Budgeting arbitrage into investor choices
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Every time people who have defined benefit retirement plans make rules for the market, their lack of understanding comes across clearly. Take people in the Ministry of Finance for instance, and then look at what subsequent Budgets have put in place. Not only is there arbitrage between asset classes on the definition of long term, there is arbitrage within an asset class too on the basis of which product you choose to buy. If tax policy is used to nudge behaviour, there is some serious malfunction in the Indian policy that is nudging in all the wrong directions and all the wrong products.
In India we answer the question, ‘How many years does it take for an asset to become long-term?’ in different ways depending on the asset. You have to hold equity for 1 year, real estate for 2 years and debt for 3 years for the profit made to become ‘long term’. This classification of assets is against Finance 101, since both equity and real estate are asset classes that cook slowly over time. They give their best performance over a long period of time. How long is long? Data analysis done by my colleague Kayezad E. Adajania (read it here) shows that it takes about a 7-year holding period to iron out volatility in equity. The thumb rule for real estate puts the cycle at about 10 years. Market-linked debt (as opposed to relatively fixed-return debt products such as bank deposits) as an asset class for retail investors is mostly used for short-term purposes for emergency funds, for near-term cash needs and for income generation. It would be more logical to make debt go long term at 1 year and keep a 5-year threshold for long term for both equity and real estate. At the very least, policymakers need to equalize the definition of long term across asset classes.
Worse, Budget 2018 is nudging investors away from mutual funds and towards equity unit-linked insurance plans (Ulips). The tax on long-term equity is applicable to direct equity and equity-oriented mutual funds, but not on equity-oriented Ulips. In terms of disclosure, transparency and retail invest friendliness, mutual funds are better than Ulips. For example, the mutual fund expense ratio includes all the costs, but Ulip expense ratio leaves out the mortality costs making the real returns lower. It is unclear why the government would want to direct retail money away from a better product to an inferior one. Why create arbitrage in the way somebody approaches equity?
Policy changes are slow and convincing babus that they don’t understand markets is an uphill task. Meanwhile, what should you do? Two things. One, rethink if you want to be in managed funds and consider shifting fully to exchange-traded funds (ETFs). Remember that managed funds carry ‘fund manager risk’ or the risk of wrong choices made by the fund manager. Till the time the long-term tax was introduced in equity funds, it was possible to exit from a poor-performing fund to buy a better performing one without a tax implication. Now, however, each time the investor shifts after a year, there is a tax to pay. This will eat into returns in hand post the expense ratios, of an average of 2% per year and the tax. Index funds or ETFs do not carry fund manager risk, since they replicate the index they are benchmarked to. They are also much cheaper, with costs down to 5 basis points in one ETF. As a long-term investor, you will need to do the math on what works for you—riding the ETF and facing lower returns than the managed fund investors or buying into the managed fund and getting your fund choice right.
Two, use the window uptill 31 March 2018 to rejig your equity portfolio. Profits made on equity and equity funds have been grandfathered till 31 January 2018. This means that your long-term capital gains as on that day are not taxed. In addition, if you book long-term capital gains, if any till 31March 2018, these will not be taxed. From today till the end of March, you have a window to rework your portfolio without there being a tax liability. Mutual fund portfolios tend to get bloated over time and also tend to get overexposed to a sub-category of funds. A portfolio clean-up is a good annual exercise anyway, but this year it is even more crucial to do the clean up before mid-March. Mid-March because you need time to sell and then buy again the funds that you choose. Choose wisely this time, for the tax on mistakes is now 10.4%. But remember, this is not a call to sell your entire portfolio, but to rejig it.
Monika Halan writes on household finance, policy and regulation. She is consulting editor Mint. She can be reached at firstname.lastname@example.org.