The investment world rarely stands still. For instance, because of the taxation reforms, the once-reliable compass of debt mutual funds now points to uncertain territory, leaving high-net-worth individuals (HNIs) scrambling to rethink their investment strategies. The question now isn’t whether to adapt but how to do so effectively. This requires a thoughtful reassessment of investment strategies. But first, let’s dive into the problem at hand.
The combined effect of announcements in the budgets for 2023-24 and 2024-25 have significantly reduced the allure of debt mutual funds for investors. The removal of , long considered a key advantage for debt fund investors, has notably impacted the tax efficiency of these instruments. Under the new regime, gains from debt mutual funds will be taxed at the investor’s income tax slab rate regardless of the holding period.
For HNIs, this change hits where it hurts most. Those in the highest tax bracket will see their effective tax rate on debt fund gains jump to 30%. With surcharge and cess, it can be as high as 39%. The result: What was once a comfortable 7% post-tax return expectation has now dwindled to a sobering 4-5% for many investors.
But as one door closes another opens, and lower net equity instruments have begun to attract attention as potential alternatives. These financial products—think arbitrage funds and equity savings funds—offer a unique proposition that merits consideration from the HNI community.
Arbitrage funds, for example, present an interesting case. Despite having zero net equity exposure, these funds have been delivering average returns of around 7.6%. While the returns are in line with those of liquid funds, the appeal of arbitrage funds lies in their tax treatment—classified as equity funds, they enjoy the favourable tax regime applied to equity investments despite behaving similarly to debt instruments in terms of risk and return characteristics.
Select equity savings funds follow a comparable approach. With net equity exposure typically capped at around 15% and the remainder allocated to arbitrage opportunities and debt instruments, these funds offer stability that resonates with traditional debt fund investors. Yet, their gross equity exposure of 65% qualifies them for equity taxation (12.5% tax if held for a year), creating a tax-efficient alternative in the current environment.
To be clear, the 15% net equity exposure may result in a 2-3% volatility and, therefore, is suitable for longer holding periods. Additionally, some funds have covered calls in their portfolio, making the net equity portion less volatile. If held for a year, these funds can deliver positive returns even in a bear market.
Let’s be clear: Debt still has a crucial role in any well-rounded portfolio. It’s the steady hand on the tiller when equity markets get choppy. The challenge lies in navigating the new tax waters more smoothly.
For HNIs considering this pivot, there’s plenty to chew on. The current portfolio composition should be evaluated to identify areas where lower net equity instruments can be integrated without compromising overall risk objectives. Liquidity requirements also play a crucial role in this decision-making process. While many of these alternative instruments offer good liquidity, some may have exit loads that must be factored into the investment strategy.
Risk tolerance, too, must be reassessed. While these instruments generally offer lower volatility than pure equity funds, they’re not quite as steady as traditional debt. It’s a trade-off that needs careful consideration.
This shift towards lower net equity instruments isn’t just a knee-jerk reaction to tax changes—it’s part of a broader trend towards more nuanced strategies. While the changes in debt fund taxation have been challenging, they have also opened up new avenues for portfolio optimization.
For HNIs willing to embrace this new paradigm, the rewards could be significant—not just in terms of returns but also in building a more resilient, tax-efficient portfolio.
Arihant Bardia, CIO and founder, Valtrust.