Should I Switch to Hybrid Funds from Debt Funds to avoid Increased Taxation?

Indian investors were shocked to see the surprise announcement by the government recently, to remove LTCG indexation taxation in debt fund from FY2023-24. Now all the gains in debt funds are taxed as per the investor’s income tax slab. The earlier indexation benefit of debt funds, which made these attractive to many investors, has now been removed now.

While the impact is lower on smaller investors, many investors with larger portfolios (with a sizeable chunk in debt funds) are worried and desperate to look for more tax-efficient alternatives.

I am getting quite a few emails like –

• Should I now switch from debt funds to Aggressive Hybrid Funds due to a change in debt fund taxation in 2023?
• Should I now switch from debt funds to Balanced Advantage Funds due to the change in debt fund taxation in 2023 in India?
• Should I now switch from debt funds to Arbitrage Funds due to a change in debt fund taxation from FY2023-24 onwards?

I have said this earlier and would repeat it now as well – Don’t be in a hurry to make any big changes in your debt fund portfolio. The change has become effective from 1st April 2023. All your previous debt funds gains are still taxed as per earlier indexation-based lower tax rules.

In view of all the emails and messages I got, I wanted to address this query for all readers.

First things first. The change in debt fund taxation has practically created 3 buckets of funds with respect to taxation:

• Funds with less than 35% in Indian equities – These are debt mutual funds and conservative hybrid funds. These will have taxation (for both LTCG and STCG) as per the investor’s tax slab.
• Funds with 65% or more in Indian equities – These are equity mutual funds, aggressive hybrid funds, balanced advantage funds, and arbitrage funds. These will have taxation at 10% for LTCG (1 year +) and STCG at 15%.
• Funds with 35 to 65% in Indian equities – As of now, the only existing category in this space is Balanced Hybrid Funds. But almost no AMC offers schemes in this category as per SEBI, AMCs can only offer one scheme from Balanced Hybrid Or Aggressive Hybrid funds. More importantly, this bucket is still to be taxed as per earlier debt fund taxation where LTCG was taxed at 20% after indexation.

As you can see, many investors are now tempted to consider other mutual fund categories like Aggressive Hybrid Funds, Balanced Advantage Funds and Arbitrage funds as alternatives to pure debt funds due to lower taxation.

But while it is true that these categories do have some debt allocation, that doesn’t mean that it is a like-to-like comparison. Here are how these categories compare with pure debt funds –

• Pure Debt Fund categories – Have more than 95% and up to 100% in debt
• Aggressive Hybrid Fund category – Can have 65-80% in equities and the rest 20-35% in debt
• Balanced Hybrid Fund category – Can have 40-60% in equities and the rest 40-60% in debt
• Dynamic Asset Allocation (or Balanced Advantage) Fund category – Dynamically manages the allocation and each AMC can follow a different strategy. Hypothetically, it can have 0-100% in equities and the same 0-100% in debt
• Arbitrage Fund category – Follows arbitrage strategy, with a minimum 65% investment in equity instruments via hedged and unhedged allocations.
• Equity Savings Fund category – Needs to have a minimum of 65% in Equity and 10% in debt. The equity allocation has two parts of i) hedged equity (via derivatives-based arbitrage holding) and ii) unhedged equity (via direct stock holdings)

So, coming to the actual question at hand now.

Should investors switch to hybrid funds to replace debt (fund) exposure?

While it is true that the hybrid categories like arbitrage, equity savings, balanced advantage and aggressive hybrid funds are taxed like equity funds which will be generally lower than the investor’s income tax slab, which is actually suitable for which investors depend on a variety of factors.

