Should you use hybrid funds to offset the new debt fund tax?

Photo: iStock
Photo: iStock

Summary

Debt funds with less than 35% equity will always be treated as short term, taxed at slab rate under new regime

The government has done away with long term capital gains tax on debt mutual funds. Any gains on debt mutual funds purchased after 1 April will be treated as short term capital gains, regardless of the holding period. The earlier favourable regime of 20% tax with the benefit of indexation for debt funds held longer than three years has been eliminated. For some mutual fund (MF) advisers and distributors, the solution is to invest in hybrid funds which are treated as equity for tax purposes. Equity funds are taxed at 10% after a 1-year holding period for gains of over 1 lakh in a year.

According to the budget amendment, debt funds with less than 35% in domestic equity are subject to the tougher tax regime. This essentially has created three categories of funds.

(Graphics: Mint)
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(Graphics: Mint)

Debt funds with less than 35% equity will always be treated as short term and taxed at slab rate. Those funds with domestic equity between 35% and 65% will enjoy the benefits of the existing debt fund taxation. If they are held longer than 3 years, they will be taxed at 20% and given the benefit of indexation.

Then there are hybrid funds with more than 65% of their corpus in equity. These will be taxed at 10% if held for longer than 1 year, for gains over 1 lakh per annum. Most categories of hybrid funds fall into this third basket, but use arbitrage strategies to reduce their effective equity exposure. For example, a balanced advantage fund (BAF) might have 67% in domestic stocks but may sell futures worth 30% of their corpus. This effectively converts the hybrid fund into a 37% equity-exposed fund even as it retains the tax benefits of meeting the 65% threshold. This financial engineering has enabled various categories of hybrid funds to lower the tax burden on MF investors.

Among the hybrid fund categories, BAF and equity savings funds are the two most natural substitutes for debt funds with some added risk of equity. BAFs are free to vary their equity-debt split as per market conditions in a wide range (from 0-100% in equity, in theory). In practice, they keep a ‘gross’ equity exposure above 65% to meet the tax threshold and use arbitrage to vary the ‘effective’ equity exposure as per market conditions. Equity savings funds have a similar strategy but the maximum effective or unhedged equity exposure they can take is more limited. This range is specified in their scheme information document, but generally varies from 10-50%. In short, an equity savings fund cannot take more than 50% effective exposure to equity. Generally, fund houses cap this amount at one-third (33%) of their corpus.

Adding equity means adding risk. Unlike debt, the returns on equity can swing wildly. However, over a three-year period, the variation isn’t that much. A Mint analysis of the rolling returns of BAFs and equity savings shows that the minimum 3 year rolling return of equity savings funds (since March 2018) is just 2% lower than a short duration debt fund. In the case of BAFs, the difference in the minimum returns is just 1.3%. One can argue that the time period considered is too short, but it is only over the last five years that the Securities and Exchange Board of India (Sebi) rules on fund classification have been in effect. Thus, entering a hybrid fund may not be as risky as you think.

“My thinking is as follows. For 0-3 months, one should opt for liquid funds. For 3-12 months, arbitrage. For 1-3 years, equity savings funds; and for 3 years and above, it should be either equity savings or BAFs, as a substitute for debt. Both these categories have a large debt component and over long periods equity actually adds to that debt return. If the industry launches some more solutions, I am, of course, open to them. As always, we continue suggest that investors fully utilize their PPF limit," said Amol Joshi, founder, Plan Rupee Investment Services.

Some financial advisors have taken a more conservative stance. "I don’t think there’s a credible hybrid alternative to debt for longer-term debt investors. People who invest in debt for the long term ideally don’t want the risk of equity, however small, in their debt fund. So sticking to debt funds continues to be a good option for them. I expect the industry will innovate and come out with products using arbitrage strategies to cater to this need,“ said Vishal Dhawan, founder, Plan Ahead Investment Advisors.

Mint Take

Hybrid funds are less risky, especially for periods greater than 3 years. If you are looking to lower your tax bill, these might be a good option to pure debt funds. Less risky however does not imply the same risk as debt funds. Hybrid funds are a substitute, but come with higher risk. For more conservative investors, sticking to debt funds still has multiple benefits. You are not taxed until you actually redeem the fund and get the benefit of set off and carry forward of capital gains against your gains or losses in other assets. Debt funds are also flexible: you can invest and redeem any amount on any business day. Fixed deposits, by comparison, are lumpy, attract tax deducted at source (TDS) and are taxed every year on accrued interest (compared to debt funds which are only taxed on redemption).

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