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Home / Money / Personal Finance /  A Swiss army knife strategy for MFs to reduce your tax bill

Should you own three equity funds covering the large-, mid- and small-cap space, or will a single flexi-cap or multi-cap fund do? Similarly, should you own equity and debt mutual funds separately, or will a balanced advantage fund (BAF) do? Fewer is better if you were to adopt the ‘Swiss army knife’ approach, a term coined by Neil Parikh, chief executive officer of PPFAS Mutual Fund—one of the pioneers of this approach, which has steadfastly refused to launch a large numbers of funds even as it has grown in size.

There were around 1,056 open-ended mutual fund schemes in India as of the end of August 2021, up from 828 in October 2017 when the Securities and Exchange Board of India (Sebi) launched a simplification drive.

Fund houses have filed for highly specific funds playing to themes such as electric vehicles and blockchain. Investors with portfolios of 15-25 funds pay the price in one of two ways. They either devote considerable time and expense on analysing large mutual fund portfolios or simply give up on the task and get sub-par performance. Those who are able to analyse and select a specific mutual fund must also actively shift between them to optimize returns, and this carries a heavy price. Investors who are shifting (rebalancing) between funds incur tax and possibly exit load.

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Satish Kumar/Mint

Redemption from an equity fund attracts a 10% long-term capital gains tax on gains above 1 lakh after one year and a 15% capital gains tax if done within a year’s holding period. In case of debt mutual funds, the tax is at slab rate for redemptions within three years and at 20% with indexation after three years. Exit load is usually imposed on redemptions within a year of investing.

One common argument that is advanced in favour of separate funds is that one fund house may be better in one space and another may be better in another. However, the gains from this type of selection seldom outweigh the money lost to tax during rebalancing. If you look at the top-performing flexi-cap fund over the past five years, its returns at 23% are actually higher than the 22% returns given by a blended portfolio of the top-performing large-, mid- and small-cap funds in the 70:20:10 ratio.

Vishal Dhawan, founder, Plan Ahead Investment Advisors, also added certain caveats to this approach. Another variation of a ‘Swiss knife’ choice is opting for a BAF over separate equity and debt mutual funds. The returns delivered by a 60:40 portfolio in the top-performing equity flexi-cap fund and the top-performing debt fund over the past five years stand at 17.7% CAGR. This is better than the top-performing BAF (Edelweiss BAF) at 15.41%. However, a static allocation without rebalancing would see your exposure to equity growing over time, possibly more than what you are comfortable with. If you do rebalance between separate funds, taxes come into play.

Financial experts continue to have two objections to a ‘Swiss army knife’ strategy. The first is that the Swiss army knife fund in question may not combine the right type of funds for their clients. “In the large-cap space, active funds have been underperforming passive funds for a while. However flexi-cap funds take an active approach in their large-cap allocation," said Dhawan. “Second, investors get excited when they hear news of this or that mid- and small-cap company going up. If they own a mid- or small-cap fund, they are less tempted to directly buy these stocks. In flexi-cap, since the largest allocation is to large-cap stocks, this comfort is less present. This second downside is a behavioural point rather than a technical one, but nonetheless an important one," he added.

Taken to its logical end point, a single fund would give an investor access to all asset classes. Such a category, multi-asset funds, does exist, but it is not heavily promoted by the asset management industry. It is relatively new (created post the October 2017 Sebi circular on reclassification) and has not yet incubated any standout schemes. In an ideal world, marketing and promotion should not matter. However fund houses have a habit of devoting their greatest attention and talent to ‘flagship’ schemes. Hence investors pursuing a ‘Swiss army knife’ strategy may find intermediate solutions such as flexi-cap or BAFs better than multi-asset funds, for now.

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