What do we understand by rebalancing the portfolio? It is all about reworking your asset class mix to make it more realistic and in tune with your long term goals. Portfolio rebalancing is required for a number of reasons. Firstly, portfolio rebalancing is required to restore your asset class mix to the original levels. For example, a sharp bull run in equities may have taken your equity component nearly 10% above the original stipulation. Alternatively, a sharp crash in the market may have reduced your equity component by more than 10%. Both are cases for rebalancing. Secondly, there are market driven factors. For example, equities may be trading closer to their peak valuations or the RBI may have guided a sustained uptick in interest rates. Both call for rebalancing your portfolio. Thirdly, rebalancing is also required with progressing age and proximity to goals. When your goals are approaching you need to reduce your risk in equities to make your portfolio less volatile.
One of the interesting ways of rebalancing your portfolio is to use mutual fund Monthly Income Plan (MIPs) to rebalance your asset mix. Let us understand the benefits of MIPs and how to rebalance the portfolio using MIPs. The need to rebalance portfolio with MIPs may arise when you want to do the rebalancing in a gradual manner rather than in a very sharp and abrupt manner. First, what exactly is an MIP?
So what exactly is an MIP?
A monthly income plan (MIP) is a form of a hybrid fund that is available in the market. Typically hybrid funds come in two categories. Firstly, there are balanced funds that invest predominantly in equities. For example a balanced fund will typically invest around 65% in equities and the balance in debt instruments. The advantage here is that this 65% exposure to equities helps classify this balanced fund as an equity fund for tax purposes. Hence a balanced fund will be able to book gains as LTCG if held for more than 1 year and enjoy concessional rates of tax.
The problem with balanced funds is that they are almost as risky as equity funds and hence for conservative investors looking to earn regular income from these funds it may not be very suitable. They will still prefer a fund that is predominantly invested in debt instruments since that will be less risky, less volatile and more predictable. That is where an MIP fits in perfectly. An MIP is a hybrid that is predominantly invested in debt. For example a typical MIP will be invested to the tune of 80-85% in debt and the balance 15-20% in equities. This makes the returns on MIP substantially predictable while the 20% exposure to equities also provides that added alpha to the MIP holders. That is why an MIP is so attractive to an investor. MIPs also provide regular income!
Using MIPs to rebalance your portfolio..
Assume that there a 50 year old investor who had invested 50% in equities, 45% in debt and 5% in liquid funds. Over the next 2 years, equities went into a major bull run and as a result the new asset class mix is 64:27 in favour of equities. That is more than a 10% deviation from the original game plan. Obviously, that calls for rebalancing your asset class mix. The question is how do you rebalance your portfolio? For that you need to understand that the objective of your rebalancing have to achieve two aims. Firstly, it has to bring back the asset class mix to the original levels. Secondly, the additional investment has to be also income generating on a regular and consistent basis. The answer could be the use of MIP. Here how the actual rebalancing takes place in this case.
Asset ClassCurrent AllocationPercentageMIP AddedNew AllocationEffective asset mixEquityRs.35 lakh63.64%MIP of Rs.20 lakh with debt/equity mix of 80:20Rs.39 lakh52.00%DebtRs.15 lakh27.27%Rs.31 lakh41.33%LiquidRs.5 lakh9.09%Rs.5 lakh6.67%TotalRs.55 lakh100.00%Rs.75 lakh100.00%
In the above case, the investor has a lump sum of Rs.20 lakhs which he must use to combine asset rebalancing and generating regular income. When the corpus is invested in an MIP with an 80:20 mix in favour of debt the entire portfolio gets rebalanced and the new asset mix comes back to 52:41 in favour of equities. This makes the portfolio more stable and reduces volatility. Also, the MIP will ensure regular income.
Making your MIP tax efficient..
The final challenge is to make your MIP tax efficient. If you opt for a dividend plan, then you need to remember that MIPs don’t assure monthly payouts. They can only pay dividends out of income earned; not out of capital. Also dividends may be tax free in the hands of the investor but it is subject to a tax of nearly 29% in the form of Dividend Distribution tax. A better way would be to opt for a MIP growth option and structure the withdrawals as a Systematic Withdrawal Plan (SWP). That will not only make the payouts more predictable but also make it tax efficient since the principal component will not be subject to tax. The next time you need to rebalance your portfolio, look at the MIP option as a veritable method of rebalancing your portfolio. You could actually hit two birds with one stone!