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Will Mr Jaitley restore balance to hybrid funds today?

Tax laws force balanced funds to be run almost like equity funds if they have to be tax efficient for their investors

Will Mr Jaitley restore balance to hybrid funds today?

Over the last few weeks, there has been some speculation that the in the Union Budget that is to be presented later today, the Finance Minister will tighten the provisions governing long-term capital gains tax on equity investments. The most common expectation is (fear?) that the minimum holding period for getting tax-free returns on equity and equity fund investments will be increased from one year to three years. Obviously, practically everyone who has anything to do with equity investments is aghast at the nature and timing of this suggestion, with the strange exception of the Bombay Stock Exchange, which actually appears to have lobbied the ministry for such an increase.

There are valid arguments on both sides, and I'm sure the finance ministry will ignore all of them in deciding what to do. However, it's important to note that in the case of equity funds (as opposed to stocks that investors buy themselves), there is yet another variable, which is the definition of an equity fund. Practically speaking, there's no such thing as a pure equity fund, as in which is always deployed 100 per cent, to the last rupee, in stocks. All equity funds keep some small amounts in cash or cash equivalents, or in some fixed-income instruments. There are also hybrid (balanced) funds, which by definition are a combination of equity and fixed-income investments. Balanced funds are an important type of fund, in which more than ₹50,000 crore are invested. Moreover, they are an ideal type of investment for the beginner investor or the hands-off investor.

However, the way tax laws define an equity fund impacts not only how much tax do balanced fund investors pay, but also the investment strategy that the fund managers follow. If tax laws were not part of the picture, one could say that a balanced fund manager could perhaps run with an equity:fixed-income ratio of anything between 40:60 to 80:20, depending on the stance of the fund and the state of the equity markets. However, it is of enormous advantage to balanced fund investors if these funds are to be qualify as equity funds under the tax laws since investments of over one year qualify as long-term capital gains and have no tax liability.

The tax laws state that to qualify as an equity investment, a mutual fund must have at least 65 per cent of its assets invested in equities on a monthly average basis. This is quite a high bar. Effectively, it means that to give a cushion for sudden declines of equity values, fund managers run with an equity exposure of at least 70 per cent equity. Moreover, when you are in this range, you end up having funds which have the return and volatility characteristics that (to investors) are pretty much indistinguishable from equity funds. The result is funds that get chosen and bought for high returns, and are thus managed for high returns.

The net result is that a type of fund that should be a less volatile hybrid of equity and fixed income gets converted into a volatile pure equity fund if it is to be tax efficient for its investors. The solution that the fund industry has asked for is the reduction of the equity qualification point from 65 per cent to 50 per cent. In fact, till about ten years ago, that's what it used to be and till that time, balanced funds offered a real balance of the returns of equity, tempered by the stability of fixed income investments.

It is notable that unlike practically every other tax-related demand that the FM must have heard, this one has no obvious revenue loss for the government. Lowering the equity limit to 50 per cent would lead to more appropriate investment options for mutual fund investor, but probably not lower tax collections for the government.