Let’s see them one by one –

• Balanced Advantage Funds – A Balanced Advantage Fund (or BAF) has the freedom to freely increase allocation to equity up to 100% and decrease it to 0%. But to remain under the definition of equity funds and have lower taxes, most BAFs keep a gross allocation to equity at 65% or more by using arbitrage strategies. So, when the equity allocation of a BAF is low, say 20% or so, then it is effectively like a debt fund. But what if it increases it to a higher equity allocation of 65-70%? Then it will effectively become like an equity fund. And most BAFs available today never reduce equity allocation to that low percentage anyways. So given the current manner in which most BAFs are managed, the Balanced Advantage Funds cannot be a like-to-like replacement for pure debt funds. So that is the answer to the question about whether should investors invest in balanced advantage funds instead of debt funds due to changes in taxation.
• Arbitrage Funds – Arbitrage funds generally hold a minimum of 65% in Indian equities via derivative positions and aim to exploit arbitrage opportunities. This is the predictable part. The other 35% of the portfolio is in bonds of different maturities that may be comparatively unpredictable. But one look at the returns and you will see that these tend to be quite like those of liquid funds, and that, even if we account for lower equity-like taxation, may not be a good reason to invest in arbitrage funds heavily for long-term debt allocation. So that is the answer to the question about whether should investors invest in arbitrage funds instead of debt funds due to changes in taxation. As for the short-term debt allocation requirements, arbitrage funds can still be considered for some investors if not all.
• Aggressive Hybrid Funds – An aggressive hybrid fund can have 65-80% in equities and the rest 20-35% is parked in debt. Most schemes in this category generally have about 65% in equity. So, this is anyways not a good alternative to pure debt funds from an asset allocation perspective. While one may look at relevant periods of past data to arrive at any conclusion one wants, like aggressive hybrid funds give much better returns than debt funds in the long term (which they obviously will due to the higher equity component), the fact is that it is not a like-to-like comparison. So that is the answer to the question about whether should investors invest in aggressive hybrid funds instead of debt funds due to changes in taxation.
• Equity Savings Funds – Equity saving schemes are hybrid funds that invest in equity, debt, and arbitrage instruments. With a combination of the hedged and unhedged equity allocation, they try to maintain overall equity exposure above 65% to get lower taxation applicable to pure equity funds. But given their structure, they are not as safe as a debt fund but still safer than pure equity funds. Equity savings funds have been quite popular as they score over pure equity funds on risk parameters because they do downside protection better (due to debt and arbitrage allocation) while their unhedged pure equity exposure enables them to generate potentially higher returns when compared to pure debt funds and bank fixed deposits with greater tax efficiency. While this category might be looking like ticking all the right boxes, it is important to understand that the underlying unhedged equity portion makes these funds exposed to the volatility of the equity market in that proportion. And this may not be acceptable to many who don’t want any risk in their debt funds till now. Also, the returns are to an extent also linked to allocation to arbitrage opportunities, which may not always be available in the market. So that is the answer to the question about whether should investors invest in equity savings funds instead of debt funds due to changes in taxation.

And please don’t make the mistake of blindly investing in any of the above-discussed hybrid fund categories instead of debt funds only to save tax.

Many mutual fund sellers are advising investors to switch to a few of the above categories in view of increased debt fund taxation. But you need to be careful. And not fall for the pitches that claim any of the above categories to be 100% suitable and tax-efficient alternatives to debt funds.

I am not saying you should not invest in these fund categories. In certain cases, there might be merit in having some exposure to equity savings funds, etc. in place of debt funds for the debt allocation of your long-term portfolio. But you need to be careful and should know what exactly you are getting into (and have the right expectation) if your reason for investing is to avoid debt fund taxation.

Also, it would be better to wait for a few months to see how AMCs adjust to the new reality. I am sure the AMCs might relook at the Balanced Hybrid Fund category as that is the only one which can still qualify for lower indexation-based LTCG taxation (like debt funds earlier) due to its definition of having 40-60% in equity. The new rule for increased debt fund taxation applies to (debt or similar) funds which have less than 35% in Indian equities. So, a balanced hybrid fund with say about 40% in equity allocation (say some hedged and some unhedged) can easily be a viable alternative to debt funds. But it is up to the AMCs to now come up with such schemes (or ones with a 35% allocation to equity/arbitrage). And also, SEBI might relook at relaxing the rule which forced AMCs to pick one among Balanced Hybrid vs Aggressive Hybrid as they couldn’t have both in their offerings. So don’t be in a hurry to make big changes to the debt allocation of your long-term portfolio.

Related reading – Why debt funds returns will improve soon, at least on a pre-tax basis?

I hope you found the above discussion on Should I Switch to Hybrid Funds to avoid Increased Taxation in Debt Funds (India 2023).