Mutual Fund

Posted on by TeamGenus Asset Allocation, Investment, Mutual Fund, Risk

White Paper – Investment Plan

One of the parts of developing a comprehensive financial plan is the development of an investment plan. Investment Planning is the process of finding the right mix of investment option based on your future goals, time horizon, and risk profile. There are six steps that you should follow when you are developing your investment plan.

The Means to Invest

In order to even begin this portion of your financial plan, you must determine that you are ready to invest. In this step, you will determine if you are going to use the money for some good or service (spend it), or if you will invest or save the money.

Investment Time Horizon

In this step, you will be determining how long you plan to invest and when you will need the funds to meet your financial objective(s). You must decide, based on the time horizon of your objectives, among short-term investments, long-term investments or some combination. In this step, you are going to be determining what you will be saving for, which should give some indication of your time horizon.

Risk and Return

You will need to determine what your level of risk tolerance is. As the level of risk tolerance increases so does the potential for higher returns as well as larger losses.

Investment Selection

Based on 1, 2 and 3 above, investments should be selected to meet your goals. These investments must satisfy your time horizon and your risk tolerance.

Evaluate Performance

Once investments are chosen and expectations are established, the performance of your investments should be determined by comparing the actual realized returns against the expected returns. The returns should also be compared to a benchmark, such as the Sensex or Nifty index. In addition, the investments should be reevaluated to determine if they continue to meet your investment criteria.

Adjust Your Portfolio

Your portfolio should be adjusted to maintain your goals and your investment criteria. If your goals change, your investments should be reviewed to determine if they continue to meet your objectives.

Benefits of Investment Planning

 Investment planning helps you:

  • Generate income and/or capital gains.
  • Enhance your future wealth.
  • Strengthen your investment portfolio.
  • Save on taxes.

Investment Strategies – Passive vs. Active Strategy

Passive

Passive strategies do not seek to outperform the market but simply to do as well as the market. The emphasis is on minimizing transaction costs and time spent in managing the portfolio because any expected benefits from active trading or analysis are likely to be less than the costs. Passive investors act as if the market is efficient and accept the consensus estimates of return and risk, accepting the current market price as the best estimate of a security’s value.

A buy-and-hold strategy means exactly that – an investor buys fund or stock and basically holds them until some future time in order to meet some objective. The emphasis is on avoiding transaction costs, additional search costs, and so forth. The investor believes that such a strategy will, over some period of time, produce results as good as alternatives that require active management whereby some securities are deemed not satisfactory, sold, and replaced with other securities. These alternatives incur transaction costs and involve inevitable mistakes.

Active

An active strategy involves shifting sector weights in the portfolio in order to take advantage of those sectors that are expected to do relatively better and avoid or de-emphasize those sectors that are expected to do relatively worse. Investors employing this strategy are betting that particular sectors will repeat their price performance relative to the current phase of the business and credit cycle.

Most of the Mutual funds in India are actively managed. The goal of active management is to beat a particular benchmark. Because the markets are inefficient, the anomalies and irregularities in the capital markets are exploited by the active fund manager. Prices react to information slowly enough to allow skillful investors to systematically outperform the market.

Building an Investment Portfolio

Asset Allocation

Investors often consider the investment decision as consisting of two steps:

  1. Asset allocation
  2. Fund selection

The asset allocation decision refers to the allocation of portfolio assets to broad asset markets; in other words, how much of the portfolio’s funds are to be invested in stocks, how much in bonds, money market assets, and so forth. Each weight can range from zero percent to 100 percent.

The asset allocation decision may be the most important decision made by an investor.

The rationale behind this approach is that different asset classes offer various potential returns and various levels of risk, and the correlation coefficients may be quite low.

Portfolio construction involves the selection of securities or mutual funds to be included in the portfolio and the determination of portfolio weights. The Modern Portfolio theory provides the basis for a scientific portfolio construction that results in efficient portfolios. An efficient portfolio is one with the highest level of expected return for a given level of risk or the lowest risk for a given level of expected return.

Asset Classes

Portfolio construction begins with the basic building blocks of asset classes, which are the following major categories of investments:

  • Cash (or cash equivalents such as money market funds)
  • Stocks
  • Bonds
  • Real Estate (including Real Estate AIF)
  • Commodity, bullion or others

Each investor must determine which of these major categories of investments is suitable for him/her. The next step is to determine which percentage of total investable assets should be allocated to each category deemed appropriate.

