In our study, we found that once the LTCG is considered, the returns generated by SWP exceed the returns generated by lump sum investment by 1.4%. 

However, we are not only going for returns and that is not our primary concern. The monthly inflow is the prime consideration that we are trying to address as also how you can get better returns. We believe an average return of 16 per cent is decent enough and need no other comparison. 

Now, many of you might be waiting to know how it is going to be taxed. The tax is calculated as in the case of SIP. So, in the case of equity funds, the withdrawals within a year attract 15% STCG (short term capital gain) tax and 10% of LTCG tax if the withdrawals are after one year over and in excess of Rs 1 lakh. In our above case, we have assumed that the investor had invested this amount some time back (more than one year), and hence,there is no tax liability for him. 

SWP is suitable for retirement planning 

In the case of SWP, investors get regular income. The strategy is very useful where an investor can spread his requirement of money over the years. The steady redemption from the fund usually benefits him, allowing him to redeem more by investing less. This is the best and suitable strategy for the retired investors or for investors who are nearing to retirement and are risk averse and just want to exit from the fund rather entering newer one. Of course, even a young investor can also opt for it, but these SWPs can be the best substitutes to pension income for an investor.

Systematic Transfer Plan 

Nonetheless, in the words of Sir Tom Stoppard, a playwright and screenwriter,“Every exit is an entry somewhere else” seems to be true in the investing world for many. The mutual fund industry also gives such avenues to complement the exit with an entry in another fund. This can be done by direct switching also or one can use systematic approach smartly by gauging the market volatility. 

Systematic Transfer plan (STP) is another smart exiting tool available to mutual fund investors. The phenomena works nearly like the SIP, but here the investor does not invest through his bank account; instead, he uses another fund as a source of funds to invest. 

STP is a technique used for making staggered investments into equity funds over a period. Here, the investor puts a lump sum amount into a scheme and then transfers a predefined amount into another desired scheme at specific time intervals. The scheme where an investor puts the lump sum money is known as the source scheme, whereas the scheme to which the transfer is made is known as the target or destination scheme. These schemes are also known as transferor and transferee scheme, respectively. 

If an investor is opting offline mode of investment for STP, then he will have to transfer the amount from one fund to another. One prerequisite for this is that both the funds need to be part of the basket of the same fund house. 

The key advantage of STP is that it helps the investor in averaging cost of the investments in a volatile market, just like an SIP. STP can also be used to realign and rebalance the portfolio. That is, if the corpus in debt funds have increased, then by using STP,you can easily rebalance your portfolio by transferring some of the money in equity-dedicated funds and thus reap the benefit of asset rebalancing. You can do vice-versa also. 

In the current volatile market, especially after the Union Budget 2018, this strategy will be useful to investors for redeeming older mutual fund investments and entering the newer ones. Another plus point with the STP is that it works like both SIP and SWP as an investor using STP withdraws as well as invests simultaneously, which helps him to face market volatility in the market in a better way. 

STP is basically for investors who do not need regular cash flows and have the goal of wealth creation over a period of time in sight. This exit strategy will be best suited to them as they will exit from a fund and,at the same time,they will be protected from volatility. 

While the SWP has two options, STP is available in three options, that is fixed, capital appreciation and flexi/variable. In fixed STP, the amount to be transferred is fixed and on the predefined date it gets transferred to the target fund. In the capital appreciation option,only the appreciation earned on the investment is transferred to the target fund. Under the flexi/ variable option,an investor has the choice of transferring variable amounts; however, the minimum amount under this option is fixed. In this option, an investor can take the benefit of market movements, that is, he can invest more when markets are at lows, and invest less when the markets are at highs. Hence, this option gives an investor an opportunity of value averaging. 

STP turns more beneficial as the withdrawn amount gets invested immediately into the target fund, which also generates returns to the investor. Let’s look at how the STP benefits the investors. For example, (See : How STP Works)an investor may go for an STP of Rs20,000 per month from a balanced fund having return potential of 15%and transfer the money to another equity fund, which can generate returns of 20% in the coming years. The equity-dedicated funds have better return potential than balanced funds because of larger exposure to equities. We have assumed that he had invested in the balanced funds one year back, that is,in March 2017 and he starts STP from the month of April 2018 for the next 12 months. 

Here, we can see clearly that the investor gets the benefit of staggered exit and entry at the same time. While exiting the fund, he earns profit and, at the same time,his investment into the new fund gives him the return during the same period. If the investor would have waited for a year and exited,then the investor would have earned less than what the STP helped him to earn. So, if we assume that the investor would exit in March-19 from the existing scheme, then his end value of investment will be Rs 3.16 lakh which would have earned him a profit of Rs 40,413, but doing STP from one fund to another fund helped him earn a profit of Rs 46,475. 

As mentioned earlier, investors who are aggressive and need no regular inflows and have an aim to create wealth can use this strategy to exit from the funds where they are stuck in. This strategy is also useful for rebalancing the asset allocation in an efficient manner. 

Using STP and SWP Simultaneously 

When an investor wishes to have regular inflows and also wants to invest in an aggressive fund,he can use a combination of both strategies. That is, he can opt for both STP and SWP simultaneously. This will let him redeem the amount from the source fund at a faster pace and allow him to invest into another fund. Let us look at how this strategy works for the investor. Continuing with the same example of the STP as above,the investor spilts his STP of Rs 20,000 into Rs10,000 for transfer into target fund and opts for SWP for the balance of Rs10,000, where he has an investment of Rs 2.4 lakh in the source fund. Then the result will be as follows (See table: How STP and SWP Works Simultanously) 

In the below table we can see that the investor has redeemed the amount of Rs 1.2 lakh over the period of one year and transferred Rs1.2 lakh to the targeted fund, where he expects a higher return. He has benefited from both, that is, he has a regular cash flow of Rs 10,000 per month and, at the same time, he has profited by ~Rs70,000, considering the balance of ~Rs59,000 and the profit of ~Rs11,000 from the investment into the targeted fund. This combination can be very useful for investors who have a moderate risk appetite. 

The mutual fund world is just full of options for all situations. You just need to analyse them keenly and decide on the perfect one that suits your needs. With all the above options available to an investor, we can see that switching or exiting an investment can be done more efficiently using a proper exit strategy. Therefore, it is said that having a proper exit strategy is also crucial to maximise the returns and minimise the risks. These exit strategies will also be very useful for investors to plan out their tax liabilities properly.