The Mutual Fund Show: Neo Banks Versus Fixed Income Funds
Neo banks offer a return of 7%, higher than certain fixed income mutual funds.
Neo banks or digital banks offer basic banking services online and a higher rate of return, in contrast to mutual funds which provide indexation benefits and better returns when interest rates start rising.
Neo banks in India work in a partnership model with traditional banks, which means that customer funds are parked in an underlying bank account.
For savings or current accounts in a traditional bank, the Reserve Bank of India guarantees an amount of up to Rs 5 lakh through the Deposit Insurance and Credit Guarantee Corp. The same rule applies to Neo bank accounts, since the underlying account is provided by a traditional bank.
Currently, neo banks offer a return of 7%, which is higher than the return of certain fixed income mutual funds.
Neo banks are used mainly by new-age millennials for saving small amounts of money, Juzer Gabajiwala, director, Ventura Securities told BloombergQuint’s Niraj Shah. He expects very few investors to have parked funds worth Rs 5 lakh in Neo banks as “...at the back of their mind, it is still not a bank”.
Amid a volatile interest rate scenario, neo banks may not be the best bet, said Harshad Chetanwala, co-founder of MyWealthGrowth.com.
When interest rates start rising, fixed-income fund categories like corporate bond, banking and PSU and dynamic bond funds can generate better returns than the interest offered by neo banks, said Chetanwala.
“As the interest rate scenario changes, there are better alternatives that mutual funds can offer—with more stability and a better way to manage the money, because you have a fund manager looking at the overall debt.”
Mutual fund investors—who invest for more than three years—also get the benefit of indexation, Gabajiwala said.
Are Low Volatility Factor Funds A Good Bet?
Financial advisers are advocating low volatility factor funds. These schemes are a blend of passive and active investment, where less volatile companies from the index become a part of the portfolio.
According to Chetanwala, investors looking for relatively stable companies where the volatility is low can consider these funds.
While these funds can do well during market correction or consolidation, and offer better downside protection, returns can be moderate and lower than diversified equity funds if the stock markets rally, he said.
An investor comes to the equity market to make returns, and if they "cannot digest volatility", equities may perhaps not be the right option for them, Gabajiwala said.
Watch the full show here:
Edited excerpts from the interview:
Why should a person not put up to Rs 5 lakh in a Neo banking account, which gives them 7% interest?
Juzer Gabajiwala: Neo banks are basically Neo-gen. You are basically talking about the new generation. It's not what you would say is a full-fledged bank. Ultimately, they have to rely on a bank. It's only on the savings bank account where they are giving you a 7%.
From a commercial perspective, it makes sense for somebody to park their funds there.
But I don't know if I have seen any investor with Rs 5 lakh say that they have kept it for a year in a Neo bank account and just let it remain there. People will be doing that with a small sum of money, because at the back of their mind, it is still there that it is not a bank.
People will always have a tendency to compare it to a mutual fund return. With current interest rates moving up, none of the fixed income mutual funds will give you a return which will match up. Even 4.5% is a big challenge because it’s purely due to mark-to-market.
Till the time interest rates are going up, this will be a fantastic argument. When you have interest rates going down, we will start talking about why people should not put money in a MF and put it in a savings account. But today, for a mutual fund also, in a liquid fund it's a challenge to even get 4%.
Let's assume an investor has a time horizon of one year. Even if the bank goes kaput, the RBI is guaranteeing a sum up to Rs 5 lakh. So, if the investor wants to invest Rs 5 lakh, what is the mutual fund alternative to the 7% rate of return?
Harshad Chetanwala: We are all aware that fixed income mutual funds are offering much lower returns because of the overall interest rate environment. There is no doubt that in the present environment, these Neo banks are offering, let's say, up to the deposit of Rs 1 lakh, around 3.5% and up to a deposit of between Rs 1-Rs 5 lakh, around 6%.
No doubt, most or all of the debt funds or fixed income funds will underperform this number – 6% in the present scenario.
The interest rate scenario will soon change and we do expect interest rates to increase. The interest rates have been on the lower side for the last two years, because the RBI would like to support the revival of the economy. Till that time (the scenario changes), we will continue to see Neo banks, and the returns given by them are good compared to debt.
To answer your question, the investor has an option to keep that money in a Neo bank for the time being because it's offering 6%, which is not being offered by any other alternative. And Neo banks are predominantly these fintechs who have also tied up with the banks in the backend.
