Tax treatment affects returns from life-cycle funds

Recently, a client approached financial planner Malhar Majumdar and said he wanted to invest in mutual funds that take care of asset allocation for the entire life cycle.

While Majumdar agreed with the basic principle that one should have schemes that change asset allocation with the age of the investor, he had reservations over tax treatment of these schemes under the debt category. He said such funds suited investors who were willing to bear the extra cost for convenience.

Mutual funds’ life-cycle schemes are in a structure called fund-of-funds (FoFs). In this, fund houses put investors’ money in their own schemes and not in securities (stocks and bonds) directly. ICICI Mutual Fund, Franklin Templeton, Birla Sun Life and IDFC have funds where a person can invest depending on his age and risk profile. The benefit: An investor does not have to keep rebalancing the portfolio on the basis of market movements.

 

In developed markets, such investing is quite a hit. A recent report from PricewaterhouseCoopers suggests fund houses need to come up with such products. Majumdar said the passively-managed New Pension Scheme (NPS) was a better option if someone wanted to pursue life-cycle investing.

What’s on offer: Franklin Templeton India offers these solutions under four plans. These include FT India Life Stage FoF 20s, FT India Life Stage FoF 30s, FT India Life Stage FoF 40s and FT India Life Stage FoF 50s Plus. “All these are plans of a single fund that has assets of around Rs 232 crore,” said Harshendu Bindal, president, Franklin Templeton Investments (India).

ICICI Prudential Mutual Fund offers these FoF through five plans. These being ICICI Prudential Advisor–Very Aggressive, ICICI Prudential Advisor –Aggressive, ICICI Prudential Advisor–Moderate, ICICI Prudential Advisor–Cautious and ICICI Prudential Advisor–Very Cautious. Birla Sun Life and IDFC have similar offerings. IDFC introduced this offering just seven months earlier.

Depending on the asset allocation, these funds can be compared to equity-diversified funds, balanced funds or debt funds. Fund houses said these products compared with other funds over the long term. For example, average returns from equity-diversified funds in the past five years have been 19.92 per cent (July 6). The Sensex delivered 19.30 per cent returns in the period.

FT India Life Stage FoF 20’s five-year returns are 19.27 per cent; ICICI Pru Advisor–Very Aggressive has given returns of 19.29 per cent in the period and Birla Sun Life Asset Allocation Aggressive has returned 20.79 per cent. Similarly, five-year average returns of balanced funds (equity-oriented) are 16.42 per cent. The life cycle-based FoFs have comparable returns, with ICICI Pru Advisor-Moderate returning the lowest (14.84 per cent) among the three funds.

Advantage: Based on an investor’s age, these funds provide an option to put money in schemes with different asset allocations, which is essential to life-cycle investing. A person in his 20s can go for an aggressive or a very aggressive fund and someone in the 50s can go for a conservative or a very conservative fund.

However, the funds do not offer automatic switching between plans. Chaitanya Pande, co-head of fixed income at ICICI Prudential, noted such switching was treated as redemption and had tax implications. “The choice rests with the customer,” said Pande.

If an investor had to shift between funds, it would attract capital gains tax and exit load. In an FoF, there is no such liability. Also, when a fund manager invests, he takes into consideration the cash level and the equity-debt ratio of each fund in the portfolio. The FoF is structured in such a way that the equity-debt ratio and the cash level of individual funds should not affect the overall mandated allocations.

The returns on FoFs, with category averages and benchmark, may be comparable, but taxation on redemption will eat into the returns, putting the funds at a disadvantage. The long-term capital gains tax (over one year) for debt is either a straight 20 per cent or 10 per cent with indexation. If an investor redeems within a year, gains are added to the investor’s income and taxed according to the applicable slab.