Hybrid funds with allocation of more than 65% of portfolio to equity, are equity funds for tax purposes. | Photo Credit: Getty Images/iStockphoto
When we think of mutual funds (MFs), we think of equity funds. There are also hybrid funds with their own utility. These funds can add to tax efficiency. To recap, taxation of equity funds, for a holding period of more than one year, is 12.5% plus surcharge and cess. For a holding period of less than one year, it is 20% plus surcharge and cess. For debt funds, it is your marginal slab rate, irrespective of the holding period. For most investors, it is 30% plus surcharge and cess. Hybrid funds with allocation of more than 65% of portfolio to equity, are equity funds for tax purposes. In the process, the debt component of the fund also gets taxed at a lower rate i.e. 12.5%. .
Fund details
There are six hybrid fund categories defined by Securities Exchange Board of India (SEBI). We start with the category called Aggressive Hybrid funds. These funds are mandated to have allocation to equity in the range of 65 to 80% of the portfolio. It is compulsory to have this allocation to equity, hence, this category is just one notch below equity funds. The allocation to debt, 20-35 % of portfolio, leads to lower volatility than pure-play equity funds. Equity allocation being more than 65%of portfolio, taxation is that of equity.
Then there are Balanced Hybrid funds with equity allocation 40-60%. As per rules, an Asset Management Company (AMC) can have either Aggressive or Balanced Hybrid fund not both. Given a fund with over 65% allocation to equity is taxed as equity and investors prefer equity taxation, AMCs have not initiated Balanced Hybrid funds.
SEBI defines Dynamic Asset Allocation or Balanced Advantage Funds (BAFs) as ‘investment in equity/ debt that is managed dynamically’.
However, the MF industry has positioned BAF is in a particular manner.
Equity component is maintained at over 65%, to be eligible for equity taxation. A part of the equity exposure is ‘hedged’. Hedging is done by taking a contra position i.e. sell/short position in stock futures. The effect is the net equity exposure, subject to market volatility, is much lower.
As an illustration, let us say the in a BAF with a corpus of ₹100, equity exposure is ₹75 and debt exposure is ₹25. There is a short position in equity of say ₹35. Thus, the net equity exposure is ₹40. The extent of the hedge is decided by the fund manager as per market valuations. The reason to make the net equity exposure lower than the apparent exposure is to make it defensive. If the equity market were to correct, the adverse impact would be to the extent of ₹40 and not ₹75.
In Equity Savings Funds, SEBI norm sets minimum investment in equity and equity-related instruments at 65% of total assets and minimum investment in debt at 10% of total assets.
There has to be an usual or unhedged exposure to equity, and a hedged exposure to equity adding up to minimum 65% of portfolio. The balance portfolio is in debt. The industry practice is the usual equity component is maintained in the range of 20-40%, and so is the hedged portion.
Though Equity Savings Funds are equity funds from a tax perspective, the equity (unhedged) portion in the range of 20- 40%, resembles fixed income or debt-oriented funds.
Arbitrage Funds earn returns from the price differential between equity stocks in cash market and stock futures market, for 65% of the portfolio.
The price at which a stock is sold in the stock futures market is higher than the price at which it is purchased in the cash or spot market. These funds have 65% or more of the portfolio in cash-futures arbitrage and 35% or less in debt or money market instruments. Returns come from price differential between the two segments.
Multi Asset Funds (MAFs) are those with exposure to a minimum of three asset categories and minimum 10% in each category. Here as well, most AMCs run portfolios with equity exposure of over 65% to be eligible for equity taxation. The balance is invested in debt and gold, or some other asset class.
As we can see in the above fund categories, exposure to equity being less than that of pure-play equity funds, you have diversification built in the fund. At the end of the holding period, you may end up with returns less than equity-only funds, but volatility during holding period will be relatively lower.
Conclusion
If you want to maintain equity exposure at a certain level, in a disciplined manner, you may resort to the relevant hybrid fund.
(The writer is a corporate trainer (financial markets) and author.)
Published – January 13, 2025 06:00 am IST
