The risk in investing for future tax benefits

There are some risks related to investing that are not widely talked about but which, I believe, one would do well to take note of.  One such risk is that of a change in tax laws (some consider this as part of what is known as, “regulatory risk”).  In a way, the recent Budget proposals to amend the way gains from debt funds are taxed, have put this risk in the spotlight.  In this post, I propose to offer my thoughts on this risk.

Tax benefits can come at three levels – on the amount we invest, on the dividends we get, and on the gains we make (or the amount we get) when we exit.  A change in tax laws that may adversely affect the latter two is what we most need to watch out for.  Depending on the nature of such a change, one may end up having to pay far more taxes than one planned for, or worse, the achievement of a financial goal may be in jeopardy.  Consider the recent proposals, for instance.  Someone who invested in an FMP with a tenure of less than 3 years could well end up paying 3 times the amount of tax originally envisaged, or even more (unless, of course, the fund house is able to extend the tenure of the fund).  On the other hand, what if, this amount was needed to fund a financial goal that cannot be deferred, such as one’s child’s higher education?

History provides us enough evidence of the unpredictability of tax laws.  Once upon a time, all long term gains (including those from equities) were defined and taxed in the manner that has now been proposed for debt funds.  Till 1999, dividends were taxable.  Some of these changes have been pleasant, some not so.  Some proposals never advanced beyond being proposals.  But at no point, was there any way of knowing for certain what would happen in the future. It remains to be seen as to whether the current proposals will become a reality and, if so, in what shape.  Time will tell what other changes may happen.  Given that this risk may not be identical across all kinds of investments, makes a case for diversification.  As I suggested in an earlier post, diversification can minimize the impact of unpleasant surprises that may affect any single investment or category of investments.

Investing is always fraught with uncertainty.  There are very few, if any, assurances that can be said to be carved in stone.  Taxes, too, as history shows, aren’t quite the certainty that some have suggested.

A wake-up call for the mutual fund industry

I refer to the Budget proposals made yesterday, specifically the ones to amend the way gains from debt funds will be taxed.

I guess the objective would have been to plug an area that was impacting tax collections.  One has to admire how perfect a choice this is- high on impact, and low on collateral damage, with some potentially interesting side effects to boot.  For me, the most interesting of these would be the impact this has on the mutual fund industry.

Mutual funds were originally envisioned as a means to help retail investors build long-term wealth. Yet, over the years, the industry did little to justify its existence for this purpose. It chased corporates and high net-worth individuals, ignoring the masses.  It unabashedly marketed FMPs as a way to get around the taxes that other debt instruments would involve.  In short, the industry constantly looked around for easy, short-term profitability. 

Sure, exceptions were (and are) there, but as a whole, the industry has taken little pride in the nobility of the purpose for which it existed.  If the Budget proposals do become a reality, this will, in my opinion, be the biggest wake-up call the industry has ever had.

Are debt funds still worth investing into?

Short answer: Yes, but…

In the first post of this blog, a couple of months ago, I mentioned three categories of investors for whom there was a compelling case to consider investing in mutual funds.  Yesterday’s Budget proposals for a change in taxation of gains from debt funds don’t negate the points I made in that post.  However, for investors with a proposed investment tenure of less than 3 years, the case to consider a debt fund is now considerably weakened. 

Some time ago, I undertook a study that covered the period 2007-2013, over which I compared the returns from debt funds with a cumulative term deposit with State Bank of India.  I looked at the calendar year returns and at the rolling 2 year (calendar year) returns.  The fund data was taken from Value Research.  No exit loads were applied. The data covered 370 debt funds, of which 153 were in existence in 2007 (and for which data was available for each year since).  Here are some findings:

1 year returns:

The best calendar year in terms of the number of funds outperforming the deposit was 2008, when 81% of the funds did so.  The worst year was 2009 when 6% of the funds did so.

Of the 153 funds in existence since 2007, no fund beat the return from the deposit in all 7 calendar years.  3 funds outperformed the deposit in 6 of the 7 years, while another 27 did so in 5 of the 7 years.  There were 58 funds which outperformed the deposit in 2 years or less (including 6 funds which did not surpass the returns from the deposit in any single calendar year.)

2 year returns:

The best two-year period in terms of number of funds outperforming the deposit was 2011-12, when 78% of the funds did so.  The worst two-year period was 2009-10 when 1% of the funds beat the returns from the deposit.

No fund surpassed the returns from the deposit over all 6 two-year periods.  2 funds outperformed the deposit in 5 of the 6 two-year periods while 18 funds did so in 4 of the 6 two-year periods.  The vast majority of the funds outperformed the deposit half the time or less.  14 funds did not beat the returns from the deposit in any two-year period.

There was no pattern that I could see across these numbers linking funds having a similar average maturity or credit quality or strategy. Looking at these numbers, I am inclined to believe that without the advantage of tax breaks, investing in a debt fund, hoping to beat the returns from a 1 year deposit or a 2 year deposit is quite like a shot in the dark.  I am also inclined to believe that for someone in the higher tax brackets, there is a case to consider allocating more to equity funds.  After all, the return required to outperform a deposit or a debt fund just went down. But maybe that’s a discussion best left for another time.  For now, consider it as food for thought.