Don’t let the tax bogey affect your mutual fund investments

It’s official. The Finance Ministry has clarified its stance on taxation for non-equity mutual funds regarding the ‘retrospective’ aspect. Also, it is evident that there will be no rollback in other proposals; Finance Bill 2014 has been passed by the Lok Sabha and is now awaiting a nod from the Rajya Sabha. For all intents and purposes, fixed maturity plans (FMPs) have lost the tax advantage they enjoyed over fixed deposits (FDs), and now debt fund investors must have an investment horizon of at least 36 months if they wish to reap tax benefits on long-term capital gains.   

An interesting outcome of this development has been in the form of investment advice. Experts are falling over each other trying to determine which investment avenue is best suited for individuals in specific tax brackets. For instance, statements such as “if you are in the lowest tax bracket then FDs make sense, however for those in the highest tax bracket, long-term debt funds will be the best bet” have become commonplace. Fund houses seem to have been caught up in the frenzy as well. Media reports suggest that some of them are trying to extend/roll over one-year FMPs for a further 24-month period so that investments therein will become eligible for long-term capital gains.

The trouble with this tax-focused muddle is that it contravenes the basic principles of investing. Don’t get me wrong—I’m not suggesting that tax implications should be ignored; however, they certainly shouldn't be the primary basis for making an investment. For instance, a fundamental difference between FDs and debt funds (including FMPs) is that the former offer safety of capital and assured returns, while the latter are market-linked investments i.e. the capital invested is at risk, and there are no assured returns. It is imperative that investors first get a fix on what their risk profile is, and accordingly pick an investment avenue, rather than start off by evaluating which avenue is more tax-efficient.

Likewise, the investment horizon is no less important. Consider a scenario wherein an investor in the highest tax bracket has surplus monies to put away for 18 months. It would not be prudent to invest in a 3-year FMP only because the taxation thereon is more liberal versus that on an 18-month FD. Simply put, investors must focus on aspects such as risk profile and investment horizon, before considering the investment’s tax-efficiency. Failing to do so could result in investors deploying monies in avenues unsuitable for them, and for inapt tenures as well.   

Arbitrage funds to the rescue…

If the aforementioned experts are to be believed, debt funds have lost their appeal for good, and now investors should focus on a new silver bullet—arbitrage funds. Sadly that argument is both preposterous and flawed.

Arbitrage funds operate on the premise of exploiting mispricing opportunities between the cash and derivatives markets. They thrive on market volatility. At its core, it is a straitjacketed approach since it will only deliver in certain market conditions. Furthermore, unlike debt funds which invest in fixed income securities, arbitrage funds operate in the domain of equities—so much for their likeness. If you are wondering why arbitrage funds exist in the first place—the answer is herd mentality. In the NFO-driven era of 2005-06 when a couple of fund houses launched arbitrage funds, others followed suit lest they be left behind. Like most NFOs, the launch of arbitrage funds had little to do with conviction in investment merit.  

So why have arbitrage emerged as the season’s flavour? Because they are treated as equity funds for taxation (read liberal tax rates and provisions) while plying a market-neutral strategy. On their part, investors would do well to steer clear of experts who profess that arbitrage funds make apt replacements for debt funds. 

Admittedly, a higher tax liability on debt fund investments is taxing both literally and figuratively. But trying to circumvent it by investing in unsuitable avenues will only make matters worse. The solution lies in coming to terms with the new scenario and staying the course.

Would you hire ‘Fonzie’ or ‘Richie’?

For followers of the sitcom ‘Happy Days’, the Fonzie-Richie duo is legendary. As similar as chalk and cheese, Fonzie is rough around the edges—a greaser who defies convention, he has a mind of his own; he has been on the downside of luck and yet beaten the odds. On the other hand, Richie is clean-cut and straight as an arrow; he has been sheltered by his loving family and will predictably play by the book. Despite their contrasting personalities, not only are they best buddies, but they always come through.

Here’s a question—if you were hiring, would you pick Fonzie or Richie? Over the years, I have often seen candidates in the Richie mould enjoy an edge over those in the Fonzie mould. An oft-repeated argument is that a Fonzie won’t make a good team player; his personality—opinionated and willingness to challenge status-quo—makes him a bad team player. Conversely, a Richie who is conforming and easy-going is seen as a safer bet. Perhaps there is some merit in that argument. But is that always true, or is there more to it than meets the eye?

An unpleasant truth is that several managers dislike dissenting opinions. A contrasting view (from a subordinate) which may potentially benefit the organisation could be shot down, because the manager believes that his authority has been challenged. Insecurity of being upstaged by a junior stalks and in turn, influences the actions of many managers. Admittedly, the organisation’s culture is an aspect too—some workplaces thrive on a familial structure wherein honchos are deemed to know what is best and juniors are simply expected to toe the line. It should come as no surprise if such entities always pick a Richie over a Fonzie.

However, should that approach be universally adopted? In an ever-changing and increasingly complex business environment, is it prudent to raise an army of compliant yes-men? What happens when the organisation faces a downturn or say the competition comes snapping at its heels? When the going gets tough, traits such as being driven, out-of-the-box thinking, resilience and courage are worth their weight in gold. Someone who has rolled with the punches is the man for the job. That’s when a Fonzie is better equipped to deliver over a Richie. For those who believe that a skilled manager is all it takes, think again. Even the best of plans (made by a manager) can be rendered useless due to poor execution (by subordinates who can’t rise to the occasion).

Like most things in life, I don’t think there is an unambiguous, ‘one-size-fits-all’ answer to the Fonzie versus Richie debate. But it is patently ridiculous that biases and insecurities result in organisations and managers inflicting damage on themselves. There has rarely been a greater need for a blinkers-off approach while hiring. As in ‘Happy Days’ itself, perhaps there is a case for Fonzies and Richies co-existing and driving the organisation’s success. To quote Fonzie—Ayyy!