Risk Reduction in the Portfolio

Diversification

One has to remember that no investment is Risk-free. Every investment has the potential gain as well as losses. The diversification is not a guarantee against any potential loss. Based on your goals, time horizon, and tolerance for volatility, diversification may provide the potential to improve returns for that level of risk.

A diversified portfolio is built by a judicious mix of assets—stocks, bonds, cash, or others—whose returns haven’t historically moved in the same direction, and to the same degree. This way, even if a portion of your portfolio is declining, the rest of your portfolio, hopefully, is growing. The intention of using this strategy is that the loss incurred due to the negative performance of a particular asset class is partially or wholly offset by gains via the positive performance of another asset class. Another important aspect of building a well-diversified portfolio is that you try to stay diversified within each type of investment.

Modern Portfolio Theory

Covariance is a measure of the co-movements between securities returns used in the calculation of portfolio risk. We could analyze how security returns move together by considering the correlation coefficient, a measure of association learned in statistics.

As used in portfolio theory, the correlation coefficient is a statistical measure of the relative co-movements between security returns. It measures the extent to which the returns on any two securities are related; however, it denotes only association, not causation. It is a relative measure of association that is bounded by +1.0 and -1.0, with

Pi,j = +1.0, perfect positive correlation

Pi,j = -1.0, perfect negative (inverse) correlation

Pi,j = 0.0, zero correlation

With perfect positive correlation, the returns have a perfect direct linear relationship. Knowing what the return on one security will do allows an investor to forecast perfectly what the other will do.

With perfect negative correlation, the securities’ returns have a perfect inverse linear relationship to each other.

With zero correlation, there is no relationship between the returns on the two securities. Knowledge of the return on one security is of no value in predicting the return of the second security.

Rupee Cost Averaging

The systematic investment with mutual funds, along with consistent periodic new purchases of the mutual fund, creates risk reduction by creating a lower cost per unit owned over time. This is known as rupee cost averaging. This strategy allows one to take away the guesswork of trying to time the market. You invest a fixed amount of money at a regular interval, regardless of whether the market is high or low. By doing so, you buy fewer units when the prices are high and more units when the prices are low. Because rupee cost averaging involves regular investments during periods of fluctuating prices, you should consider your financial ability to continue investing when price levels are low. However, this approach reduces the effects of market fluctuation on the average price you pay for your shares. Additionally, it helps you maintain a regular investing plan.

Conclusion

Even the best-laid investment plan will fail if you can’t control your behaviour.  That’s one of the biggest reasons for keeping your disciplined investment strategy as simple as possible.

It’s much easier to control how you behave with a simple strategy since you won’t be tempted to jump in and out of the market or find the next best investment trend.  And basing your decisions on complex and structured products won’t keep you in your plan when turmoil hits.

There is enough statistical evidence to suggest that if you invest regularly for a long term, your money will grow on a consistent basis.

References

  1. Investments: Analysis and Management by  Charles P. Jones

  2. US SEC
Posted on by TeamGenus Asset Allocation, Black-Litterman Model, Reverse optimization

White Paper – Asset Allocation

“Don’t Put All Your Eggs in One Basket”. It means don’t risk everything all at once. If you had a certain number of “eggs”, it would be safest to put those eggs in different “baskets” and not “put them all in one basket”. To “put all your eggs in one basket” would be to risk losing all of your “eggs” in case you drop that one “basket”.

Even if you are new to investing, this old adage explain you the most fundamental principles of sound investing. If that makes sense, you’ve got a great start on understanding asset allocation and diversification.

Studies have shown that proper asset allocation is more important to long-term returns than specific investment choices or market timing. Asset allocation means diversifying your money among different types of investment categories, such as stocks, bonds, and cash. The goal is to help reduce risk and enhance returns.

The process of determining asset mix in your portfolio is a personal choice. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.

Time Horizon – Your time horizon is the expected number of months, years, or decades you will be investing to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable ups and downs of our markets. By contrast, an investor saving up for a teenager’s college education would likely take on less risk because he or she has a shorter time horizon.

Risk Tolerance – Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favour investments that will preserve his or her original investment. Check your risk tolerance here.

The two most commonly used terms when referring to asset allocation are strategic and tactical asset allocation.

Strategic (or neutral) asset allocation refers to the neutral asset allocation that aims to achieve the investor’s long-term investment objectives. It is based on the longer-term risk and return outlook for the asset classes.

Tactical (or dynamic) asset allocation aims to take advantage of perceived inefficiencies in asset pricing in the short-term. The deviation from the Strategic asset allocation is done with the aim to enhance returns in the shorter term. The decision rule that defines how the Tactical asset allocation is implemented could be different for each investor.

