Are MIPs useful as a form of hybrid mutual funds - Motilal Oswal
Are MIPs useful as a form of hybrid mutual funds - Motilal Oswal

Are MIPs useful as a form of hybrid mutual funds?

Monthly Income Plans (MIP) has emerged as a distinct asset class category within mutual funds. To put things in perspective, MIPs are the reverse of normal balanced funds.  A balanced fund maintains a minimum 65% exposure to equities and only the balance is invested in debt. The idea is to combine the capital appreciation of equity with the stability and regular returns of debt. The 65% exposure to equity is designed to maintain their status as an equity fund for taxation purposes which gives them a better mileage in tax treatment.
But a 65% exposure to equity makes the product quite risky and many first time investors and conservative investors are slightly wary about balanced funds. What MIPs do is to reverse the equation by allocating a much larger allocation of 65-70% to debt instruments and the balance to equity instruments? For taxation purposes, an MIP remains a debt fund but due to its higher debt exposure a MIP is safer and also assures regular income with a greater degree of certainty. At the same time, the small exposure to equities ensures above market returns and enhances the returns on the MIP overall compared to pure debt funds.

So, what is a hybrid MIP all about?
The difference between hybrid and balanced mutual funds is quite clear and let us also look at hybrid mutual fund returns. A MIP is not only a debt oriented fund with a small exposure to equities but also pays out dividends on a regular basis. That is how the name MIP comes but essentially it is a hybrid fund with a predominant exposure to debt. This is a good starting point for more conservative investors in mutual funds. Such MIPs are typically structured as regular dividend payout plans. While dividends are tax free in the hands of the investor, there is a fairly large dividend distribution tax that is levied on dividends distributed. The table below explains the DDT on MIP funds..

ParticularsAmountExplanationDDT on debt fund dividends25%Applicable to all non-equity fundsSurcharge levied on DDT3% (12% on 25%)This rate was recently increased from 10% to 12%Cess on tax payable1.12% (4% on DDT + surcharge)The cess was increased in 2018 budget from 3% to 4%Total Tax Payable as DDT by individual MIP investors29.12% (sum of the above)This is the total DDT on the Gross dividend on MIPWhat the MIP declaresRs.100 (Gross dividend on MIP) What the investor getsRs.70.88 (Net dividend earned) 

Are MIPs useful as a hybrid mutual fund product?

Monthly Income Plans (MIP) is a great entry level product for retail investors who can start off with conservative fund products with a small exposure to equities and then go higher on the equity plan once there is a certain comfort level.

MIPs regularly declare dividends hence the name MIP. Hence this product is preferred by conservative investors and retirees who are looking at regular income. However, as shown in the table above, out of every Rs.100 declared as dividend, only Rs.70.88 reaches the pocket of the investor due to the high incidence of DDT on dividends.

An MIP can only declare dividends from earnings and not from capital. An MIP earns returns from 4 sources viz. interest on debt, dividends on equity, capital gains on equities and profits on debt trading. These four sources can be netted and that can be used to pay out MIP dividends. But strictly paying dividend out of capital is not allowed.

Unlike what a lot of first time investors are led to believe, MIPs are not assured return products. An MIP can only declare dividends when it makes money from regular interest, dividends and from trading. If the MIP makes losses then there will be no income to distribute among the investors. That means; there will be no monthly payout to investors. So, perish the thought that MIPs are assured return products; the name can be quite misleading.

As an investor in MIP, you are exposed to the larger risk of debt exposure and the smaller risk of equity exposure. The risk is entirely yours and the monthly income is subject to the fund actually earning returns on their capital. Your risk in an MIP is the same as any normal combination of equity and debt funds.

MIPs are largely invested in fixed return debt instruments with high rating quality and long maturities. Such instruments are negatively impacted when rates move up. Considering that the RBI has already hinted at rate hikes in 2018, investors in MIPs need to tread with caution.

Dividends paid out by MIPs are tax-free in the hands of the investor but there is DDT at 29.12% (as explained earlier) which substantially reduces the investor’s retention of dividends. You need to factor that into your calculations while calculating MIP returns.

MIPs are efficient if sold after 3 years since they will be classified as long term capital gains. That means they will be taxed at 20% after considering effect of indexation. The indexation effect can be stretched by buying MIPs close to the end of the fiscal year and selling immediately on commencement of the fourth fiscal year.

Remember, dividends are not technically assured but as an unwritten principle, MIPs do tend to ensure that dividends are declared at regular intervals. Surely, if you are looking at a conservative asset class with some prospects of growth, then MIPs are a really good option.

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