Mutual funds in India - Part 2

Quite a bit has changed since I wrote the last post. After more than a decade, the government reintroduced long-term capital gains for equities and equity mutual funds. Does that change anything? Lets see

 

Are Equity Mutual Funds still worth it?

To answer that, we need to look at two factors.

  • What is the rate of return on Equity MFs vs other asset classes?
  • What is the tax treatment on Equity MFs

For the first, there’s a lot of articles such as this and this that show that Equities and Real Estate have been the asset classes that have outperformed over the last decade and longer.

While real estate might have outperformed equities over periods, they have two large disadvantages -  the investment size and the lack of liquidity when you need to divest. Equity investments start in the thousands, real estate in the lakhs. Equities can be sold in minutes, real estate deals often take months and an emergency sale usually means selling at a significant discount.

For the second, the answer is equally clear.

All asset classes other than equities are taxed at your marginal tax rate for short-term gains. Equities are taxed at 15%. Unless your marginal tax rate is under 15%, Equities are  a better short-term investment.

For long-term capital gains, other asset classes are taxed at 20% with indexation. These asset classes fall into the long-term bucket only after being held for 3 years.

Equities are now taxed at a flat rate of 10%, with no indexation benefit. The holding period still remains a year.

This implies that unless you’re holding an asset over a very long period of time, Equities still see favorable tax treatment.

What about something less risky?

So, if you want to allocate part of your portfolio into a set of less risky assets, debt is your best bet. However, it comes with all the disadvantages I mentioned above. Besides, with the specter of rising interest rates looming, debt can badly underperform in the short to medium term.

There is an alternative here -  Equity Arbitrage Funds. These funds make money by taking advantage of short-lived market inefficiencies. Here’s a good article explaining what they do. They attempt to be risk free, but they do hold some risk in that both legs need to be executed together to actually make the money.  In periods of high volatility, they tend to make good money (around the same as debt funds) but can underperform in quiet markets.

if you look at their performance over the last 12 quarters, you’ll see that they have good, regular returns while having very low risk.

Why they’re attractive is twofold

- They don’t depend on interest rates, so are insulated from rising rates

- They’re treated as Equity funds, not debt, so offer superior returns for anyone in the higher tax brackets

Some closing thoughts

  • Equity mutual funds are still the most attractive investment option for the average investor
  • Long term capital gains make them a little less attractive, but not by enough to change that fact
  • Arbitrage funds offer equity-style taxation benefits with a low risk profile
  • If you’re investing in mutual funds, always go the direct route -  through industry platforms such as CAMS, or MF Utilities that are free to use, or through broker platforms such as Coin, which charge a very modest fee.