So, of course, the money is secured till Rs 5 lakh by the RBI. But the most important point is that, as the interest rate scenario will start changing, you will see that there are better alternatives than Neo bank’s interest rate.
If you go back to about 2021, look at the last four or five years, there are a few categories which have a better opportunity to generate returns than just 6%. Typically, anyone who has a horizon of 1 year or 1.5-2 years predominantly uses debt and fixed income funds.
There are categories like Dynamic Bond Funds, Corporate Bonds, and Banking and PSU. If you pull out any of these categories and see the returns generated, not on a CAGR basis, but on a calendar year basis, that is what the time horizon of investors are typically in fixed income.
Most of the funds would be about 6%, those who are doing well.
Right now, the interest rate offered by Neo banks is good and investors should take benefit of it. But having said that, as the interest rate scenario changes, there are better alternatives that mutual funds can offer – with more stability and a better way to manage that money, because you have a fund manager looking at the overall debt.
What if the person has a time horizon of over three years, in which case the benefits of indexation come into play as well? Does the math change quite a bit? Does the benefit of indexation blunt the advantage that a 7% savings account option has over any mutual fund product?
Juzer Gabajiwala: Let us assume that if somebody is getting a savings bank interest of 7% (let's not get into the Rs 10,000 deduction as it's nominal). So, if you are under the 30% tax bracket, you will be paying 2.1% as tax. 30% of 7% means your post tax will be somewhere around 4.9. So, you are going to get a 4.9% return.
I'm doing a thumb rule calculation. If you look historically, indexation is roughly around 5%, and inflation keeps going on (rising) every year. So, over a three-year period, you get 15% indexation. It will work up to somewhere around 5 to 6% as effective differentiation in terms of the taxation rate is what you get. You assume that your tax rate will be around 5-6% because on indexation you pay 20%.
Previously, when inflation was low at 4%, we used to take 10% as a thumb rule to do a back-of-the-envelope calculation as an effective tax rate.
With a 5%, I would assume around 6 to 7% is the effective tax rate, considering the benefit of indexation. So, if you are going to get say 6% return on any debt instrument over a period of three years – I presume you could get up to 6, 6.5 as of now in any of the G-Sec type of an instrument you hold for three years.
On 6.5, we would pay around 5% to 7% tax. So, your post tax will still be higher than 4.9. So, the math would make a person switch instead of being into a 7% instrument because of the taxation. It would be better off for them to move into a debt fund and take the benefit of indexation.
What are the best categories of debt funds that should be used at the current juncture?
Juzer Gabajiwala: Gilt is the one which would offer those types of returns. There are now some of these Target Maturity Index Funds, which are there with a three-to-five-year horizon. Those are the places where you will get this type of yield, specifically where right now you have a scenario where interest rates could rise. That's why all the Corporate Bond Funds or your credit risk and all are going to get adversely impacted.
The important thing is that the person will need to ride out the volatility in the interest rate for the next six months to a year. We could see a half percent increase in the interest rates, and this has a negative impact on all mutual funds.
So, in the short term, they would have to go through that pain, but then they have to wait it out for three years. I am assuming that the person has a three-year plus time horizon to take the benefit of indexation.
Harshad, what is your view and what is your math?
Harshad Chetanwala: Most people do not keep money in a savings account for three years. They would like to either deploy it in debt or debt instruments or a blend of equity and debt.
We will stick to the topic about savings accounts and debt mutual funds. Another element is the duration. Right now, considering the interest rate scenario, where we all expect interest rates to go up – and this has been the stand for almost one or two years that it is better to remain on the shorter maturity of the debt instrument – as interest rates start increasing, there will be an impact on the overall portfolio of debt funds.
Even though today I have a horizon of three years, and want to invest in fixed income, I would like to continue to remain in shorter duration – could be short duration or ultra-short duration funds – because I know that within three or four months, there will be an increase in interest rates. As and when the interest rates start increasing, it is the right time to start chipping into the debt side.
Let's assume that the person doesn't have the luxury to wait for the right time and wants to invest the money today. What is the option that you would give to somebody with a three-year horizon?
Harshad Chetanwala: I will continue to be on the shorter side, maybe short term, short duration funds at present. If you do not want to time the market, I'll be comfortable with Dynamic Bond Fund or Banking and PSU fund. One thing to definitely look at is the maturity of the overall portfolio.
