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Mutual funds sahi hai despite capital gains tax

Author: Balaji Rao/Saturday, February 10, 2018/Categories: Cover Feature, Expert View

Mutual funds sahi hai despite capital gains tax

The Finance Minister finally made the mutual fund investors to bite the bullet by introducing long term capital gain tax on mutual fund gains. Not only there will be  tax on the long term gains, even the dividend received under equity schemes will now be taxed.

The direction and resolve of all budgets are very predictable. While during the first two years of a new government,  announcements tend to be  aggressive, growth oriented with  tough decisions being taken,  the budget preceding  the election year becomes populist, voter-friendly with a lot of rural focus.  Senior citizens also get a special mention in the run up to an election year.

The measurement of how good a budget is can be estimated from how the market closes  on the day of budgetary announcements. The more populist the udget is, there are higher  chances of  market  turning red as the sops  given to the common man bleeds the  economy which is definitely not a good news for market participants. Also, the usual style of all governments  to put money in one pocket by  removing it from the other doesn’t find favour among investors.

In fact, the government had other ways to mop up taxes instead of taxing the hapless mutual fund investors who have just begun to warm up to the concept of investing outside traditional asset classes. Ironically, that’s not the way the government has looked at it. The government could have thought of disinvesting  its stake held in various PSUs that accounts to over Rs3.00 lakh crore or the SUUTI stake with a valuation of  close to Rs1.00 lakh crore and bridged the fiscal shortfall. However,  it seems emptying the wallets of the common man and just leaving a nickel in their pockets is the best strategy for every government.

The biggest USP of  equity mutual funds for advisors and third party product distributors including mutual fund houses (the manufacturers) all these years was that the gains from this asset class on holding for one year and above was fully exempted from tax, but all that is going to change with immediate effect. All these stakeholders have to brace for some hardship, at least in the short-term and think of new ways to entice the investors to invest in such products. .

This also raises some important questions. Will this announcement dampen the spirit of  hordes of new investors who are pouring money into stock markets through the indirect route of mutual funds? Will they refrain from investing? On the brighter side, that may not happen because equity as an asset class is a long term investment proposition and is also goal oriented, considering the fact that the returns from equity and equity oriented instruments have been offering handsome returns on CAGR basis.Even the worst performing diversified equity schemes have generated 12% to 15% returns on 5 year and above time period as per  empirical evidences.So, 10% tax may not make a big difference. But, it all depends on how the market  performs, which is dependent on the performance of  the general economy. If the returns continue to be good, the tax component of 10% may get ignored.

Do investors have any alternative to equity as an asset class? Will they decide to invest their money in fixed deposits? No, despite the tax slapped on the long term gains, investors will have to move on and continue to invest and that’s what perhaps the finance minister has banked on.

There are no free lunches.  Since the beginning of   bull-run  in India from 2002 with a brief pause between 2008 and 2009, long term investors in mutual funds have been the wealthiest investors- particularly those who have followed an asset allocation based investing within their mutual fund portfolios. A healthy allocation of 20% to large cap, 20% to balanced funds, 30% to multi-cap and the rest in mid, small-cap oriented funds in the top 10 fund houses (based on the AUM) would have easily generated CAGR of 16%, which is quite impressive considering the risk-free products have not been able to beat the real inflation numbers.

Thankfully, the returns have been grandfathered and not retrospective which is a good news. Otherwise, market would have burnt to ashes on  February 1.).Meanwhile, there is more clarification expected on the tax treatment since it is announced that the 10% will be taxed on gains above Rs1.00 lakh in a financial year. For example, if an amount of Rs1.30 lakh would be your long term capital gains, then the 10% tax has to be made only on Rs30,000 and not on the entire Rs1.00 lakh. More clarity on calculation and accounting aspects will emerge in the days to come. 

A tax of 10% may be  just the beginning of another round of increased taxes in  coming years which cannot be ruled out. To borrow from  Benjamin Franklin who famously said   that there are only two things certain in human life – death and taxes, so let’s learn to live with it.

Interestingly, while this budget seems to be senior citizen friendly by giving them a few sops which will  make them slightly cash-rich, introduction of  dividend distribution tax on dividend received from equity funds for the same set of citizens will nullify the positive impact to a great extent. Senior citizens have to stop depending on dividend income; otherwise what they have earned from one will be lost after imposition of this tax.

Nevertheless, existing and new investors should move beyond long term gains tax as  it had to happen some day.Investors should focus on their goals and objectives and also make prudent decisions on the fund selection. They should ensure that they follow portfolio based allocation across all core themes and avoid random investing which could prove to be  counterproductive at later stages. It is highly recommended that a good research should be done before investing and if not, engage a qualified advisor to manage your goals and objectives.The loss from 10% tax outflow can be offset with a well-diversified portfolio.

All said and done, Mutual Funds Sahi Hai…..go for it!

The author has written six books on investing and personal finance. He has 23 years of industry experience and six years in academics

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Balaji Rao
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