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What's better: hybrid or debt?

Short-term debt funds now score over equity-savings funds, as the former allow indexation benefits on LTCG while the latter don't


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Pure equity funds may still manage higher post-tax returns than debt funds. But what about hybrid funds such as arbitrage funds, equity-savings and balanced-advantage funds?
The Budget has substantially whittled down post-tax return advantage that arbitrage, equity-savings and balanced-advantage funds enjoyed over pure debt funds. These funds will now have to outperform their debt-fund rivals (liquid funds, short-term funds, income funds) purely based on their portfolio choices and will not have any tax-related crutches to showcase a higher return.

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The bull run in stocks in the last five years has made it easier for hybrid equity-oriented funds (equity savings, balanced advantage) to soundly trounce pure debt funds. But with the stock market already at relatively high valuation levels, we think this may prove far more challenging in the next three or five years.

To find out how the newfangled hybrid funds (equity-savings funds and balanced-advantage funds, which invest 65 per cent in equities and arbitrage, with 35 per cent in bonds) would stack up against pure debt funds and monthly income plans if the new LTCG tax was applied to them, we took the actual returns of the largest funds in each of these categories and compared their three-year returns.

We found that the equity-savings fund (9.59 per cent CAGR), in this case, proved slightly better than the short-term debt fund (8.43 per cent) and the MIP (8.15 per cent). But then, you should attribute this to a really strong one-way equity market in the last three years, where multi-cap equity strategies have delivered a 12 per cent CAGR. A repeat of this equity performance in the next three years appears difficult and interest rates also look unlikely to head any lower.

Therefore, if you're a risk-averse investor seeking growth for a three-year plus horizon, short-term debt funds or MIPs now score over equity-savings funds, as the former allow indexation benefits on long-term gains while the latter don't.

For dividend-seeking investors, given the high dividend distribution tax of 29.1 per cent on all debt funds, equity and arbitrage funds still make sense, with lower distribution tax of 10.4 per cent. The systematic-withdrawal-plan route on debt funds, however, is a good way to stick with safer debt funds, while enjoying lower tax incidence on 'income'.

Hybrid or debt - which fund is better?

Okay, some hybrid funds have become less tax efficient. But should I continue investing in aggressive equity-oriented (balanced) funds?
If you are a risk-averse investor who invested in aggressive equity-oriented (balanced) funds on the basis of 'assured' monthly tax-free dividends, this may be the right time to cash out (before April 1). Higher equity market volatility may dent their ability to sustain those dividends. These funds will also be suffering a 10.4 per cent dividend-distribution tax on every payout they make.

But if you are an investor with some risk appetite who chose balanced funds for long-term wealth creation, you should stay put with the growth option. The case for investing in balanced funds relies on the fact that equities will deliver returns superior to other asset classes over the long term. Yes, the difference between balanced-fund returns and pure debt options will now be narrowed by the LTCG tax and the lack of indexation benefits on them. But on the bright side, steady-state balanced funds (65-35 variety) take care of the periodic rebalancing of your portfolio between equity and debt on their own and do not need to shell out LTCG or STCG tax every time they do this. You, on the other hand, will need to shell out both LTCG and STCG tax if you attempt periodic rebalancing.

In short, that Budget has given fund investors a lot to think about over the next few days. But when making any rejigs to your portfolio, don't be in a hurry and keep market conditions in mind. Given how hard you've worked to earn those capital gains over the years (we know that making capital gains requires 'effort'), try to avoid exits on the big down days for the stock market and wait for things to settle.

After all, you shouldn't be taking a many-percentage point hit on your entire portfolio just to save a few percentage points on taxes!

Don't worry about double taxation!
How unfair is LTCG
The grandfathering clause Sit tight on good stocks through bad phases Switches are treated as redemptions for tax purposes

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