Every investor or portfolio has a Strategic asset allocation that is used to model the returns that the investor is likely to achieve in the long-term.

Based on data since 1997 and Risk Tolerance level, we have created five model strategic asset allocations using reverse optimization process through gradient quadratic programming method of Nobel laureate William F. Sharpe.

  1. Conservative Asset Allocation – Equity: 1.6%, Debt: 79.1%, cash: 19.3%
  2. Moderately Conservative Asset Allocation – Equity: 6.4%, Debt: 93.6%, cash: 0.00%
  3. Moderate Asset Allocation – Equity: 23.9%, Debt: 76.1%, cash: 0.00%
  4. Moderately Aggressive Asset Allocation – Equity: 33.9%, Debt: 66.1%, cash: 0.00%
  5. Aggressive Asset Allocation – Equity: 44.0%, Debt: 56.0%, cash: 0.00%

You can check these models here.

We use another reverse optimization model – Black Litterman model to arrive at the tactical asset allocation. Though Nobel laureate Harry Markowitz’s mean-variance optimization is one of the cornerstones of modern portfolio theory and has become the dominant asset allocation model. However,

  1. Mean-variance optimization is very sensitive to the estimates of returns, standard deviations, and correlations. Of these three inputs, returns are by far the most important and, unfortunately, the least stable.
  2. Input sensitivity indicates that the model’s output (the asset allocations) changes significantly due to small changes in the input (the capital market assumptions). Input sensitivity causes mean-variance optimization to lead to highly concentrated asset allocations.

The Black-Litterman model was created by Fischer Black and Robert Litterman. The Black-Litterman model enables investors to combine their unique views regarding the performance of various assets with CAPM market equilibrium returns in a manner that results in intuitive, diversified portfolios. More specifically, the Black-Litterman Model combine the subjective views of an investor regarding the expected returns of one or more assets with the CAPM market equilibrium expected returns (the prior distribution) to form a new, mixed estimate of expected returns (the posterior distribution).

The CAPM market equilibrium returns are calculated using the reverse optimization technique described by Sharpe. You can see the tactical asset allocation area graph based on risk tolerance here.

Our five-step asset allocation process:

  1. Establish a Strategic (long term) allocation
    1. You need to know the Risk Tolerance Score
    2. And to align with one of the five Market Portfolios based on risk tolerance
    3. Market portfolios are your reference point for monitoring deviation from your risk profile.
  1. Shift your asset allocation away from strategic allocation only when there are “valuation” opportunities:
    1. When one asset class is extremely undervalued relative to competing asset classes
    2. When we can make high-confidence assessments of the impact of cyclical factors that might enhance or detract from such opportunities
  1. Analyse and choose actively managed mutual funds, and in some cases Exchange Traded Funds (ETF), to implement your asset allocation. Use the Fund Screener to select the top-rated Schemes. Choosing more schemes leads to greater diversification, but avoid unnecessary diversification. Eliminate any schemes you do not want to own for any reason; however, you should keep at least 20 schemes in an effort to properly manage risk.
  1. Hold for at least One year – For better Tax Efficiency
    1. In our opinion, it is a better idea to keep your investment for approximately one year. This to maximize your after-tax returns; therefore, holds the gains for more than a year to become long-term, and book any losses before the one year holding period is reached.
  1. Go Back to Step 1
    1. Once you have sold any gains and any losses, select and purchase a new portfolio by following step 1 to 3.

Conclusion

The greatest asset allocation strategy won’t work if you can’t control your behaviour. That’s one of the biggest reasons keeping your disciplined investment strategy as simple as possible. The truth, that long-term investing after fees and taxes beats active wealth management, is hard to accept.

It’s much easier to control how you behave with a simple strategy since you won’t be tempted to jump in and out of the market or find the next best investment trend.  And basing your decisions on complex and structured products won’t keep you in your plan when turmoil hits.

Attachment

  1. Reverse Optimization aa_gradient_tgblog
  2. Black-Litterman Model aa_bl_tgblog

Acknowledgment (For idea, content, formula and calculation)

  1. http://www.blacklitterman.org and the reading list published on the website.
  2. Macro-Investment Analysis by William F. Sharpe

  3. Financial Modeling by Simon Beninga

Posted on by Devesh Deepak Bonds, Mutual Fund, Risk

Deciphering Bond – 2

In a country like ours, the bank fixed deposits and government sponsored products like Tax-free bonds, PPF and Post office schemes created an illusion that Debt is risk-free. This is a bit surprising because there were numerous defaults in NBFC FDs, Company deposits, RNBC deposits and chit funds in last two-to-three decades but every such default only strengthens the views that the government sponsored product are high in security and returns and what’s the need to invest in other debt products.

