With 20% short-term capital gains tax and 12.5% long-term capital gains tax, the difference in tax rates is now 7.5%, which was 5% earlier (with 15% STCG and 10% LTCG).
As a result, PMS funds now need to maintain an alpha of 2% to 4% annually over mutual funds only to match post-tax returns.
“If a mutual fund returns 12% a year, for an equivalent post-tax return, a PMS needs to return 13.97%. If a mutual fund returns 15%, the PMS has to make 17.53%. This is based on the assumption of 100% short-term gains in PMS, and that all taxes on capital gains and dividends are removed from the portfolio each year,” Krishna Appala, Senior Research Analyst, Capitalmind Research, told ET Markets.
Mutual funds already had a tax advantage over PMS schemes even before the Budget, but now the gap has widened.However, many PMS funds have historically outperformed mutual funds by a significant margin, often delivering much higher delta in return. When seen on a 10-year timeframe, PMS schemes have given excess returns than mutual funds, according to a study by PMS Bazaar. PMS investment approaches were found to have outperformed their benchmarks by an impressive 70% on average across all timeframes and categories, while MFs managed a respectable 48%.”For example, if a mutual fund yields a 20% return, a PMS might achieve around 35%. After accounting for the increased tax, PMS returns still tend to be superior compared to mutual funds. This suggests that despite the higher tax burden, the overall returns for PMS clients can remain favorable,” said Hemant Shah, Fund Manager at Seven Islands PMS.The difference, he says, lies in the portfolio structure: mutual funds distribute wealth, while PMS concentrates wealth which leads to higher returns.
ArunaGiri N, Founder CEO & Fund Manager, TrustLine Holdings, points out that if the PMS strategy is long-term focused with lower churn and higher holding period, the increase in STCG is unlikely to impact their returns.
βOf course, it limits their ability to look at tactical opportunities to enhance the overall returns on the margin. Having said that, this move is certainly negative for momentum based short-term focused PMS strategies with shorter holding period and higher churn. Such strategies will find it difficult to compete with mutual funds on post-tax returns basis,β he says.
In Trustlineβs value focused long-term fund, the churn is less than 10% and hence this STCG hike will not have a material impact on overall returns.
Capitalmind’s Appala says PMS fund managers typically engage in tax loss harvesting, strategically selling securities at a loss to offset gains, thereby minimising the overall tax liability.
Seven Islands PMS takes a balanced approach by allocating 75% investments in the long term, with the remaining 25% kept for short-term churning.
“The rationale behind this strategy is that while long-term stocks might not move for a year, we continue to hold them because we believe in their potential. However, the non-performance of blue-chip stocks can be offset by profits from short-term trades or churning within our portfolio,” Shah says.
Will the tax rules discourage HNIs from investing in PMS schemes?
“Higher taxes on long-term gains might be a deterrent, but the increase in short-term capital gains tax is acceptable for HNIs. Mutual funds, on the other hand, are tax saving that suits retail investors better. The tax structure for both investment vehicles is appropriate given their target markets,” says Shah, while arguing that the existing tax structure does not disadvantage the PMS industry, nor does it give undue advantage to the mutual fund industry.
(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)
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