- Wealth PMS
This occurs often. A common money goal we all deal with from time to time. You have some money you need to park.
You know you will need it back in a few months. Could be for a down payment on a home, a medical procedure for a loved one, tickets for a family vacation package or your kids’ college fees.
Where should you keep the money for such short-term expenses?
For any investment problem, start with the simplest instrument that lets you solve the problem. Think of simplicity in terms of the effort required to implement, monitor and redeem.
In this case, that simplest solution is to just let it sit in your savings account, today. At 4% or so of interest, this gives you about 2.8% post-tax.
The upside is you have to take literally no action to implement or monitor. Just do an NEFT / RTGS transfer on the target payment date.
Two downsides to this:
The next simplest option is a short-duration Fixed Deposit. As of this writing, you can get ~6% on a 9 to 11-month lock-in. That’s 4.2% post-tax.
We’re biased against Fixed Deposits because of a few reasons, not least because there are products that better returns for almost no additional risk, but also how they like to sucker you at the time of renewing deposits. Also, if we had to be nitpicky, we’d point out RBI only guarantees up to ₹ 5 Lakh of all your money across savings, fixed and recurring deposits. And even that doesn’t always work like you would expect, like in the case of PMC Bank. So they are not exactly bullet-proof.
However, if the idea of anything more “exotic” than fixed deposits promises to increase your consumption of antacid, then stop there, and just put the money into a fixed deposit. After all, being able to sleep well at night is a pre-requisite to make any investment worth it.
So far, a 4.2% post-tax certain return is the benchmark. Any alternative instrument you pick has to deliver more while not increasing the risk of not being able to make that fixed payment. This means Direct Stocks, Equity Mutual Funds, Long duration Debt Funds are out.
The two remaining contenders are Liquid Funds and Arbitrage Funds. Both have higher risk than a plain Fixed Deposit, but not by a huge margin.
Think of the risk like this. If the risk of not getting the promised return on an FD is the same as your flight not landing safely at its intended destination, the risk in liquid/arbitrage funds is that of your Uber / Airport Pickup not making it to its destination safely. Higher risk than the flight itself, but still close to certain as these things can be.
Both Liquid and Arbitrage Fund Pre-Tax Returns are comparable and vary with time. Nowhere near as much as equity funds, but they do vary in a narrower band.
As of writing this in January 2020, here are how the two categories of funds have been doing.
Arbitrage Funds (Illustrative List)
Liquid Funds (Illustrative List)
Both tables are ordered in descending order of Assets Under Management (AUM) and not on returns simply because recent returns are not how you pick your investment.
Median returns from both liquid funds and arbitrage funds are comparable in the 6.60% to 6.75% range.
Arbitrage funds are treated as Equity Mutual Funds i.e. Short-Term Capital Gains apply until a year and are taxed at 15% (irrespective of your tax slab).
Liquid Funds are Debt funds. Short-Term gains apply for 3 years. Which wouldn’t be a problem in this discussion given we’re only looking for 11 months or sooner, except, the income from liquid funds is considered as “Other Income” and gets taxed at your slab Income Tax rate, which is investor-specific can be as high as 42.7%.
If you are in tax slabs higher than 15%, arbitrage funds make more sense than Liquid Funds for parking money for short durations (< 12 months).
Look for the direct plans of Arbitrage Funds available today, that have been around for at least 3 years, have delivered reasonably consistently relative to the category, and have AUM of at least ₹ 100 Crores
You should use the concept of Dividend Reinvestment in Arbitrage funds. Dividends are taxed at source (at 10%) and if you automatically have the dividends reinvested, your effective tax rate for the short term will only be 10%. That is lesser than the 15% you will pay if you exit within a year. So choosing the Dividend Reinvestment option, rather than Growth, is a good strategy.
(Note: This only applies if Dividend is not taxed in the receiver’s hands. If that changes in a future budget, ignore this section)
Budget 2020 has changed this section. From April 1, 2020, dividend is taxed in your hands, not at the mutual fund level. This means you should not use the dividend reinvestment option, but use the growth option instead. That will give you capital gains when you exit, but short term capital gains taxes are only 15%. (Your tax bracket may be higher)
More than the risk to the category itself, there tend to be fund-house specific risks depending on the kind of positions the fund manager takes. They bear some (not too much) monitoring from time to time to ensure the holdings are not drifting lower on the quality or higher on exposure to any single corporate house that might blow up. Their track record on what they do when the proverbial shit hits the fan tells you which ones to avoid.
Also, tax treatments change, which in turn change by how much one type of fund is better than another.
We maintain an updated list of our recommendations on the Capitalmind Answers page [premium access required].