There is another counter view which is gradually catching the imagination of investor is Debt mutual fund. The AUM (Asset under management) of Debt schemes in the Mutual fund industry stands at over Rupees Ten lakh crore as on September 30, 2016. Often there is a great deal of discernment about an investment avenue that brings clueless investors down the wrong path. Investors also have such beliefs for Debt funds that could be partly true at best and misleading at worst. Here we will try to decipher risk associated with investment in Debt, which is equally true for debt mutual funds.

No market-related investment is risk-free, be it equity or debt. While debt funds are not as risky as equity funds, they are not without risks either.

The two prime risks in a debt instrument are the interest rate risk and credit risk.

Interest Rate Risk

Interest rates and bond prices carry an inverse relationship; as interest rates fall, the price of bonds generally rises. Conversely, when interest rates rise, the price of bonds tends to fall.

Let’s assume you purchase a bond from Company ABC. Because bond prices typically fall when interest rates rise, an unexpected increase in interest rates means that your investment could suddenly lose value. If you expect to sell the bond before it matures, this could mean you end up selling the bond for less than you paid for it (a capital loss). Of course, the magnitude of change in the bond price is also affected by the maturity, coupon rate, call option, and other characteristics of the bond.

One common way to measure a bond’s interest rate risk is to calculate its duration.

In general, short-term bonds carry less interest rate risk; less responsive to unexpected interest rate changes than long-term bonds are. This implies that short-term bonds carry less interest rate risk than long-term bonds.

Credit/Default Risk

Credit risk is the likelihood that a bond issuer will not make the interest payments or principal repayment to its bond-holders. It means the issuer may default. All bonds, except for those issued by the government, carry some credit risk. This is one reason why corporate bonds almost always have a higher yield than government bonds.

While the definition of credit risk may be straight forward simple, measuring it is not.  Many factors, like a business loss, poor cash flows, change in business environment, country’s socio-political situation etc can influence an issuer’s credit risk and in varying degrees.

Rating agencies like CRISIL, ICRA, Moody’s and Standard & Poor’s analyse bond offerings in an effort to measure an issuer’s credit risk on a particular security. Their results are published as ratings that investors can track and compare with other issuers.

These ratings range from AAA (the most secure) to D, which means the issuer is already in default.

Rating downgrades generally come from rating agencies. A downgrade from any one of them is a major signal that an issuer is more likely to default on its debt. If a bond is downgraded to a level below investment grade (aka, “junk”), there is often a serious sell off of those bonds, because most institutional investors are forbidden from owning junk bonds.

Ratings have a large influence on the demand for a security. Downgrades (or even rumours of downgrades) tell investors that a security is now believed to be riskier, which may have a negative impact on the security’s price. In turn, downgrades often lead to less trading activity and lowered liquidity.

Other Risks

a) Reinvestment Risk

Reinvestment Risk is the likelihood that an investor won’t have the opportunities to reinvest income streams from the Bond at a rate equivalent to the Bond’s present rate of return

For example, consider a Company ABC bond with a 10% yield to maturity (YTM). In order for an investor to actually receive the expected yield to maturity, she must reinvest the interest payments she receives at a 10% rate. This is not always possible. If the investor could only reinvest at 8% (say, because market yield fell after the bonds were issued), the investor’s actual return on the bond investment would be lower than expected. This risk becomes more pronounced if issuer has the call option to retire the bond before the maturity.

b) Inflation Risk

Inflation risk also called purchasing power risk, is the likelihood that the returns from the Bond won’t be worth as much in the future on account of changes in purchasing power because of inflation.

For example, Rs.1,00,000 in bonds with a 10% coupon might generate enough interest payments for a retiree to live on, but with an annual 5% inflation rate, every Rs.10,000 produced by the portfolio will only be worth Rs.9,523 next year and about Rs.9,070 the year after that. The rising inflation means that the interest payments have less and less purchasing power. And the principal, when it is repaid after several years, will buy substantially less than it did when the investor first purchased the bonds.

Inflation-indexed bonds were designed to provide a hedge against rising prices or inflation. They attempt to address this risk by adjusting their interest rate for inflation to prevent changes in purchasing power.

c) Liquidity Risk

Liquidity risk is concerned with an investor having to sell a bond below its indicated value, the indication having come from a recent transaction. Liquidity refers to how deep or liquid the market is for a particular security. If the market is deep, an investor can purchase or sell a security at current prices.

