So far, these funds used to be known by the rather odd name of 'Equity Income Fund'. Now, under SEBI's 'Categorization and Rationalization of Mutual Fund Schemes', they have officially been named 'Equity Savings' funds. Let's see what's different about these newly named funds, and how they can deliver lower-risk while having the same lower tax liability as the balanced or equity funds that investors are used to. Fund investors know that under the tax laws, capital gains from equity investments are zero if you stay invested for more than one year. At least, that's the status right now, notwithstanding rumours that this could change in the coming budget. To qualify as an equity investment, a fund must invest more than 65 percent of its assets in equity. If the equity exposure drops below this level, then the risk will be lower, but investors will have a heavier tax liability, as for any income fund.

That's the problem that Equity Savings funds solve. They deliver lower equity exposure, combined with the lower taxation of equity funds. They do this by utilising equity derivatives in such a way that the returns are predictable and safe, while the investment is still classified as equity for tax purposes. Therefore, if one creates a balanced fund where some of the equity exposure is in the form of arbitrage trades, then one gets the very useful combination of lower risk and lower tax.

The idea is straightforward. The fund manager looks for opportunities where there is a price gap between a stock price and its futures price. To take a simplified example, let's say the market price of a stock is Rs 100, and the price of its futures a month hence is Rs 101. Then, the fund manager could buy the stock and simultaneously sell the derivative. Effectively, this is a predictable and safe gain of one per cent over the month. However, it is an equity trade, and therefore a fund composed of such investments would get classified as an equity fund, and its investors would pay no long-term capital gains tax. In principle, this kind of an investment does not have the safety level of the kind of investments that short-term debt mutual funds make, and definitely not of bank fixed deposits. However, in practice, they offer a much higher post-tax return in exchange for a small technical increase in risk.

There are now fifteen such funds. In comparison to balanced funds, their returns are modest--over the last year, an average of 14.3 per cent compared to 24.2 per cent. However, their potential for quick decline is also limited. The average decline in the worst month that equity savings funds have suffered is 4.5 per cent. The equivalent for balanced funds is 13.3 per cent.

Of course, as I mentioned earlier, the existence and utility of such funds depends heavily on the current tax laws. As it happens, the periodic rumours that there will be a change in the tax exempt status of long-term capital gains is particularly strong before this year's budget. If they are true, there will be some readjustment in the approach to these funds, but their basic utility is unlikely to be dented.