Budget 2018 And Its Impact On Mutual Funds

As experts debate the long term capital gains tax, the bigger worry is its impact on long-term equity investments.

Budget 2018 left investors in Indian equities unhappy. Finance Minister Arun Jaitley reintroduced the long-term capital gains tax on stocks. Gains of over Rs 1 lakh on shares held for more than a year will be taxed at 10 percent from 1 April. Jaitley also retained the short-term capital gains tax at 15 percent.

As market experts debate the fairness of the tax, the bigger worry is its possible impact on long-term equity investments. The benchmark S&P BSE Sensex is down a little over 7 percent from its January high, as investors grapple with the double-whammy of a global sell-off and tax concerns.

For independent financial advisor Harsh Roongta, the impact so far has been more sentimental than anything else. Mutual fund investors should look at investments as a means to an end and not the end itself, he said. “The end is meeting the goal for which you’re making those investments.”

Roongta said the stock market sell-off has not been big enough to warrant a major concern. The index levels are higher than what they were on January, he reiterated.

For somebody who is planning for the long haul, this is not something which should change anything for now. It is something which you should keep an eye on. If you are planning for short term —  for the next two-three years— maybe then you should review.

Harsh Roongta, independent financial advisor

Here’s the edited transcript of the interview:

From a mutual fund investor’s perspective, does this budget cause some real damage or can an average mutual fund investor or a product can take it in its stride?

Harsh Roongta: Let me put it in two buckets, one is sentimental and other is facts. On sentiment, any tax causes negative perception. So, to that much extent tax on something that you were supposedly enjoying for free for 13 years, it causes a negative perception. Fact is what is the impact of all of this? Investors should be looking at investments not as an end in itself. Investments are a means to an end.

The end is meeting the goals for which you are making those investments. Investment is not a sport, you don’t have to come first, but you have to complete the race. I think, most investors are beginning to understand that now. Let’s look at the impact of fact of such an event of new tax for such investors. Two things can happen. Because of tax your return from equity comes down.

So, you might want to evaluate to see whether the investments that you were making to meet your goals, whether they need to increased now because the assumptions around returns, you may reduce versus what they were earlier. I will do it, not now but when the legislation actually gets into place. Maybe there will be changes, so that is not something which I will do right now.Second, which is not related to LTCG tax directly, but to the down trend in equity, typically a big spike, plus or minus could trigger an asset allocation review.

You should anyway review your asset allocation consistently once a year. But if there is a big spike up or down, then you would want to do a midway review. Right now, I don’t think there is big spike. There is a 5 percent spike, but the index level is still higher than what they were on 1 January. If you plan your portfolio for equity or debt, if your equity has fallen because of the fall, may be there is a case to increase the equity. But in most cases, they have not reviewed when the equity increased.

So, they will not find any need to review the asset allocation unless it is normal review date, in which case they should do it. In short, for somebody who is planning for the long haul, this is not really something which should change just anything. It is something which you should keep an eye out for. If you are planning for short term, for next 2-3 years, maybe then you should review.

What have you told your small ticket clients about a tax on SIP?

Gajendra Kothari: Any investors we met, they are aware of this. So, everybody has taken note of this budget. We have comfortably taken for granted 13 years of the non-tax regime, so now when it suddenly comes back, it is uncomfortable. Any change for that matter will be uncomfortable. It is 10 percent LTCG tax at the time of withdrawal.

One should appreciate that this is a deferred tax. Unless you are going to withdraw we don’t have to pay tax. For the last 13 years, I have been an SIP investor. I have only put money into markets and I have never withdrawn it. For me, if there is a tax or not tax, does not matter me. One should understand the power of deferment. It is compounding in itself.

In FD, if you are in a 30 percent tax bracket and you have gone for a deposit which will mature after five years and after that you will get a cumulative amount, but you have to pay tax every year. There is no deferment. So, this in itself a great thing. This is not a material impact. It will have some impact but the kind of returns you get in equity over a longer term is far more than any other options that you can consider.

The price as of 31 January now becomes your base price. If you sell it post 1 April, then the NAV of 31 January will be the base price and the gains are calculated on that front. Is it right?

Harsh Roongta: Broadly yes. There is nothing in tax is complete. There would be so many exceptions. That is the higher base provided, otherwise, the cost remains same. It could be the base provided you completed one year. There are many such exceptions. People talk about tax harvesting. You should sell a bit every year and take advantage of 1 lakh. Don’t try this at home. Tax harvesting is for the rich folks because it requires expertise, which costs money. Tax harvesting makes sense, but the amount of investment you need to bear the cost of tax harvesting, which is the expertise, is large. So, don’t try it at home with small investments.

Will the number before and after LTCG change?