The risk that investors may experience issues finding a purchaser when they need to sell and might be compelled to sell at a significant rebate to market value. Liquidity risk is greater for thinly traded securities such as lower-rated bonds, bonds that were part of a small issue, bonds that have recently had their credit rating downgraded or bonds sold by an infrequent issuer. Bonds are generally the most liquid during the period right after issuance when the typical bond has the highest trading volume.

Posted on by Devesh Deepak Bonds, Risk

Deciphering Bond

In the annals of Investment folklore there is an old saying, if you want to make the most money, you should invest in stocks. But if you want to keep the money you made in stocks, you should invest in bonds.

We always consider Bonds as the most important asset class though it also has the lowest expected rate of return. Bonds are largely regarded as being lower-risk investments than shares, which is why they’re so popular with big institutions such as Banks, Provident Funds, Insurance and pension funds.

Bonds are important as they are a better indicator of wider macro signals and risk measures, rather than shares. Bonds and especially government securities tend to react very quickly to the macroeconomic signals and risk measures. Equity markets try to remain ahead of any earning and the economy uptrend; that is, they’re probably about six months ahead of any data indicating an economic recovery. Equities, in particular, can be very volatile and sometimes share prices are moved by factors that have nothing to do with interest, inflation or GDP growth rates, or economic/business cycles.

Basic Things to Know About Bonds

A bond is a type of investment that represents a loan between a borrower and a lender. With bonds, the issuer promises to make regular interest payments to the investor at a specified rate (the coupon rate) on the amount it has borrowed (the principal amount) until a specified date (the maturity date). Once the bond matures, the interest payments stop and the issuer is required to repay the face value of the principal to the investor.

Because the interest payments are made generally at set periods of time and are fairly predictable, bonds are often called fixed-income securities.

Maturity

The maturity date of a bond is the date when the principal or par amount of the bond will be paid to investors, and the company’s bond obligation will end.

Bonds often are referred to as being short-, medium- or long-term. Generally, a bond that matures in one to three years is referred to as a short-term bond. Medium or intermediate-term bonds generally are those that mature in four to 10 years, and long-term bonds are those with maturities greater than 10 years.

 Not all bonds reach maturity, even if you want them to. Callable bonds are common: They allow the issuer to retire a bond before it matures. Call provisions are outlined at the time of issuance of the bond itself.

Coupon

A bond’s coupon is the annual interest rate paid to the bondholder, generally paid out annually or semi-annually on individual bonds. The coupon is always tied to a bond’s face or par value and is quoted as a percentage of par values. It is also referred to as the coupon rate, coupon percent rate and nominal yield.

Bonds that don’t make regular interest payments are called zero-coupon bonds. As the name suggests, these are bonds that pay no coupon or interest. Instead of getting an interest payment, you buy the bond at a discount from the face value of the bond, and you are paid the face amount when the bond matures.

Yield to Maturity (YTM)

Yield to maturity (YTM) is the most commonly used yield measurement. The yield to maturity (YTM) is a very meaningful calculation that tells you the total return you will receive by holding the bond until it matures. YTM equals all the interest payments you will receive (assuming you reinvest these interest payments at the same rate as the current yield on the bond), plus any gain (if you purchased the bond at a discount) or loss (if you purchased the bond at a premium) on the price of the bond. YTM is useful because it enables you to compare bonds with different maturity dates and coupon rates.

Coupon vs YTM

Fluctuations in interest rates usually have the biggest impact on the price of bonds – interest rates can be affected by many things, including a change in inflation rates. Generally speaking, bond prices move inversely to interest rates because the coupon rate usually remains constant through to maturity. If current interest rates are higher than the coupon rate, the bond is less attractive to investors and drops in value, since investors aren’t willing to pay as much for a series of lower coupon payments. Bond prices increase when the coupon rate is higher than current interest rate levels. To an investor who holds bonds through to maturity, price fluctuations may seem irrelevant.

Let us assume that a bond has a face value of Rs 100 with an 8% coupon rate. A coupon rate or nominal yield indicates that if you hold a bond from issuance to maturity, you are expected to receive the amount equal to the coupon rate every year and par value at maturity. This means that the investor will earn Rs 8 per annum on each bond he invests in.

Scenario1: Interest rates rise to 10%. Even so, the investor will continue to earn Rs 8 that is fixed and will not change. So to increase the yield to 10%, which is the current market rate of interest, the price of the bond will have to drop to Rs 80.

