What Is STP in Mutual Funds and Why It Makes Sense at a Market High

September 19, 2024 Mutual Fund

The Indian equity market in 2024 is navigating a blend of opportunities and challenges. As of mid-2024, both the NIFTY 50 and the S&P BSE Sensex have shown significant growth, reflecting India’s resilient economic fundamentals, strong corporate earnings, and investor confidence. However, this growth is tempered by global macroeconomic factors like rising interest rates, inflation concerns, and fluctuating oil prices, which continue to impact market sentiment.

In the volatile market of 2024, mutual funds have emerged as an attractive investment option due to their ability to provide diversification and professional management. By investing in a mix of assets across various sectors, mutual funds help mitigate risk, especially in an environment where factors like inflation, interest rate hikes, and global tensions create market uncertainty.

When it comes to mutual fund investments, investors are often familiar with Systematic Investment Plans (SIPs), which are widely recognised as a disciplined approach to investing. SIPs also make mutual funds appealing in a market where indices like NIFTY 50 and S&P BSE Sensex are at all-time highs. However, another equally powerful tool, especially during times when markets are rising, is the Systematic Transfer Plan (STP).

[Read: STP in Mutual Funds and How You Can Use It to Tackle Volatility]

In this article, we’ll explore what STP is, how it works, and why it makes sense during market highs. We’ll also elucidate the difference between SIP and STP, helping investors understand when and how to use these strategies.

Understanding the Basics of Systematic Transfer Plan (STP)

Systematic Transfer Plan (STP) is a strategy that allows investors to transfer a fixed amount of money at regular intervals from one mutual fund scheme to another within the same fund house. Typically, STP is used to shift money from a debt fund to an equity fund or vice versa. This transfer happens systematically, thus allowing investors to capitalise on market opportunities or reduce risk by balancing their portfolios.

How Does STP Work?

STP works by automating the transfer of money between two mutual fund schemes. Investors usually park their lump sum in a low-risk mutual fund, such as a liquid or debt fund, and then gradually transfer a pre-decided amount into an equity fund over time. This strategy helps mitigate the risk of investing a large sum during volatile market conditions or when markets are at their peak.

For example, if an investor parks Rs 5 lakh in a debt fund, they can set up an STP to transfer Rs 25,000 per month into an equity fund over 20 months. This approach enables the investor to diversify their exposure to equity across different market levels, thus averaging their cost over time.

Types of STPs

There are different types of STPs based on the frequency of transfer:

• Fixed STP: A fixed sum is transferred at regular intervals (monthly, quarterly, etc.).
• Capital Appreciation STP: Only the profits generated in the original fund are transferred to another fund, leaving the capital intact.
• Flexible STP: The investor can choose how much to transfer based on market conditions or personal preferences.
• Swing STP:  Under this type of STP option, the investor is allowed to pre-set the exposure in the respective schemes based on the target market value. The transfer/swing takes place based on the target market value set, which could be more or less than the investment meant to be in the target scheme on the respective transfer date.

Why STP Makes Sense at a Market High

When the stock market is at a peak, it can be nerve-wracking for investors to deploy large sums of money in one go. Equity markets are known for their volatility, and investing lump sums at market highs increases the risk of buying at inflated prices. Here’s why STP is particularly useful during such times:

1. Averaging the Cost

When markets are high, there’s always a risk of a correction. By using STP, you can spread your investments over a period, thus averaging the cost of purchasing units. This is known as rupee cost averaging, where you buy more units when the market is down and fewer when it’s high. This helps in managing the volatility of equity investments and protects against the risk of buying at an unfavourable price point.

2. Lower Market Timing Risk

Timing the market is extremely difficult, even for seasoned investors. By opting for STP, you reduce the risk associated with trying to time the market. Instead of investing a lump sum at a potentially overvalued level, you can spread your investment over time, ensuring that you participate across different market levels. This approach smooths out the impact of short-term market fluctuations.

3. Gradual Equity Exposure

In a rising market, investing in equities all at once can expose an investor to a sudden downturn or correction. An STP allows for a more gradual increase in equity exposure, giving investors more control over their portfolios. This is especially beneficial when markets are near their peak, and the chances of a pullback are higher.

4. Minimising Emotional Decisions

Market highs can tempt investors to either pull out completely due to fear of a downturn or invest aggressively in hopes of higher returns. Both strategies are rooted in emotional decision-making. STP introduces discipline and helps in making systematic investments without letting emotions dictate the process. It brings about a balanced approach to investing, especially during uncertain times.

5. Maximising Debt Fund Returns

While waiting for the equity market to present a more favourable entry point, your money remains invested in a low-risk debt or liquid fund. These funds generally provide better returns than leaving money idle in a savings account, allowing you to earn modest gains while you gradually move your investment into equity.

[Read: Adding New Mutual Funds for Better Gains? Here’s Why It Could Be a Risky Move]

SIP vs. STP: What’s the Difference?

Both SIP and STP are systematic investment tools, but they differ in their application and purpose. Understanding the difference between them is crucial for selecting the right strategy based on your financial goals and market conditions.

Tax Implications of STP

Each transfer made via STP is treated as a redemption from one scheme and a purchase in another, which could trigger capital gains tax. The tax treatment depends on the type of fund you are transferring from:

[Read: The Changes in Capital Gain Tax Done by Modi 3.0 Budget 2024-25 You Need to Know]

• Equity Funds: Gains from equity funds are considered long-term if held for over one year, and they attract long-term capital gains tax at 12.5% for gains exceeding Rs 1.25 lakhs in a financial year with effect from July 23, 2024.Gains on redemption of equity mutual fund investment held for less than 12 months will be considered short-term capital gains (STCG) and will be taxed at 20% (as per July 23rd Modi 3.0 budget announcement) compared to 15% earlier.
• Debt Funds: Gains from debt funds are considered long-term if held for more than three years and were taxed at 20% with indexation benefits. Notably, the government had amended the Finance Bill in 2023 under which it removed the indexation benefit for debt mutual funds. Given that, the gains would now be taxed as per your income-tax slab (just like the way STCG on debt mutual funds are taxed).

It’s important to factor in these tax implications when opting for an STP in mutual funds.

Choosing the Right STP

When opting for an STP, ensure that the STP aligns with your financial goals, whether it’s wealth creation, risk management, or goal-based investing. Use STP strategically in times of market volatility or when markets are peaking. Choose the right funds for STP, keeping in mind your risk appetite and financial objectives.

Using an STP calculator helps you understand how funds are systematically transferred between schemes, showing the growth potential of your investment’s equity and debt/liquid components.

Simply input the investable amount, STP duration, and the expected returns from both the Equity Fund and Liquid Fund to get instant results.

Based on the return assumptions you provide, the calculator estimates the potential returns from each fund and gives you an indicative future value of your investment.

PersonalFN’s STP Calculator for a detailed calculation.

To conclude…

STP is a powerful tool for investors who want to gradually shift their money from one fund to another, especially during volatile market conditions. It helps reduce market timing risk and allows for a smooth transition between asset classes. During market highs, STP helps in averaging costs and mitigating risks, making it a prudent strategy for lump sum investors.

While SIP and STP share some similarities in terms of systematic investing, they cater to different investment needs and goals. Understanding when to use each can significantly enhance your investment strategy, especially in today’s unpredictable market environment.

By incorporating STP into your investment plan, you can balance risk, capture market opportunities, and ensure a more disciplined approach to managing your portfolio, particularly when market conditions are uncertain.

This article first appeared on PersonalFN here