PPF As A Tool For Portfolio Rebalancing (Yes You Read That Right)

The Public Provident Fund (PPF) is a fantastic tax saving investment. But not everyone makes optimal use of it. Most people just use it as a means to meet the Section 80C limit of Rs 1.5 lakh when being taxed under the old regime. And they may invest the entire annual limit of Rs 1.5 lakh very early into the financial year. But this does not allow them to take advantage of a highly underrated benefit of the PPF account.

There are situations where the PPF can be used to effect one way portfolio rebalancing. In other words, a PPF account can be used to rebalance portfolios for long term goals from equity to debt. This may seem counterintuitive since PPF is quite illiquid owing to an initial lock in period of 15 years. But it can certainly be done. And in today's post I am going to explain how it can be done in detail. I will support my explanation with a worked example using illustrative figures.

Consider the figures given below for a certain long term goal (say a newborn child's UG and PG education). They represent the minimum monthly investments required for the goal. The asset allocation of the portfolio designed for this goal is assumed to be 60% equity and 40% debt. No investments have been made towards the goal at present.

The monthly debt investment required for this goal is Rs 7,408. The debt component of a portfolio for a long term goal must achieve a balance between liquidity and stable returns. For this goal, the balance has been achieved by combining a PPF account (stable tax free returns, but illiquid) with a liquid fund (low risk, low return, but highly liquid). The required debt investment amount has been split equally between these two avenues.

Therefore the monthly amount going into the PPF account would be Rs 3,704. The maximum permissible monthly investment amount in a PPF account is Rs 12,500 (Rs 1,50,000/12). But the amount going into the PPF account every month is only Rs 3,704. This means there is excess capacity available in the PPF account each month as shown below.

This translates into an annual excess capacity of Rs 1,05,552 (8,796 * 12). With regard to portfolio rebalancing, there can be three possible scenarios.

Scenario A : The Portfolio Needs To Be Rebalanced From Equity To Debt

In such a case upto Rs 1,05,552 of the amount redeemed from equity can be parked in the PPF account. This would mean that the amount would continue to grow tax free at 7.1% per annum (current PPF interest rate). The entire amount would not need to go to lower return avenues such as a bank account or a liquid fund. This would allow optimal use of the amount redeemed from equity. An illustrative example of this is show in the graphic below.

Scenario B : No Rebalancing Is Required

In such a case a lumpsum amount of Rs 1,05,552 may be deposited into the PPF account before 31st March of that particular financial year. This would satisfy the available excess capacity of the PPF account in full. It would mean that the PPF account is again being used optimally, since there is no rebalancing required. Of course doing this would mean that commensurate investments would be required in equity, to maintain the intended asset allocation for the goal. Leaving the excess capacity unused is also a viable option.

Scenario C : Rebalancing From Debt To Equity

If the portfolio needs to be rebalanced from debt to equity in a particular year, there is always the option of tapping into the liquid fund. The inherently high liquidity of this product makes it an ideal facilitator of rebalancing from equity to debt. There role of the PPF here is insignificant owing to its relative illiquidity.

Final Thoughts

Clearly, the PPF is more than a great tax saving product. If used smartly, it can be an extremely effective tool for rebalancing. Therefore PPF must be used in line with the demands of our long term goals. The required minimum monthly investment amounts and intended asset allocation for the goal must have a major say in the way the PPF is used. It would allow us to use the PPF a lot better in comparison to blindly rushing to invest the annual maximum of Rs 1.5 lakh each financial year.