Scenario2: Interest rates fall to 6%. Again, the investor will continue to earn Rs 8. This time the price of the bond will have to go up to Rs 133.

Duration

The maturity of the bond matters. The greater the maturity – the longer the life of the bond – the stronger the effect with regards to gains and losses is of interest rates in the economy.

To estimate how sensitive a particular bond’s price is to interest rate movements, the bond market uses a measure known as duration.

Duration is a weighted average of the present value of a bond’s cash flows, which include a series of regular coupon payments followed by a much larger payment at the end when the bond matures and the face value is repaid.

If you know how to calculate the present value of the future cash flows, you will very well calculate the duration of the bonds. As an investor, it is good to know the calculation but it is better to understand the relationship among price, yield and modified duration of a bond.

            ΔP = – MD * ΔY

where,

Modified duration = Duration / (1 + yield)

P = Price

Y = yield

Let’s assume that modified duration of the bond is 3 years. So if the yield fell by 0.5%, the price would go up by 3 x 0.5% = 1.5%. If the yield rose by 0.5%, the price would fall by 1.5%.

Modified duration is a standard risk measure in bond fund management but it is important to remember that it is used only for small movements in yield.

Conclusion

Many people including legendary investor Warren Buffett has argued that bonds fail to protect investors’ purchasing power. When taxes and inflation are subtracted from bond returns, investors fail to gain wealth.

This is true if you hold your entire portfolio in cash or bonds, you run the risk of losing out to inflation. This is particularly a threat in the low-interest-rate environment. We don’t think bonds should be shunned. When held to maturity, bonds provide a consistent return of capital. Bonds also have low long-term correlations with stocks, making them a good diversifier. Bonds and shares are two important component of asset allocation and you can’t wish away any of them.

1 Comment Posted on by TeamGenus Mutual Fund, Tax

Tax Treatment of Mutual Fund Investments

Tax issues concerning Indian Mutual Fund:

Mutual Fund registered with SEBI and as such is eligible for benefits under section 10 (23D) of the Income Tax Act, 1961 to have its entire income exempt from income tax under the provisions of Section 10(35), this exemption does not apply to income arising on “transfer” (switching) of units of a mutual fund. The Mutual Fund receives all income without any deduction of tax at source under the provisions of Section 196(iv) of the Act.

By virtue of section 45 of the Wealth Tax Act, 1957, wealth tax is not applicable on  Mutual Fund and units held under the Schemes of Mutual Fund are not treated as assets within the meaning of section 2(ea) of the Wealth Tax Act, 1957 and are, therefore, not liable to Wealth-Tax.

Tax issues concerning Unit holders

I. Equity Oriented Funds – Tax Treatment of Investments

A.  Tax on income in respect of units
As per the section 10(35) of the Act, income received by investors under the schemes of any Mutual Fund is exempt from income tax in the hands of the recipient unit holders.

B. Dividend Distribution Tax:
By virtue of proviso to section 115 (R) (2) of the Act, equity oriented schemes are exempt from income distribution tax. As per section 115T of the Act, equity oriented fund means such fund where the investible funds are invested by way of equity shares in domestic companies (as defined under the Act) to the extent of more than sixty-five percent of the total proceeds of such fund.

C. TDS on the income of units:

As per the provisions of section 194K and section 196A of the Act, where any income is credited or paid on or after 1st April 2003 by a Mutual Fund, no tax is required to be deducted at source.

D. Tax on capital gains
i)  Long Term Capital Gains
Long term capital gains on transfer of units of equity oriented fund where security transaction tax is paid are exempt u/s 10(38) of the Act. However such long term capital gains arising to a company shall be taken into account in computing the book profit and income tax payable under section 115JB.

ii) Short term capital gains
Units held for not more than twelve months preceding the date of their transfer are short-term capital assets. Capital gains arising from the transfer of short-term capital assets being unit of an equity oriented scheme which is chargeable to STT is liable to income tax @ 15% under section 111 A and section 115 AD of the Act. The said tax rate is increased by the surcharge, if applicable.

iii) Securities Transaction Tax (STT)
As per Chapter VII of Finance (No. 2) Act, 2004 relating to Securities Transaction Tax (STT), as amended by Finance bill 2013 (section 98), with effect from June 01, 2013, the STT is payable by the seller at the rate of 0.001% on the sale of unit of an equity oriented scheme to the Mutual Fund.  The STT is collected by the Mutual Fund at the source.

