Earlier, investments in debt mutual funds (MFs) had indexation benefits vis-a-vis long-term capital gains (LTCG) tax, making investments tax efficient. If you stay invested for three years or more, with the benefit of indexation, tax incidence used to be much lower. Since April 2023, new investments in debt MFs are taxable as short-term capital gains (STCG) at a marginal tax rate. For most investors, this is 30 per cent plus surcharge and cess. This makes tax incidence on debt funds higher than earlier. Dividend option, now called Income Distribution cum Capital Withdrawal option was anyway taxable in the hands of the investor at a marginal slab rate.
Then there was a twist in the tale. In the July 2024 Union Budget, certain changes were made in the context of taxation. Earlier, Fund of Funds (FoFs) were taxable as debt funds. Since July 2024, FoFs are taxable at 12.5 per cent plus surcharge and cess over holding period of two years. Today, there are some funds offered by the MF industry that are debt oriented but taxable at a rate lower than your marginal slab rate.
Fund of Funds
FoFs, over a holding period of two years, are taxable at 12.5 per cent plus surcharge and cess. FoFs may be equity or debt oriented, or hybrid. As long as it is debt oriented, your tax rate is lower than the marginal slab rate for most investors, which makes it tax efficient. The risk profile satisfies the need of the relatively stable portfolio component. The typical structure is allocation to debt funds is, say 60 per cent for the sake of discussion. The balance, 40 per cent will be to Arbitrage Funds.
These are equity funds. However, there is no directional call on equities. That is, returns are not dependent on equity prices rising . It is about the differential, called spread, between price of a stock in the cash/spot segment and the futures segment. This can be part of fixed income allocation. In Arbitrage Funds, the allocation to cash-futures arbitrage is usually 65-75 per cent of the portfolio. The balance is in money market instruments.
One aspect of FoFs is there are two layers of expenses. The FoF has its expense ratio. The underlying funds, in whose units the FoF is investing, have own expense ratio. The funds positioned in this bracket, do not keep expenses prohibitively high. In other words, net of the tax efficiency, for people in higher tax bracket, and two layers of expenses, it is beneficial for the investor.
Multi Asset Funds
Since April 2023, another category of MFs opened for taxation purposes. Funds with allocation to equity in the range of 35-65 per cent of the portfolio, were eligible for LTCG and indexation benefit over a holding period of 3 years. The 2024 Union Budget took away indexation. After July 23, 2024, the funds are taxable viz. LTCG at 12.5 per cent over a two-year holding period.
The typical structure of these funds would be equity at less than 65 per cent of portfolio, say 60 or 50 per cent, 10-15 per cent in commodities like gold or silver, and balance in debt instruments. The question here is, there is an equity component of say 50-60 per cent of portfolio and it is not a pure debt fund. There are two ways of looking at it. One, if AMC (asset management company) is doing an arbitrage strategy in the equity component, then it becomes quasi-debt. Two, this is a hybrid fund and you may allocate to equity in overall portfolio. This 50-60 per cent equity allocation in a fund should fit into overall portfolio allocation.
Arbitrage Funds
The funds earn from the spread in stock prices. The price in futures segment is usually higher than in cash/spot segment, which is captured. Even if equity prices fall, the spread is captured. The funds are quasi-debt in a sense. Technically, these are equity funds, taxable at a LTCG of 12.5 per cent over a holding period of 1 year. For less than one year, these are taxable at 20 per cent.
Gold ETFs
Gold and Silver Exchange Traded Funds (ETFs) are taxable at 12.5 per cent plus surcharge and cess, on 1-year holding period. You can buy and sell ETFs on stock exchanges similar to equity stocks. You need demat and trading accounts with a broker. Online facilities make it easier. There are apps you can download and trade.
Conclusion
Tax efficiency is not the criterion for portfolio allocation. It is done as per investment objectives, risk-return profile and investment time horizon. After deciding on overall portfolio allocation, in debt component of the portfolio, rather than paying tax at marginal slab rate, you may consider these debt-oriented funds. The risk-return profile of the funds is not exactly same as debt funds but similar. You can stay invested over an adequate time period and take home tax-efficient returns.
(The writer is a corporate trainer (financial markets) and author)