The Hindu Business Line : Mutual funds — Odds stacked against debt funds

BY OFFERING significant concessions on capital gains tax for securities traded on the stock exchanges, Budget 2004 appears to have made direct investing an attractive option relative to investments routed through mutual funds.

Investors in equity mutual funds may still have reason to cheer Budget 2004, as dividends paid out by these funds continue to be exempt from tax. But the budget proposals may significantly erode the attractions of debt-oriented mutual funds in relation to assured-return savings options.

Proposals for equity funds:

Equity funds have once again been exempt from dividend distribution tax. Equity funds were exempt from dividend distribution tax in 2003-04, but this exemption lapsed on March 31 2004. Investors can now take home tax-free dividends from equity funds for this year as well.

Though capital gains tax has been pruned; this is applicable only to "securities transacted through stock exchanges". When you invest directly in stocks, you may now have to pay only 10 per cent as short term capital gains tax, while long term capital gains is totally exempt from tax.

In contrast, if you route the investments through an equity fund, you may have to shell out long term capital gains tax at 10 per cent. Short term capital gains, on units held for less than a year, will be subject to your marginal rate of tax, which may range between 10 and 30 per cent.

This seems to weaken the case for routing your investments through equity funds. But quite a few equity funds have delivered substantially higher returns when compared to the stock markets over a five-year period. So if you plan to invest for the long term, weigh the higher tax incidence on equity funds, against the value added by the fund manager when you decide between the two.

The best way to reduce tax incidence on your equity fund investments would be to stick to the dividend option. That way, you will be able to periodically encash the returns that your fund earns, in the form of tax-free dividends.

Equity and debt funds can no longer be used for dividend or bonus stripping as both loopholes have been effectively plugged.

If you enter a fund prior to its dividend date, you now have to stay in for at least nine months before you exit.

The turnover tax of 0.15 per cent imposed on all transactions on securities, may peg up transaction costs for equity funds. Since most equity funds churn their portfolios quite frequently, the cascading impact on the expense ratios of funds may be high. Not an issue as long as equity funds outperform their benchmarks by hefty margins; but could begin to hurt if the gap narrows. Higher transaction costs could peg up tracking error for passively managed index funds.

Proposals for debt funds

The Budget proposes to tax dividend distributions from debt funds at different rates based on the identity of the investor. Fund houses will continue to pay distribution tax of 12.5 per cent on dividends paid to individuals. But the distribution tax will be at 20 per cent if paid to others (read corporates). This proposal is welcome in theory. It may force fund houses to segregate schemes into different plans for corporate and retail investors. Only then can differential taxes be imposed on the two sets of investors. Such segregation will help retail investors as they will no longer be subject to the volatile flows and the associated costs that results from treasury flows into debt funds.

But as this differential tax is proposed only for dividend options, in practice, corporates may simply switch their investments from the dividend to the growth options of debt funds.

Returns on the growth option, which are reckoned as capital gains, are proposed to be taxed at the same rate both for corporate and individual investors.

Like with equity funds, direct investments in bonds will be more tax-efficient than investing through debt funds, as transactions in debt fund units will continue to be subject to the earlier rates of capital gains tax, while capital gains tax has been cut for bonds traded through the exchanges.

The growth option may be more tax-efficient than the dividend option for individual investors in debt funds, provided you plan to hold for over a year.

The proposal to levy a 0.15 per cent turnover tax on all transactions in securities seems to include transactions in bonds.

These transaction costs can have a significant impact on bond fund returns. Due to volatile corporate flows, bond funds suffer a significant churn on their portfolios and transaction costs will have to be borne every time the fund puts through a transaction.

Bond fund returns have hovered in the 4-5 per cent range over the past year. If portfolio turnover is high, the impact of transaction costs can be quite sizeable.