by Mr.
Dhirendra Kumar, Value Research Online
Once
upon a time, a type of mutual fund (MF)
called monthly income plan (MIP) used to be a great favourite among
conservative investors who wanted slightly better returns than one could get in
fixed income alone. The basic idea of such funds is that they are essentially
conservative fixed income funds with a garnish of equity .
Taxation..!
That
garnish could be 10% to 25%, and its
intent is to boost the returns of the fund to above what can be earned from a
fixed-income fund alone. Essentially , such funds encapsulate the entire
portfolio of a conservative investor who wants a little bit of equity returns
in exchange for a little bit of equity risk. Over any period longer than three
to five years, the equity risk becomes minimal.
The
fly in this ointment is taxation. Long-term capital gains on equity mutual fund
investments if held for over a year is zero (O). However, to qualify as an
equity fund, at least 65 per cent of a fund's assets have to be invested in
stocks.
Clearly
, MIPs do not qualify and are thus exposed to the same tax levels as non-equity
funds. Now, after the recent Budget, this tax load has become even more
onerous.
In
fact, the income tax situation is quite adverse. Having a little bit of equity
in what is mostly a fixed-income fund means that equity returns are taxed as
non-equity . This is actually quite ridiculous, since longterm investments in
equity are practically the only kind of investments that are genuinely tax-free
in India. To generate any equity gains and then get them taxed as non-equity
gains sounds like the worst kind of tax inefficiency .
Traditional
MIP fund
Nevertheless,
in the traditional MIP fund, this is unavoidable. Interestingly , the recent
adverse tax changes on non-equity mutual funds seem to have triggered some
innovation in this area. One of these is the use of arbitrage between equities
and their derivatives to run funds with the low risk and returns level of
fixed-income investments, but the tax treatment of equity .
Such
funds have been around for many years, but have gained new attention in the new
tax dispensation. And now, Kotak Mutual Fund has even launched an MIP -
equivalent fund that uses equity-derivative arbitrage to offer investors the
stability of an MIP with the favourable tax treatment of an equity fund.
How
does this magic work?
The
idea is quite simple. The fund manager looks for opportunities where there is a
price gap between a stock price and its futures price.For example, let's say
the market Rs. 100, and ket price of a stock is the price of its futures a
month hence is Rs. 101. Then, the fund manager could buy the stock &
simultaneously sell the derivative.
Effectively
, this is a predictable and safe gain of 1 % over the month. However, it is an
equity trade, and therefore a fund composed of such investments would get
classified as an equity fund, and its investors would pay no long-term capital
gains tax.
In
principle, this kind of an invest ment does not have the safety level of the
kind of investments that short-term debt mutual funds make, and definitely not
of bank fixed deposits. However, in practice, they offer a much higher posttax
return in exchange for a small technical increase in risk.
The MIP-equivalent
arbitrage fund that Kotak Mutual Fund has launched is slated to dedicate 40% to
75% of its assets to equity arbitrage, 10% to 35 % to debt investments and 10%
to 25% for normal (non - arbitrage) equity investments.
To
ensure tax efficiency , the fund will ensure that total equity & equity
derivative investments that it has stays within the prescribed limits.
About
the author..
Mr.
Dhirendra Kumar CEO, Value Research
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