Amended as on Apr 1, 2023: Please note that as per amendments in Finance Bill 2023, from April 1, 2023, profits made on investments in debt mutual funds are now taxed as short-term capital gains if these funds invest <=35% in equities. This means, debt mutual funds are now taxed as per the income tax rates as per an individual’s income.
Also note that with effect from Apr 1, 2020, Dividend Distribution Tax (DDT) was abolished, and mutual fund dividends were made taxable in the hands of investors. Dividend income is now considered as ‘income from other sources’ and investors need to pay tax on it as per their individual tax slabs.
This article is currently in the process of getting updated, as it was originally written at a time when tax rules were different. Please treat this note as the latest updated tax information in the meanwhile.Whether you’re a first time investor or an experienced one, mutual funds are often considered by experts to be an investor’s best friend due to their many advantages. But with so many different options available today, how do you make the right choices for your portfolio?
Let us look at some of the key factors you should keep in mind while selecting funds:
- Investment Objective and Style
The investment objective of a scheme is what the scheme intends to achieve through its investments. For instance, an equity diversified fund may have the objective of investing in growth stocks to achieve capital appreciation; a sector fund will have the objective to invest in companies in the chosen sector to achieve capital growth and earn dividends.
When you consider the investment objective, you will need to consider whether or not it matches your financial goals and requirements. This should also incorporate the timing of your financial goals and other elements such as your risk profile (your ability to take risks and your tolerance towards risk).
To make it easier to understand, consider a mismatch: Rakesh is retiring and needs to secure his income; he invests in a sector fund with high volatility because in the last 2 years, the fund has outperformed the relevant sectoral index. Imagine that at the time when Rakesh needed the income from the fund, there was a reversal in the fortunes of that sector and the fund value fell. Rakesh’s income will dwindle. He may also lose some of the capital that he invested at the outset. Considering Rakesh’s life stage and risk profile, he would have been better off investing in a low-risk income fund. Was the product the problem or was the choice of product in the given circumstance the issue?
You also need to consider your risk profile to identify how best to build your mutual fund portfolio according to investment styles. For example, you may choose to do this according to market capitalization (small & micro-cap/ mid cap/ large cap) or according to fund management style (seeking growth, discovering value, a blended approach etc). All of this information is readily available on the asset management companies’ websites and in the Scheme Information Documents.
- Role of the fund
Different mutual fund products have different roles to play, just like the characters on a chess board, or the members of a cricket team. Some are meant to be aggressive, some are meant to be balanced and some are meant to be conservative. Identifying what role a product needs to play will keep your portfolio clean and well balanced.
Think of teamwork every time you consider your portfolio and then think of the reason why a particular fund is there in your portfolio. If you cannot remember the reason why you bought a fund in the first place, or you cannot understand why you’re adding a new fund to your portfolio, it could be an indication of the need for you to rethink your decision.
- Your time horizon and risk profile
The next factor to consider is the time horizon of your financial goal. In general, the closer the goal is, the lower the risk you should seek to take, especially if you are close to achieving the goal. For instance, taking the above example forward, since Rakesh has reached retirement, he should invest in a low-risk income fund. However, if Rakesh was in his 20’s or 30’s, he could have invested in a high-risk equity fund to build wealth for his retirement. Had Rakesh been in his 40’s, he would do well to invest in a mix of equity and hybrid funds (which invest a part of its corpus in equity and the balance in debt).
- Performance / track record
You should consider the following points while analyzing the performance of a fund:
- Consistency: The fund should have performed consistently in the past vis-à-vis its benchmark index and the category average (the average returns of all schemes within that category). The past in this case is not only the last 6 months, it should include 1 year, 3 years, 5 years as well as since inception comparisons
- Outperformance: A fund that consistently outperforms its peers and its designated benchmark over the short and long term is generally considered to be well-run and most likely to bring you positive returns. However, as the famous saying goes, there is no guarantee of this!
- Volatility, or variation in performance: The volatility in returns of the fund should be in sync with its objectives; for instance, if the fund is a high-risk-high potential return fund, then volatility is a given; however, if it is a low-risk fund, the returns should not be volatile. This can be checked with the help of risk ratios published in the fund factsheets.
- Fund Manager: Assess the fund manager’s track record – both in terms of his experience & reputation and the past performance of the other funds under his management. In general, a fund manager’s skills are visible across the entire range of funds he manages.
- Size of the fund: Small is not, in general, beautiful in the mutual funds’ world. While the largest fund may not necessarily have the best performance or strategy to match your goals, an optimal size would ensure your ability to cash in your investment when you need it, and for the fund manager to be able to execute his or her investment strategy. However, it is true that higher the assets under management, higher the number of investors that trust the fund manager in question.
All funds incur expenses to manage the fund (fund management fees, administration charges, brokerage, marketing and sales expenses, commissions, etc.). All of these expenses are chargeable to the fund’s investors as a percentage of assets under management, and are described as the “total expense ratio” or TER of a fund. The lower the TER, the better the potential return on your investment.
Different type of schemes of mutual funds are taxed differently. The mutual funds schemes are predominantly divided into 2 broad categories for the purpose of taxation.
i. Equity Oriented Funds
If you invest in an equity-oriented mutual fund (i.e. one whose allocation to equity shares of domestic companies listed on stock exchange is at least 65%) and hold your investment for more than 12 months, your long-term capital gains exceeding Rs 1 lakh per financial year will be taxable at 10% (without indexation) as per the Finance Bill, 2018 w.e.f 1st April, 2018. However, if you hold the same for less than 12 months, it attracts tax at 15%
Note: Here, 12 months is the cut off time to be considered as ‘Long Term’.
ii. Non Equity Oriented Funds
Non equity oriented funds are further divided into two categories on the basis of their allocation to equity shares of domestic companies
a. Specified mutual funds -
Specified Mutual Fund" means a Mutual Fund by whatever name called, where not more than thirty five per cent. of its total proceeds is invested in the equity shares of domestic companies.
Finance Act 2023 has inserted Section 50AA in the Income Tax Act, 1961. As per the said section, with effect from 1 April 2023, gains/losses from units of Specified Mutual Fund would be deemed to be short term capital gain/loss irrespective of period of holding and would be taxed as per the slab rate applicable to investors. This is applicable for all such units which are acquired on or after Apr 1, 2023.
Any investment in specified mutual funds prior to April 01,2023 would continue be taxed as per point b given below.
b. Non Equity oriented funds Other than specified mutual funds
The said category includes such mutual funds whose allocation to equity shares of domestic companies is more than 35% but less than 65%.
If you held your investments in such non-equity-oriented funds for more than 36 months, your capital gains would be taxed at 20% with the benefit of indexation (which reduces the capital gains tax payable), or at 10% without indexation if the units are unlisted which ever is more beneficial to investor . Here, 36 months was considered as the cut-off time for such investments to be considered ‘Long-Term’. However, holding such investments for less than 36 months would attract tax at a rate based on the tax slab your total income fell under.
- No single factor is enough when considering a mutual fund, a combination of all relevant aspects need to be considered.
- Generally, pick funds that fit your risk-reward profile, your investment objective and the time horizon you’re willing to invest for.
- Consider the performance, tax impact and fee structure of the funds.
- Contact a financial advisor to understand more, including any tax implications and your risk / reward profile.