For years, debt funds were pitched to investors with a clear emphasis on the tax edge these provided over fixed deposits. Now that this tax advantage has been taken away, many investors feel bereft. Despite their many benefits over FDs, investors appear keen to move away from debt funds towards more tax-friendly alternatives.
According to financial advisers and market observers, equity savings funds, arbitrage funds and even balanced advantage funds are being considered for superior tax-efficiency. These get taxed as equity investments, resulting in a lower tax liability of 10% on any capital gains exceeding Rs.1 lakh in a financial year. Feroze Azeez, Deputy CEO, Anand Rathi Wealth, observes that hybrid funds will now be the flavour of the season. He remarks, “Inflows will continue, especially on the retail side, by mixing products which have both equity and debt and not just debt or gold or any other asset class standalone.”
Hybrid funds may not be good substitutes for debt funds
Most hybrid funds exhibit higher drawdowns and volatility than debt funds.
Several advisers are asking investors to take this path. But others are cautioning against using hybrid funds as debt alternatives. Bhavana Acharya, Head – Mutual Funds and Equities, Primeinvestor.in, says, “There is a high chance that you would be sold hybrid funds not fitting your risk profile or time frame. Please stay clear of such sales pitches.” Most hybrid funds would be poor substitutes for debt funds. There is varying degree of equity exposure in these funds which puts them on a different risk profile. Santosh Joseph, Managing Partner, Germinate Investor Services, likens the shift to substituting tax risk for market risk.
“The tax nudge is pushing investors to be more aggressive and risk taking in their investment choices,” he says. Even supposedly safer categories like equity savings funds are not strictly fit as alternatives for debt funds. These funds run around 20-40% exposure to equities together with arbitrage bets taking total equity allocation to 65%, with the rest parked in fixed income. This modest net equity exposure is enough to introduce risk not many would be comfortable with. Over one year time frames, equity savings funds have fetched higher returns than short duration debt funds, but they have experienced sharp drawdowns and volatility aswell. Low interest rates for the past few years weighed on debt fund returns even as hybrid funds’ return got propped up by high performance of equities. This scenario can change dramatically going forward.
Acharya remarks, “When equity goes down, you cannot expect equity savings funds to provide the support that debt would. They can form part of shorter duration portfolios for their tax efficiency but there is a return penalty in the long term.” Also on investors’ radar are balanced advantage funds. These are often pitched as the ideal avenue to weather volatile market conditions. But if equity savings funds lie several notches above debt funds on the risk spectrum, these also have a high element of risk. Balanced advantage funds typically alter equity allocation between 30% and 80%. Even if some part of this exposure is hedged using derivatives, it still leaves investors open to high risk in certain market conditions.
This makes balanced advantage funds a very poor choice as a defensive arm of your portfolio. “Based on hedging strategy, they can be similar to aggressive hybrid funds with very high equity exposure. That again makes them poor debt substitutes. While you can increase allocation to these funds for tax benefits, do not expect them to take over the role of debt in your portfolio,” says Acharya. Joseph avers, “There are various sub-categories within balanced advantage funds offering varying levels of equity exposure, with the nature of exposure also differing a lot. It is difficult to fathom how much risk you are taking on.”
However, some insist that a shift to hybrid funds need not necessarily alter the investor’s risk profile. Azeez feels investors can maintain similar risk profile within their preferred asset allocation. “Most investors have debt and equity in their portfolio but in separate funds. The smart thing to do now is combine them in a single hybrid fund.” Instead of paying 30% tax on your debt funds gains and 10% on the equity side, a combined fund will be taxed at the lower rate of 10%. Amol Joshi, Founder, PlanRupee Investment Services, insists such a switch will not alter asset allocation much. “Investors who were investing via separate funds can shift to certain hybrid categories if the risk appetite permits by adjusting portfolio allocation once.” However, Joshi warns anyone doing so to first maximise their fixed income allocation in traditional avenues.
