If your rationale for choosing a balanced fund is the marginal tax efficiency over a focused allocation, where the debt component gets taxed as debt fund, it is not a decisive criterion and the tax efficiency is not huge.
Prior to market regulator SEBI’s fund categorisation norms and the Union Budget effective April 1, the reason to allocate to balanced funds, as against a focused allocation to equity and debt funds were: (i) Discipline: In balanced funds, the fund manager will allocate to equity and debt, whereas if you do it yourself, when the equity market runs up, the allocation gets skewed in favour of equity; and (ii) Tax advantage: Balanced funds are taxed as equity funds, whereas in a focused allocation the debt fund gets taxed at a relatively higher rate.
Things have changed somewhat, after the changes in rules of the game, which we will discuss now.
Focused allocation Focused allocation is not only about the ratio, e.g. 75 percent to equity and 25 percent to debt, but also what is it you are allocating to. The fund norms by the Securities and Exchange Board of India state that in aggressive hybrid funds 65 percent to 80 percent allocation should be in equities. However, it does not mention any further specifications, for example largecap/smallcap, diversified/ sector-heavy, etc.
One may prefer largecap stocks against smallcap or a diversified portfolio over sector-oriented bets. If that be your investment outlook, you would rather go for a fund with suitable specifications. Similarly, in the debt allocation of 20-35 percent, SEBI norms don’t specify whether it should be long/ short maturity or highest credit/investment grade rated instruments. If one prefers a portfolio of short maturity, highest credit rated securities, then you have to take a fund of those specifications. From the risk management perspective, allocation ratio to equity-debt is important, but what we are allocating to (i.e. the nature of the underlying) is equally important.
If you are doing a focused allocation as per your desired ratio, you have to maintain discipline and do periodic portfolio rebalancing to avoid a skew in allocation.
Tax efficiency With effect from April 1, there is a dividend distribution tax of 10 percent plus surcharge and cess i.e. 10.8 percent. It is a tad bit higher in equity and balanced funds. Here we are talking of aggressive hybrid funds with more than 65 percent in equity, not the balanced hybrid funds with less than 60 percent in equity. As against this, the DDT rate on debt funds is 29.1 percent for individuals and 34.94 percent for corporates. If you do a focused allocation of say 75 percent to equity funds and 25 percent to debt funds, the debt component will be subjected to this relatively higher tax rate.
However, if you have a horizon of 3 years, debt funds also are tax efficient. In the growth option, over a 3-year holding period, you get the benefit of indexation. Assuming a return of say 8 percent CAGR and inflation indexation of say 4 percent per year, at a tax rate of 20.8 percent, you pay tax of about Rs 2.8 per Rs 100 of investment over the entire investment period. Your return in this case works out to about 7.2 percent CAGR net of long term capital gains tax.
Though aggressive hybrid funds (the new category name for tax efficient balanced funds) have a tax advantage, it is not an overwhelming advantage. For example, you invest Rs 100 in an aggressive hybrid fund, growth option, for a horizon of 3 years and earn 8 percent CAGR. Ignoring the tax-free ceiling of Rs 1 lakh per year for the sake of simplicity, over a period of 3 years, Rs 100 becomes Rs 126. At a tax rate of 10.8 percent, you pay tax of about Rs 2.8 and earn net of tax CAGR of about 7.2 percent. As against this, if you do a focused allocation to equity and debt funds, assuming the same rate of return for illustration purposes and indexation of 4 percent per year, you earn the same net of tax return. For a horizon of less than 3 years, you have a pay a little higher tax in the debt fund.
Investments should be decided on fundamental parameters i.e. what the investment is about. Tax efficiency is relevant as an additional parameter, not as the sole decision criterion. If your rationale for choosing a balanced fund is the marginal tax efficiency over a focused allocation where the debt component gets taxed as debt fund, it is not a decisive criterion and the tax efficiency is not huge, as we saw above. The advantage of a focused allocation is that you can decide the type of fund e.g. in equity it may be largecap/smallcap and in debt it may be long bond/short bond.