19 May, 2015

How to build an equity portfolio for the extremely risk averse investor

One of the problems faced by retired people is to make their portfolio earn well so that the corpus lasts their entire lifetime. There is a paradox inherent in that statement. If the portfolio has to earn well, they would need to take some risk – which many seniors may not want to take with their retirement corpus. But if they don’t do that, they run the real risk of the corpus dwindling in their lifetime itself. A real Catch-22 situation!

So, is there any way out?

There is. This can help a person who does not want to take too much risk but also wants to participate in market upsides and inject some steroids into their portfolio. A low risk way of going about it is through a Dividend Transfer Plan.

What is a Dividend Transfer Plan?

A Dividend Transfer Plan( DTP ) is one where the dividend declared in a source scheme is transferred as an investment in a target scheme. The advantage here is that the original investment is intact and only the dividend declared is being transferred out. Hence, in this plan, there is inherent capital protection.

How does it work in favour of a retired person?

Firstly, one needs to invest in an appropriate debt scheme. That way one ensures that the capital erosion possibilities are minimized ( as it is a debt scheme ). This is the source scheme. Next, there would be a target scheme, which would be an equity scheme.

What kind of equity scheme one would want to invest would depend on one’s propensity to take risk. Ideally, it is suggested that the target scheme is a large cap oriented fund, an Index fund or hybrid scheme. These schemes have comparatively lower risk profiles as against a midcap/ small cap/ thematic or sectoral funds. Hence, these schemes may be more suited for a retired person.

When dividends from the debt scheme are transferred to an equity scheme, only the dividend amount is exposed to the vagaries of the market. However, the amounts that get transferred may be small in comparison with the original investment and accretion to the equity fund would be slow. This would work well over a long period, in which time the equity fund would have got enough corpus through dividend transfers and due to the growth from the funds already in the corpus.

By this process equity exposure can be built up without jeopardizing the original investment amount.

How to go about it?

One needs to find out which debt schemes can one invest in, from where dividends can be transferred out. Each AMC would have a list of schemes from which DTP is available. Then one needs to identify a set of equity schemes into which the dividends can go into. Once the DTP mandate has been filled and submitted, it takes about a week to get activated. After that, the dividends start to get transferred into the target equity scheme automatically. One can stop this, if needed, anytime.

What are that tax implications?

If one is in the highest income bracket, dividend distribution tax is 28%+  would be advantageous. In the lower income slabs, the tax paid due to dividend distribution would be higher than the slab they fall under. Hence, irrespective of whichever slab one falls in, the tax paid by the AMC before distribution would be 28% plus, which depresses the amount being transferred to the target scheme to that extent. This is one of the downsides of this dividend transfer plan for those who may be in the lower income tax slabs.

Overall, this Dividend Transfer Plan limits the downside risk of capital erosion as well as helps in building a corpus of equity assets which can potentially offer higher returns, to enable a person to get better portfolio returns. This is a case of a Catch-22 situation being sorted out beautifully. It’s something like having the cake & eating it too!

Author : Suresh Sadagopan   |   Article published in Moneycontrol

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