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Aarati Krishnan

THE Budget makes several changes to the tax dispensation for mutual fund investments. Here is what the proposals mean for retail investors and how they may have to rejig their strategy for mutual fund investments:

If you are invested in equity funds...

Stay invested, but switch to the dividend option

Don't pull out of equity funds just because of the higher tax element, especially if you plan to stay invested for the long term. For one, evaluate if you will be able to match the returns delivered by the fund manager if you select stocks on your own.

Quite a few equity funds have delivered returns that are 5-10 per cent higher than those on the broad market over a five-year period. This may more than make up for the higher tax element.

Second, you can stick to equity funds and still take home tax-free returns, if you stick to the dividend option of the fund, rather than the growth option. Dividends distributed by equity funds are proposed to be exempt from distribution tax allowing you to encash your returns periodically whenever the fund declares a dividend.

The dividend option may also be preferable because it enables you to skim off excess returns from the fund and re-balance your portfolio when the market is on a high.

Stick to top-notch funds

The case for investing in equity funds is no longer reinforced by their superior tax efficiency. This makes it all the more important for you to make sure that the fund managers you have chosen will deliver value in the form of higher returns, in comparison to direct investments in stocks. So choose your equity funds carefully and go only for those with a consistent track record.

Weaker case for sector/index funds

Index funds, which will now find transaction costs pegged up because of turnover tax, may find it a little more difficult to accurately mirror the index.

Stock market indices are rejigged quite often in the Indian context and index funds do not necessarily come with low portfolio churn.

The more often index funds turn over their portfolios, the higher the transactions costs and thus, the gap between their returns and that of the index. That active funds have convincingly beaten index funds over a five-year period, of course, remains the key reason to prefer the former.

Sector funds are usually suited to informed investors who have a view on a particular sector. Investing in sector funds may call for a fairly active strategy on the part of the investor, in terms of buying and selling investments.

With such transactions set to attract short term capital gains tax at the marginal rate, investors may have examine if they would be better off choosing specific stocks from the sector on their own.

If you are invested in debt funds...

Check out small-savings schemes

With the interest rates on small savings schemes retained, these remain islands of high returns. Returns on debt funds have dwindled to the 4-5 per cent range in recent times in line with the market rates.

If liquidity is not a priority, investors should lock into the higher investment returns available on small savings schemes, for a significant portion of their portfolio and only then, consider debt funds.

Keep an eye on costs

The transaction tax on bonds will peg up costs for debt funds. Unlike equity funds, where turnover tax may not matter in light of the potential for double-digit returns, transaction costs of even 0.15 per cent could whittle down the already low returns on bond funds. Investors may have to keep an eye out for fund costs and avoid those with higher expense ratios.

Growth or dividend?

If you plan to stay invested in a debt fund for less than a year, go for the dividend option. Any dividends paid out by the fund to you will bear a distribution tax of just 12.5 per cent.

The same returns if earned by way of appreciation on the NAV will be subject to short term capital gains tax at your marginal rate (could be 10-30 per cent).

If you plan to stay invested for over a year, go for the Growth option. The long-term capital gains you earn by way of NAV appreciation would be taxed at 10 per cent. But dividends would be subject to a higher rate of tax at 12.5 per cent.

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