Mutual Funds: Eye on Hybrid Funds for Tax-Efficiency

Investment in hybrid funds has emerged as a suitable option, especially against the backdrop of the recently proposed amendments to the Finance Bill, 2023. From April 1, 2023, onwards, capital gains arising from debt-oriented mutual fund schemes will be treated as short-term capital gains, irrespective of the period of holding.  

While it may involve taking some additional risk, an investor can think about adding hybrid funds, with a gross exposure of over 65% to equities, to their investment portfolio to get incremental exposure to debt. This way, an investor can gain from tax efficiency, as they will be taxed as equity-oriented funds.

The taxation of capital gains for an equity-oriented fund, for an individual investor, in the short-term (holding period less than equal to 12 months), the capital gains are taxed at 15% (plus applicable surcharge and cess), as per the Income-tax Act (ITA), 1961. In the long-term (holding period greater than 12 months), the capital gains are taxed at 10% (plus applicable surcharge and cess) for gains exceeding Rs 1 lakh.

As the tax levied on the capital gains will be at the investor’s income tax rate for investments in debt funds on or after April 1, 2023, getting incremental exposure in debt via hybrid funds can be a better tax-efficient route.

Through investment in hybrid funds, an investor can allocate their assets to three different asset classes, namely: equity, debt and commodity.

Considering that these asset classes have a low or negative correlation between themselves, investment in multiple asset classes can aid in decreasing the volatility (a measure of risk) of the overall portfolio during periods of sharp movements in a single asset class. This non-linear relationship between the asset classes is the prime reason for opting for hybrid funds.

The selling of securities within a mutual fund portfolio is exempt from tax under Section 10(23D) of the ITA. Therefore, the re-balancing of portfolio between asset classes within a hybrid fund will not attract any tax as well. This makes asset allocation via a hybrid fund highly tax-efficient.

However, it remains crucial for an investor to assess risk tolerance levels before opting for a hybrid fund. It is important to note that as per the asset allocation, especially the exposure to equities, each hybrid fund differs from another.