What's best for STP?

Ram, one of our subscribers, recently contacted us, saying he had received Rs 50 lakh from a property sale and wanted to invest in a hybrid fund to build a sizable retirement kitty.

But since Ram knows he should not put the entire money in a mutual fund in one go, he is wondering if stashing the money in an arbitrage fund and then setting up an STP to a hybrid fund over the next three years would be the better option.

That way, he'd be able to spread his Rs 50 lakh investment in a hybrid fund over three years, and at the same time, the money that would lie in the arbitrage fund would earn acceptable returns. (For the uninitiated, please watch this video to understand what arbitrage funds are).

His proposed idea got the number-crunchers working in our dark, damp dungeon excited, now that they had a new project of finding out if there were better options than an arbitrage fund.

But before we lay out the numbers, let's take a step back and understand what on earth an STP is and its benefits for the larger audience.

What is STP
Full name: Systematic transfer plan.

Role: It allows investors to transfer a specific amount from one fund to another at regular intervals.

Benefits: Markets are generally volatile over short periods. Therefore, putting all your money in a mutual fund in one shot is not ideal, as it can fall in value over the short term.
This is where an STP comes in.

It ensures your large sum of money - Rs 50 lakh in Ram's case - is protected from market volatility, while earning acceptable returns that match or beat inflation at least.

Last but not least is the STP's ability to provide the benefits of rupee-cost averaging. In layperson's terms, spreading your investment helps avoid catching the market high. Instead, you invest more when the markets are depressed, and less when markets are expensive. (This is a strategy investors dream of, to be honest).

Now that we know what an STP is, let us tackle Ram's question of whether he should put his Rs 50 lakh in an arbitrage fund and then start an STP to a hybrid fund.

Tackling Ram's question
Arbitrage funds have competition in this space. Besides them, Ram can also think of stashing his Rs 50 lakh in the following options:

• Fixed deposits (FDs)
• Short-term debt funds
• Bank savings account

Let's tackle arbitrage funds first. Over the last 12 months to five years, these funds have generated 3.9-5.19 per cent on average, and their tax outgo is 15 per cent in the first year and 10 per cent after that.

Short-term debt funds. They have delivered 5.68-6.51 per cent returns on average in the last 12 months to five years, and the tax outgo depends on which tax bracket you fall under. For instance, if you earn over Rs 10 lakh per annum and are in the old tax regime, your gains from these funds will be taxed at 30 per cent.

Fixed deposits. FDs have delivered assured returns in the 6-7 per cent range in recent years, but you can be taxed up to 30 per cent on the interest earned. Worse, you'll need to pay tax yearly, unlike short-term debt funds where you pay tax only when you withdraw your money.

Even worse is that FDs aren't very STP-friendly. Here, you need to manually withdraw your money each month to get the STP going. Hence the reason it's not recommended.

Savings account. The humble savings account in your bank offers assured interest of around 3 per cent. (There are a few small banks that provide 6 per cent interest as well).

But even in their case, you can be taxed up to 30 per cent on the interest earned, though interest up to Rs 10,000 is tax-exempted if you are below 60.

What should Ram or you do
There is no clear winner here. Different options have different strengths (and weaknesses).

From a tax perspective, arbitrage funds emerge victorious.

From a returns perspective, they are all closely bunched together. Perhaps, short-term debt funds eke out slightly higher post-tax returns than the other three options. Looking ahead, these funds will provide higher returns as yields of bonds have risen in the last few months. By that logic, returns of arbitrage funds will rise too, as some portion of their portfolio is invested in debt.

That said, returns should not be of paramount importance when you plan to start an STP. You should look at capital preservation instead.

In that case, savings account, FD and short-duration debt funds hold up well. But let's rule out FDs because, as mentioned earlier, they are not well-configured for STPs.

Lastly, if you prefer convenience over an extra per cent or two returns, you can simply stash your money in a savings account and start an SIP to a hybrid fund.

Suggested read: The 3S in mutual funds