The shorter the maturity of these funds, that is Corporate Bonds and Banking and PSU and Dynamic Bond Fund, the safer you are from that volatility. Of course, you can ride along when the interest rate changes with these funds.
A lot of people have been recommending Low Volatility Factor Funds. Are these good and for what kind of investors are these good?
Harshad Chetanwala: Basically, Low Volatility Funds are a blend of active and passive fund investments where the investments will happen. Let's say, the universe is defined as Nifty 100 and within this Nifty 100, there are 30 stocks which will be picked where the volatility is lesser. Or it starts with the lowest volatile stock and that will have your top holdings.
As the name suggests, these funds are meant for investors who are preferably looking at stable companies to invest into, being on the equity side. What kind of investors should be investing into it? I think those investors who want stable companies to park their money.
Keep in mind that these funds can play a role when on the downside. So, the downside could be lesser compared to an equity diversified fund, when the markets are not in favour, and vice versa. When the markets are doing well, you will see that these funds will probably underperform the actively as well as equally diversified funds. So, risk-averse investors who would like to park some part of their money in this kind of portfolio can consider it.
These low volatility funds have a shorter history right now, I think three to four years. If you try to put it in a four-year horizon, there have been two years like 2018 and 2020, which have been volatile. During these times, the low volatility funds have done better. And if we see a horizon of 2019 and 2021, that is where your diversified equity funds have done better. So, a lot depends on the risk appetite and what the investor is looking for.
Of course, the portfolio also changes drastically because most of the equity diversified funds will have, let's say, financial services across the category as the most preferred sector, which is very different than low volatility where FMCG or consumer staples is the top sector.
A lot depends on the investor’s profile and those investors who would like to take investments or do investments in much more stable companies can consider investing into low volatility funds.
Juzer, are you recommending Low Volatility Factor Funds?
Juzer Gabajiwala: People need to be clear if they are confusing risk with volatility. If you are coming into equity, the equity market is going to be volatile. If you expect that equity is not going to be volatile, then you are in the wrong market. We used to have something called as a Dividend Yield Fund. For me, it’s like old wine in a new bottle.
We have seen that if you are in for a year, the volatility is at the highest. As you keep on progressing, two years or three years or five years, seven years and 10 years, the volatility reduces drastically. So, the timing of the investment is more important. The investor is coming to the equity market to make returns and if he cannot digest volatility, the product is not for him. And he should not confuse this with risk.
I'm sure we all have heard the stories of ITC Ltd. It has been a no-volatile stock. So, it didn't move at all for many years. And you always find stocks which are going to be like that.
What's the kind of returns that people can get from Low Volatility Factor Funds?
Juzer Gabajiwala: The three-year return has been somewhere around 13%, and that is also more or less tracking the Nifty 100. It has more or less been the same.
The biggest disadvantage or advantage of any point-to-point return is that you can look at it at whatever time you want, which is convenient to you. So, you change the time horizon, and you can get the result you want. When I look at it today, it is 13%. Nifty and this are the same.
You will find that when markets are very volatile, this fund has given better returns in comparison to the Nifty. There will be times when Nifty will give returns better than this particular fund. So, you will always keep having different time horizons.
Let's assume an average 30- to 40-year-old person, earning an average salary, wants average returns over an average timeframe. What is the right number of mutual fund schemes that a person should have? I have seen examples of people having an innumerable number of mutual fund schemes in their portfolios.
Juzer Gabajiwala: I don't think that there is a right number because no solution fits each and every investor completely. So, you will not have a foolproof answer to that.
What one needs to look at is what is the overlap of the portfolios. It is more important to see that you don't land up with two schemes where 70% to 80% of the portfolio is the same. If it is going to have the same portfolio, then you need to consider moving out of one of the schemes.
If I have to give a number, I am sure that maximum is 10 to 12 because ideally, I will want my client to hold a small cap fund, I would want him to hold even a mid-cap fund so that he has different baskets to cater to. Now you have international as another flavour or you could have a region-specific fund. Then, a person may want to hold gold as an investment.
So, at different points of time, a person is using funds for different objectives. For example, if somebody is looking at creating an investment for their child's education, maybe you would give them a Balanced Fund, which is not very aggressive. So, that would add one more scheme to the portfolio.
If it is a retirement fund, and the number of years are long enough, you would also give them a small cap and mid cap so that they have got enough alpha which can be built up over a period of time.
This is not something which is a complete solution. But a person should try to minimise the number of schemes.