With effect from 01st April 2008:

  • the deduction under section 88E of the Act has been discontinued, and
  • the amount of STT paid by the assessee during the year in respect of taxable securities transactions entered into in the course of business will be allowed as deduction under section 36 of the Act subject to the condition that such income from taxable securities transactions is included in the income computed under the head “Profits and Gains of business or profession”.

E. TDS on Capital Gains
(i) Resident Investors
As per Central Board of Direct Taxes (‘CBDT’) circular No.715 dated 8th August 1995, in the case of resident unitholders no tax is required to be deducted from capital gains arising at the time of redemption of the units.

(ii) For NonResident Investors
Long-term capital gains
No tax is deductible from the proceeds payable to nonresident investors from long-term capital gains arising out of redemption of units of an equity oriented fund.

Short term capital gains
As per Part II of the First Schedule to the Finance Bill 2010 {Clause 1 (b) (i) (C)}, the Mutual Fund is liable to deduct tax @ 15% on short-term capital gains. The TDS is to be increased by the applicable surcharge.

(iii) In the case of a Company
Other than a Domestic Company (foreign company, as defined under the Act):
Long-term capital gains
No tax is to be deducted from the proceeds payable to nonresident investors from long-term capital gains arising out of redemption of units of an equity oriented fund.
 
Short term capital gains
As per Part II of the First Schedule to the Finance Bill 2010 {Clause 2 (b) (vii)}, the Mutual Fund is liable to deduct tax @ 15% on short-term capital gains. The TDS will have to be increased by the applicable surcharge.

(iv) Foreign Institutional Investors (FIIs) (as defined under the Act): In the case of Foreign Institutional Investors (FIIs), no tax would be deductible at source from the capital gains arising on redemption of units in view of section 196 D (2) of the Act.

Retirement Benefit Plan, Unit Linked Insurance Plan, Equity Linked Savings Scheme: Tax benefits under section 80 C
The contribution made by individuals and HUFs in the above Plans / Scheme will be eligible for the deduction of the whole of the amount paid or deposited subject to a maximum of Rs.1,50,000/- under Section 80 C of Income Tax Act, 1961 as provided therein.

Rajiv Gandhi Equity Saving Scheme (RGESS)

The Rajiv Gandhi Equity Saving Scheme (RGESS) was launched after the 2012 Budget. Investors whose gross total income is less than Rs. 12 lakhs can invest in this scheme. Upon fulfillment of conditions laid down in the section 80CCG, the deduction is lower of, 50% of the amount invested in equity shares or Rs 25,000.

II. Other than Equity Oriented Funds – Tax Treatment of Investments

Tax issues concerning Unit holders

A. Tax on income in respect of units
As per section 10(35) of the Act, income received by investors under the schemes of Mutual Fund is exempt from income tax in the hands of the recipient unitholders.

B. Dividend Distribution Tax:
i) For Individual (Resident and NRI) and HUF:
As per section 115R of the Act, the dividend distribution is 25% plus surcharge. With effect from 1 October 2014, for the purpose of determining the tax payable, the amount of distributed income has to be increased to such amount as would, after reduction of tax from such increased amount, be equal to the income distributed by the Mutual Fund.

ii) For NonIndividual:
As per section 115R of the Act, income distribution tax shall be levied at 30% plus. With effect from 1 October 2014, for the purpose of determining the tax payable, the amount of distributed income has to be increased to such amount as would, after reduction of tax from such increased amount, be equal to the income distributed by the Mutual Fund.

C. TDS on income of units

As per the provisions of section 194K and section 196A of the Act, where any income is credited or paid on or after 1st April 2003 by a Mutual Fund, no tax is required to be deducted at source.

D. Tax on capital gains
(i) Long Term Capital Gains
Resident Unitholders
Any long term capital gain arising on redemption of units by residents is subject to treatment indicated under Section 48 and 112 of the Act. Long-term capital gains in respect of units held for more than 12 months is chargeable to tax @ 20% after factoring the cost inflation index or tax at the rate of 10% without indexation, whichever is lower. The said tax rate is to be increased by the surcharge, if applicable.

NonResident Unitholders
Under section 115 E of the Act, Long-term capital gains on transfer of unlisted units arising after April 01, 2012 will be subjected to the income tax at the rate of 10%. However, no benefit of Currency Inflation Indexation or the Cost Inflation Indexation is available. Long term capital gains on listed units will be taxable @ 20% After providing indexation. Tax rates are to be increased by the applicable surcharge.

