A tweet from @TheMFGuy started the debate on social media a few weeks back. The tweet read: “Like wallets @SEBI_India should now make rules for mutual fund portability allowing to switch from one fund house to another." Portability in a service is the option to move your business to another service provider without losing the identification number (as in a telephone number), or losing the history your account has built up (as in a medical insurance policy where a no-claims-bonus builds up for every claim-free year) or having a tax implication when an investment is switched rather than redeemed.
What does portability in a mutual fund mean? There are four kinds of portability that we need to understand in a mutual fund. First, between asset classes, for example, between stocks and bonds. Second, between schemes, for example, from the large-cap to a multi-cap fund of the same fund house. Third, between fund houses, for example, from the mid-cap fund of one fund house to the mid-cap fund of another fund house. Fourth, between various options in a scheme—for example, switching between growth and dividend or between regular and direct.
There are two kinds of costs that we as investors have to pay when we move between asset classes, between funds and fund options—exit load and tax. The exit load is put in place to deter us from churning, or moving our money too often. The tax is imposed by the government on profits made when we sell our investments.
Portability in a mutual fund would mean that there is no tax liability if an investor is simply moving her money from one asset class to another without redeeming the money for use. It would mean no tax liability if an investor moves her money from a poorly performing scheme to a better performing scheme, within or outside the fund house. If an investor has chosen a multi-cap fund as part of her portfolio to target her retirement and after a few years finds that fund underperforming, she would want to switch to a better performing fund offered by some other fund house. Today she will need to pay a long-term capital gains tax of 10% on her profits. The argument for portability is this: if the money is staying invested and is not getting redeemed for consumption, then why tax it?
Other parts of the market have this portability in different ways. The National Pension System allows two switches between various fund types within a pension fund manager and between fund managers at no tax impact. There is a small transaction cost attached to the switch. Unit-linked insurance policies (Ulips) allows a switch within the funds offered by an insurance firm across, and within, asset classes with no tax impact. An investor can move from a bond fund to an equity fund, and she can move from a large-cap to a mid-cap fund within the options offered by the same insurance firm. Real estate too is portable in a limited way. If you sell a residential property after holding for two years (that makes it a eligible for a long-term capital gains treatment), then you pay no tax on your profit if you had bought another residential property in one year before this sale or within two years of the sale. Looking at the tax treatment of other parts of the market, there does seem to be a case for mutual fund portability as long as investors are not redeeming the money for use but are just reallocating their money.
There is a lot of investor confusion on the differing treatment of the same asset class across financial products (for example, between NPS, Ulips and mutual funds) and with the time it takes to declare something “long term". Equity turns “long term" after holding for one year. Real estate turns long term after two years. Debt, strangely, turns long term after a three-year holding period. There is need to bring parity to different parts of the market and among different asset classes. The capital market regulator can lay down rules on how to switch between schemes and fund houses. But it will be the tax department that will have to make this switch tax-free. Better order in the market and parity between various parts of the market will help investors take better decisions based on the merit of the products and not their tax treatments.
Monika Halan is consulting editor at Mint and writes on household finance, policy and regulation