What we have seen with investors nowadays is that because of technology, and everything is available on the desktop and online, they don't bother whether they have got 10 schemes or 20 schemes because everything is available to them through the system.
Should people not have 20 schemes in the portfolio because it might be difficult to monitor?
Harshad Chetanwala: We have seen portfolios which range from 50 to 60 funds, which is absolutely not the right way to invest in mutual funds.
Of course, there's an overload of funds. There are more than 1,000 mutual funds and 400 equity funds. What you need maximum is around eight to 10 funds. The key is aligning these eight to 10 funds based on the financial objective and the time horizon.
Like I am a 35-year-old person, I am investing for an average duration of X and I need Y money. That should be the starting point. On that basis, we start building the mutual fund portfolio. Now, the key is the overlapping of the portfolio.
When you are trying to build a portfolio across equities and debt, along with overlap one needs to look at the blend of market capitalisation. At the portfolio level, it's important to look at market capitalisation, how much of my percentage is into giant caps and large caps and then into small and mid-caps.
The ideal way to build the mutual fund portfolio across let's say, eight to 10 schemes can be through Index Funds and Large Cap and Large and Mid-Cap and Flexicap funds.
If you look at the universe, you could be higher on the large cap side, but that's the right approach to begin with. There is no need for anyone to start with eight to 10 funds. Start with three-five funds and then bring it to eight to 10 funds as you start working on your financial objectives.
And it’s the same for debt and equity on the debt side. Depending on your investment horizon, one has to look at the maturity of the fund.
There is a massive mismatch that we have seen. For example - If I need the money in six months and I tend to go in for a Gilt fund or long duration fund. So, on debt, it is more important to look at the maturity of the fund and your investment time horizon.
You don't need multiple portfolios – eight to 10 is good enough.
For an equity mutual fund investor, are there any good funds that may have come up recently in your research, keeping in mind all that's happening around, volatility, etc.
Harshad Chetanwala: No particular fund, but you can consider looking at large and mid-cap and Flexicap category. There are good funds available in that space today. The key is considering the market environment. It is important to go in a gradual manner rather than doing it all at one time.
Can you give a list of two or three names so that people have some actionable information?
Harshad Chetanwala: In case anyone is looking to invest in a large cap fund, we are putting forward Canara Rebeco Blue Chip or a Mirae Large Cap Fund. In a large and mid-cap space, where Mirae Emerging Blue Chip Fund is not accepting lump sum, there is Canara Emerging Equities and Kotak Equity Opportunities Fund. On a Flexi Cap, it is Parag Parikh Flexi Cap, followed by UPI Flexi Cap.
These are some of the funds that we are putting forward from an overall allocation perspective. The key is to limit the allocation towards each of these funds. We are saying that limit your costs to around 15% and keep it more diversified. That is where the number of six to eight or 10 funds goes, on an overall portfolio construction perspective.
Looking at the market environment today, it's very important not to put all the investible surplus in one go. You can go gradual. That's a better approach because markets could go through some pain in the near future and that could also give you an opportunity.
It is very difficult to catch the bottom. But try to invest gradually, as and when you see. The last two days have been very good barring today where markets have been almost down by 4% and if we see from the last eight days, except today, markets are down by 8% or so. These are the opportunities where investors can chip in and start investing 10-15% on these falls, and then over a period of time, build it. The key is not to take knee-jerk reactions and continue to invest.
Juzer, what do you recommend?
Juzer Gabajiwala: Most of the schemes have been named by Harshad. So, I will also go by that.
I think he has only missed out a few on the small cap space. So, one can even look at Nippon Small Cap and Quant Small Cap which has also been doing pretty well. It is more for people who would like to have a momentum type of play. So, some allocation can be considered there.
We should not expect the same returns which we have seen in the last two years to continue. Today the expectation of everybody is that we are going to be having the same sort of a journey. That is not going to happen.
The next question comes ‘Should I get out’? My answer is ‘Please, do not try to time the market’ because I am only telling you not to expect but I don't know what is going to happen.
Stay focused on what you are doing.
People are getting jittery because markets are volatile. But markets will always be volatile, whether you talk about Ukraine and Russia, or tomorrow we have something else. We will just have talking points.
So, continue SIPs, do not stop them. Stick to your asset allocation. People are getting very hyper in the market. When everything goes hunky dory, we tend to lose sight of our asset allocation. Avoid leverage at all costs.
