How are hybrid funds attractive from a tax perspective? - Motilal Oswal

How are hybrid funds attractive from a tax perspective?

What exactly do we understand by hybrid mutual funds in the Indian context? We all understand equity funds and debt funds in plain vanilla terms. But when equity and debt are combined in the same portfolio, it combines the security and regularity of debt with the long term wealth creation potential of equity. One of the key advantages of hybrid funds is that it combines the best features of equity and debt and enhances the risk-adjusted returns for the investor. One of the key advantages of these funds is the subject of hybrid mutual fund taxation. Hybrid funds give the flexibility to structure your mix in such a way as to give you the optimal tax plan. Lastly, there is a common tendency to use hybrid funds and balanced funds interchangeably. When you compare hybrid funds versus balanced funds you need to understand that balanced funds are actually a sub-set of hybrid funds.

Hybrid funds may come in various forms and nomenclatures. But structurally they fall into 4 broad categories..

Predominantly equity Hybrids – Example is a Balanced Fund

Predominantly debt Hybrids – Example is a Monthly Income Plan

Predominantly dynamic asset allocation – Example are most flexi plans

Mirroring debt using equity – Example is arbitrage funds

Let us understand each of these categories of hybrid funds in greater detail..

Balanced funds as an example of equity-oriented Hybrid funds..
A balanced fund has emerged as a key investment avenue due to its judicious mix of equity and debt. Normally, balanced funds are predominantly equity funds. At least 65% of the total AUM is invested in equities and the balance is invested in debt. This 65% exposure to equity will help the balanced fund to get the tax benefits of an equity fund. That means dividends will not attract dividend distribution tax (DDT), the short term gains will attract a concessional rate of tax of just 15% and long term capital gains (held for over 1 year) will be classified as tax free profits. This makes balanced funds a very tax-efficient option compared to pure debt funds. That is why balance funds will strive to maintain a minimum equity exposure of 65% to be eligible to be classified as an equity fund under the Income Tax Act. Balanced funds combine the wealth creation potential of equities with the regularity and security of debt. Remember, hybrid funds versus balanced fund are not the right comparison as the latter is a sub-set of the former.
Monthly Income Plans (MIPs) as an example of debt-oriented Hybrid Funds..
MIP in some ways is the reverse of the balanced funds in that they are predominantly invested in debt and only have a small exposure to equities. If you look at the typical MIP in India, they will have an exposure of 80-85% to debt. Within debt, the mix includes call money for liquidity, government debt for safety and private debt for alpha. The 15% equity component is for long term wealth creation. However, since equity component is less than 65%, the MIP is classified as a debt fund. Hence it is normally structured as to pay out dividends each month so that the dividends can strip out the gains and be distributed tax-free to the investors. Of course, DDT will still apply.

Dynamic asset allocation funds – An example being Flexi Funds..
When we look at the advantages of typical hybrid funds, one of the key aspects is flexibility. Both the balanced funds and the MIP are typically rigid in their allocation mix. These flexi funds go a step further. They leave the asset allocation to the discretion of the fund manager. So if the fund manger feels that the equity is overpriced and rates are going to go down then the entire corpus may move towards debt.  Similarly, if the fund manager is of the view that equities are truly underpriced then they can shift 100% allocation to equities. There are 2 issues to understand here. Firstly, considering their asset shift potential, these funds can be productive only if held for a very long period of 15-20 years. They can a tool for long term financial planning. Secondly, there is a lot of accent on the discretion of the fund manager as the asset allocation is too dependent on the fund manager view. That is not a great idea if you are looking a more structured approach.

Using Arbitrage Funds to mirror the return structure of debt..
Hybrid mutual fund taxation is the key element here. Here the arbitrage fund has nothing to do with debt. The arbitrage fund captures the pricing anomalies between spot price and the future price of the stock and locks in the spread. Normally, stock futures trade at a premium to the spot price and this is called the basis. This basis arises due to the opportunity cost of locking money in equity. Hence the spread between equity and futures over a time frame will broadly correspond with the prevailing interest rates. Typically, arbitrage funds can give a return of 8-10% annualized. But the big kicker comes from the tax benefit. Since these funds are invested over 65% in equities, they are equity funds for tax purposes and get the capital gains benefits of equity funds. That is what makes these arbitrage funds specifically attractive.

The advantages of hybrid funds are quite clear. Hybrid mutual fund taxation is the key element, while returns stability and risk also matter. That is what hybrids are all about!