Gajendra Kothari: Yes. But it also means that this 14 percent difference is over a 5-year period. So, per annum is just 1-2 percent. If equity gives you 15 percent return, still you are making 13-13.5 percent return which is far better than any other asset class in the long term can give you.

How will the money flow back to ULIPS because they have a tax advantage over mutual funds?

Harsh Roongta: The tax reduces your return. Therefore, the tax exemption for ULIP will not reduce the return. ULIP is a mixture of an insurance policy with a mutual fund. The mutual fund portion will not have its return reduced, whereas in a mutual fund where if I invest in an equivalent equity mutual fund, then my return will be reduced by a certain percentage. It is an advantage that ULIP enjoys.

Disadvantage: Unlike mutual funds, I am stuck with the insurance company. I can shift funds within the insurance company, but I cannot shift out for 5 years. The principal of ULIP works on the fact that some amount of expenses are upfronted which you will get the benefit in later years. But overall the expenses ratio will be less the mutual fund or equivalent to direct funds.

If you get out after 5 years, you will be losing a lot. You are going to pay cost for the insurance. It is exempt only if the insurance is 10 time your premium. If I am investing Rs 50,000 per month, its Rs 6 lakh a year in equity mutual fund. If I was to do that in a ULIP, my insurance sum assured needs to be Rs 60 lakh for the Section (10) (10D) to apply. For Rs 60 lakh, depending on my age, the premium, and as I age the premium will increase, that will be a cost.

Not everybody needs an insurance. It is a cost. If you need the insurance, then it is not the cost as you could have taken it anyways. But if you don’t need the insurance, then that’s an unnecessary cost. So, the combination of an unnecessary cost, if it is unnecessary, and the fact that you are stuck to an insurance company plus you make a commitment for 5 years. Remember, in an insurance ULIP policy, after one year if I discontinue, then the value will move to a debt fund which is essentially a liquid fund. So, all the benefits of equity will go away.

So, I am committing not just to the first year’s premium but committing to next four year’s premium. There are several disadvantages to ULIP which makes it unattractive. Lot of investors have realized that mixing insurance and investment is a terrible cocktail. I don’t think you will get those people to drink that cocktail again. There are going to be distributors, primarily banks, who would find more profitable to push ULIPS.

Should investors refrain from taking advice from the bank to go for ULIP?

Gajendra Kothari: In banks, most relationship managers try to push your product as they have targets given by the seniors and they have to sell that particular thing, whether it makes sense to you and not as an investor. If you to go an advisor, he will see your risk assessment, time horizon, capacity and then he will advise you right course of product.

Just because the tax is not there right now, we didn’t know what is going to happen after five years. In the fifth year, when your chicken comes home after roasting, what happens you don’t know. You have committed for five years, you have to pay the premium for five years. In ULIPs the charges are upfront. So, you are not starting with Rs 100 but Rs 90-95. To come back to Rs 100, it will take 5 years. One point which people don’t consider is performance itself.

Would I earn better returns in a term insurance plan versus the entire money being in a ULIP plan?

Gajendra Kothari: If you take data from 5 years point of view, in 95 percent of the cases mutual fund would beat ULIP products even after accounting for charges for term insurance. We have tested it where a person has invested for 11 years, Rs 1 lakh premium in an insurance company of a large conglomerate. We took the same mutual fund from the same house, in one case the Rs 11 lakh insurance have been Rs 24 lakh today. In mutual funds, it could have become Rs 43 lakhs today in the same manner.

Are there any misconceptions regarding this which needs to be cleared?

Harsh Roongta: The queries from investors are that markets are down, so can they get in. You should not get in or out. Don’t try to time the market. A normal investor should not involve to time the market. Don’t get out because the markets are down and vice-a-versa. Do it systematically, as per your plans and goals. Both things need proper planning.

Gajendra Kothari: On the budget front, this dividend distribution tax, the imposition of LTCG, there was a product called equity savings fund which was getting a huge flavors as FD rates were coming down and it was FD plus product which was pitched to investors with 25-30 percent equity investors. With the tax coming is, the differentiation is not huge. Anyway, you have to pay 10 percent tax. If the returns from it was 8-10 percent, now you have to 10 percent tax and earlier it was tax free. Many experts are now saying if MIP can come as a tax alternative as it is also similar product with 70 percent debt, and 30 percent equity. It is 3-year taxation but after 3 years, you enjoy a 20 percent tax with indexation benefit. It may lower the tax impact compared to LTCG tax. For equity savings funds, 25-30 percent fund going to arbitrage, a 70 percent debt is a better option compared to here 40 percent debt and 30 percent arbitrage from returns perspective. So, MIP could come back strongly as a category compared to equity savings fund purely from a tax and return point of view for conservative investors.

(This article has been published in an arrangement with BloombergQuint.)