The recent amendments in taxation on gains from mutual fund schemes having lesser than 35% in equity assets have made debt mutual funds taxation at par with Fixed Deposits (FDs), irrespective of the holding period of the investor. Despite losing the long-term indexation benefits, debt mutual funds still provide advantages over FDs.
One of the main advantages is, that unlike bank FDs where the investor is taxed irrespective of tax accrued or credited to the bank account, in debt mutual funds the investor is taxed only at the time of redemption. Another advantage is that an investor can set off capital gains thereby reducing their tax liability, further capital losses can be carried forward to other financial years.
In the wake of these recent tax announcements, hybrid funds have once again come into the investing radar for investors whilst debt funds seem to be less attractive. So are hybrid or debt investments worth investing in now? Let us evaluate this.
What are Hybrid Funds?
Hybrid funds are those funds that invest in a blend of Equity, Bonds, and other asset classes. Some hybrid funds like Multi-Asset or Asset allocator funds invest in international stocks and REITs apart from investing in Equity, Bonds, and Gold.
What is the tax advantage of Hybrid funds currently?
Before the tax change, if an investor had invested in a debt mutual fund and held it for more than 3 years, the investor would get the benefit of indexation with a 20% tax rate. As a result of this, the effective tax rate would be in the range of 10%-15%. This was long-term capital gains on non-Equity instruments. However, post the change, the time definition was removed & as a result of this, there is no long-term or short-term definition for debt mutual funds.
Taxation on hybrid funds is levied as per equity taxation depending on whether the particular hybrid fund is equity-oriented or non-equity oriented. For hybrid funds that invest 65% or more of their assets in equity & equity-oriented instruments, such funds qualify for lower taxation.
When such funds are held for less than 1 year, then gains will be taxed at 15% under the Short-Term Capital gains tax (STCG). However, if the funds are held for more than 1 year then an investor will pay 10% LTCG. Thus, an investor in the higher tax bracket will have tax efficiency by investing in hybrid funds as it will help lower the tax liability.
Conservative hybrid funds, however, invest 75% or more of their assets in debt instruments & as a result of this investors there is taxed as per the marginal tax slab rate irrespective of the holding period, which now makes these funds tax-inefficient.
Let us evaluate the categories of Hybrid funds
In this type of category, there are 3 different sub-categories where there is more than 65% equity exposure or equity-like instruments and these funds are taxed as per equity taxation.
1-Balanced Advantage Funds– Balanced Advantage funds (Dynamic Asset Allocation funds) invest both in equity and debt instruments. The fund manager uses an internal valuation model like Price-to-earnings or Price-to-book ratios or some proprietary research to rebalance the scheme portfolio from time to time. Such a fund usually invests ~ 40% to 60% (by definition 0-100%) in Equity and Equity related instruments. This category of funds is suited for investors who wish to have a dynamically adjusted equity-debt mix in their portfolios. Investors would need to hold such funds for a long-term horizon as these have a sizeable equity component in them.
2-Aggressive Hybrid Funds– Aggressive Hybrid funds are as riskier as balanced advantage funds as they invest ~65% to 80% in Equity and Equity related instruments. In this type of fund, the fixed income allocation is between ~20% to 35%. As the allocation of equity is usually higher than balanced funds, one can expect higher volatility in these funds. A long-time horizon is needed here as well.
3-Equity Savings Fund– In an Equity savings fund, the risk is higher than in a short-term debt fund as these funds have equity allocation in it. The fund manager hedges some part of the equity portfolio by using derivatives exposure and may take exposure to equities and debt as well. These funds provide better tax-adjusted returns than Fixed Deposits as these are taxed as per equity taxation whilst having potentially better returns due to the presence of equity and stock arbitrage.
Conclusion: Investors should not assume that hybrid funds can be a substitute for automatic asset allocation as these asset allocations are done at the fund level, so investors still have to do asset allocation at their individual portfolio level.
In addition, it’s important to note that even though the taxation on debt schemes has become unattractive, conservative debt mutual funds and debt investments do have a role to play in portfolio strategy and goal planning.
Also, investors should bear in mind that tax laws can also evolve over a period of time and therefore an investment strategy that is relevant for today may not be relevant for tomorrow.
To conclude, investors are suggested to opt for hybrid funds only if they are comfortable with the risk associated with them. Enhancing post-tax returns should not be the sole objective of investing in hybrid investments.
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