FIIs
As per section 115 AD of the Act, long-term capital gains on the sale of units are to be taxed @ 10% and short term gains are to be taxed@ 30%. Such gains, in either case, would be calculated without indexation benefit as the first and second provisos to section 48 do not apply to FIIs by virtue of section 115 AD (3) of the Act. The applicable tax rates are to be increased by the applicable surcharge.

ii) Short Term Capital Gains
Units held for not more than twelve months proceeding the date of their transfer are short-term capital assets. Capital gains arising from the transfer of short-term capital assets will be subject to tax at the normal rates of tax applicable to such assessee.

E. TDS on capital gains
i) Resident Investors
As per Central Board of Direct Taxes (‘CBDT’) circular No.715 dated 8th August 1995, in the case of resident unitholders no tax is required to be deducted from capital gains arising at the time of redemption of the units.

ii)   for NonResident Investors
Long Term Capital Gains
As per Part II of the First Schedule to the Finance Bill 2010 {Clause 1 (b) (i) (D)}, the Mutual Fund is liable to deduct tax @ 20% on long-term capital gains.

Short Term Capital Gains
As per Part II of the First Schedule to the Finance Bill 2010 {Clause 1 (b) (i) (K)}, the Mutual Fund is liable to deduct tax @ 30% on short-term capital gains.

iii) Other than a Domestic Company:
Long Term Capital Gains
As per Part II of the First Schedule to the Finance Bill 2010 {Clause 2 (b) (viii)}, the Mutual Fund is liable to deduct tax @ 20% on long-term capital gains.

Short Term Capital Gains
As per Part II of the First Schedule to the Finance Bill 2010 {Clause 2 (b) (ix)}, the Mutual Fund is liable to deduct tax @ 40% on short-term capital gains.

(iv) FIIs:
In the case of Foreign Institutional Investors (FIIs), no tax would be deductible at source from the capital gains arising on redemption of units in view of section 196 D (2) of the Act.

 Cess and Surcharge:
The TDS is to increased by the applicable surcharge.

Certain common provisions for equity oriented funds and other than equity oriented funds

1. Double Taxation Avoidance Agreement (DTAA)
As per CBDT Circular No. 728 dated October 30, 1995, in the case of remittance to a  country with which a DTAA is in force, the tax is to be deducted at the rate provided in the Finance Act of the relevant year or at the rate provided in the DTAA, whichever is more beneficial to the assessee. For the unitholder to obtain the benefit of a lower rate available under a DTAA, the unit holder is required to provide the Mutual Fund with a certificate obtained from his Assessing Officer stating his eligibility for the lower rate.

2. Short-Term Capital Losses
As per section 94(7), if any person acquires units within a period of 3 months prior to the record date fixed for declaration of dividend or distribution of income and sells or transfers the same within a period of 9 months from such record date, losses arising from such sale to the extent of income received or receivable on such units, which are exempt under the Act, will be ignored for the purpose of computing his income chargeable to tax.

Further, as per Section 94(8), where additional units have been issued to any person without any payment, on the basis of existing units held by such person then the loss on sale of original units shall be ignored for the purpose of computing  income chargeable to tax, if the original units were acquired within 3 months prior to the record date fixed for receipt of additional units and sold within 9 months from such record date. However, the loss so ignored shall be considered as the cost of acquisition of such additional units held on the date of sale by such person.

3. Investment by Trusts:
Investment in units of the Mutual Fund rank as an eligible form of investment under section 11(5) and section 13 of the Act read with Rule 17C(i) of the Income Tax Rules, 1962 for Public Religious & Charitable Trust.

4. Higher TDS if PAN not available:
With effect from 01st April 2010, a new provision (section 206AA) has been inserted in the Act. As per this provision, any person entitled to receive any sum or income or amount, on which tax is deductible shall furnish his Permanent Account Number (PAN) to the person responsible for deducting such tax, failing which tax shall be deducted @ 20% or the prescribed rate, whichever is higher. The applicable surcharge, education cess, and secondary & higher education cess will also be deducted from such amount of TDS.

4. Wealth Tax
Units of Mutual Fund are not covered under the definition of ‘assets’ under section 2(ea) of the Wealth Tax Act, 1957, and hence the value of investment in units is completely exempt from Wealth Tax.

5. Gift Tax
The Gift Tax Act, 1958 has abolished the levy of Gift Tax in respect of gifts made on or after 1st October 1998. Thus, gifts of units on or after 1st October 1998 are exempt from Gift Tax. Further, subject to certain exceptions, gifts from persons exceeding Rs.50,000/- are taxable as income in the hands of donee pursuant to section  2(24)(xiv) of the Act read with section 56(2)(vi) of the Act.