Hybrid mutual funds can be the next big wave. But do they suit everyone?

A big outcome from the Finance Bill amendment on March 24 is that post-April 1, mutual fund schemes will be subject to three different types of taxation. On schemes that invest 35-65 percent in equities, you will now pay Short-Term Capital Gains (STCG) tax in line with your income tax rates; long-term capital gains (LTCG) will attract 20 percent tax with indexation.

To be sure, the Finance Bill has removed the capital gains tax and indexation benefits for debt funds that invest less than 35 percent in equity. In the third category of taxation, nothing changes for funds that invest at least 65 percent in equities.

For the Rs 40 trillion mutual fund industry struggling to come to terms with the latest tax shocker, this new category of taxation has changed little. The fact that hybrid funds were left untouched by the Finance Bill amendment actually opens new opportunities.

The question is: should you really switch to hybrid funds, if you’re affected by higher taxation on you debt fund investments?

MF industry officials and experts say that the 35-65 percent equity category, which largely makes up hybrid mutual fund schemes, would be under the spotlight.

Hybrid funds comprise six categories: Conservative Hybrid, Balanced Hybrid/Aggressive Hybrid, Balanced Advantage, Multi Asset Allocation, Arbitrage, and Equity Savings.

Hybrid schemes with total Assets Under Management (AUM) of Rs 4.87 trillion are the second-lowest open-ended mutual fund category after Solution Oriented Schemes. Compared to this, Growth/Equity Oriented Schemes commanded AUM of Rs 15.01 trillion as of February-end.

Dynamic Asset Allocation/Balanced Advantage funds, which are expected to benefit from the tax changes, are the most popular categories among the hybrid schemes with AUM of Rs 1.91 trillion.

A better alternative?

Experts say that with a slight upgrade in their risk profile, hybrid funds can offer a better alternative when it comes to generating returns, over and above fixed deposit rates.

In this category, equity allocation can move anywhere between 20 percent and 80 percent or even 0-100 percent depending on market conditions. Currently, 30 such funds are available in the market, but most are keeping their equity exposure in the range of 65-100 percent and debt in range of 0-35 percent.

Equity Savings is a neglected category among hybrid schemes with the lowest AUM of Rs 16,445 crore. But that could change soon.

“For retail investors, hybrid funds would make more sense. BAFs and Equity Savings may come in handy for retail investors as they can take debt allocation in a tax-efficient way,” said Niranjan Awasthi, Head of Products Marketing and Digital Business at Edelweiss Asset Management Company.

Equity Savings and Arbitrage Funds

In Equity Savings, minimum investment in equity is 65 percent and minimum investment in debt is 10 percent while arbitrage is also allowed.

In mutual funds, arbitrage is the simultaneous purchase and sale of a stock to take advantage of the price differential in the spot and futures markets. This helps in increasing the equity exposure in the scheme while avoiding a rise in the risk profile.

Experts say that Equity Savings have largely remained neglected as retail investors generally look at equity allocation in hybrid funds. Case in point, Conservative Hybrid, where equity allocation can stay between 10 percent and 25 percent, has a total AUM of just Rs 22,716 crore.

Kirtan Shah, founder of Credence Wealth Advisors LLP, believes that a lot of money will start flowing into Equity Savings.

“Asset management companies will start pushing Equity Savings as a category for fixed income kind of investments. These funds, in four or five years of history, have kept equity in the 20-30 percent range. If you look at all the other hybrids, the equity range is much higher,” he said.

Apart from Equity Savings, the expert also sees money starting to flow into Arbitrage Funds.

“A pure debt replacement will move to Arbitrage and Equity Savings. However, the problem is that in both these categories, if a lot of money starts flowing in, then automatically the spreads will reduce on the arbitrage. That is one big problem that can arise in the future. If we are anticipating that Arbitrage and Equity Savings will see a lot of flows, then the return expectations have to be slightly tempered,” Shah added.

Can hybrid replace debt?

Over the past few days, fund houses have gone on an overdrive suggesting that investors put as much money into debt funds as they can until March 31 to take advantage of lower taxation.

Many experts say that while some people may feel the urgency to shift out of debt mutual funds to save some taxes, they will realise eventually that debt funds can still outperform traditional FDs. There may just not be other credible options available in their risk profile.

Dhirendra Kumar, CEO, Value Research, said, “In terms of taxation, nothing changes for Liquid funds, Ultra-Short Term and Money Market Funds. Debt funds can give investors great convenience, and also a little better return. Plus, for a fixed income investor, equity is risky. In March 2020, the equity went down by around 30 percent in a few days, and that time people were running for cover and they hate equity for that.”

Experts are also of the opinion that investors shifting from debt to equity will risk having a complete change in their risk profile.

Swarup Mohanty, director and chief executive officer (CEO), Mirae Asset Investment Managers (India), does not like selling a hybrid fund to a debt fund investor. “That’s the worst thing that can happen.”

Edelweiss’ Awasthi added: “Specifically, for longer-tenured bond funds and Target-Maturity Funds, there will be times, even like now (high interest rate regimes), where funds which are closely comparable to a fixed deposit, would still do well.” When interest rates fall, bond prices rise; this benefits your debt funds.

What should mutual funds do?

According to Mohanty, the mutual fund industry used to talk about fixed deposits versus income funds in the early 2000s.

“Maybe we have to start from there now, now that the taxation is similar,” he said.

Deepak Chhabria, CEO of Axiom Financial Services, says that if the debt industry has to survive, it has to bring in alpha compared to other fixed-income products.

“In early 2000s, the return on say a long bond fund used to be around 1 percent higher than the corresponding deposit rate. With indexation and tax benefit, it used to be a decent 1.5-2 percent alpha. That alpha over a period disappeared because of the competitive pressure. The pitch has to change, there has to be an additional return and safety will have to come in too,” said Chhabria.

Another aspect debt mutual funds may look to work on is simplification of language so that they can make themselves understood to lay investors.

“The language that we speak; long debt, duration, CAGR (Compounded Annual Growth Rate), compared to a simple FD 8 percent interest is very complicated. We have had the benefit of taxation until now, but debt sales will continue as usual,” said Mohanty.


Source: Moneycontrol

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